Loan Tip: Ticking Time Bomb of Interest Only Loans Expiring

Ticking Time Bomb of Interest Only Loans Expiring

As servicing tightens up and bank policies change I expect (and others) it to be much more difficult for people to renew the IO term of interest only loans in the future. This will probably be the case not only for owner-occupied loans but for investment loans too.



The problem

Someone with a large amount of debt will suddenly be hit with a large jump in repayments.

Example –

A person with

• $500,000 owner occupied debt, not deductible

• $1,000,000 investment debt, deductible.

If the interest rate is say 4.5% owner occupied and 5% investment, the interest only repayments will be:

$22,500 per year for the owner occupied
$50,000 per year for the investment
$72,500 in total


What will happen in 5 years’ time when both revert to PI?

PI will result in a higher level of repayments because each month you will be paying back principal of the loan together with interest. Over a 30 year period the amounts would be:

$30,396 per year for the owner occupied (assuming monthly x 12)
$64,416 per year for the investment
$94,812 in total


As you can see this is a big jump in repayments. But it will be worse than this because after 5 years the loan term will only have 25 years left, so we really should calculate the PI repayments over a loan term of 25 years.

$33,348 per year for the owner occupied (assuming monthly x 12)
$70,152 per year for the investment
$103,500 in total


So the repayments now are approx. $72,500 and the repayments in 5 years will be $103,500. That is a $31,000 increase which works out to be 42% more than what you would be paying now.


If you entered the loan before your loan terms on reversion to PI may be calculated on shorter remaining terms and this would increase the repayments even more.


Some say reverting to PI doesn’t matter as rents will have increased during this time. Hopefully, rents will increase over the next 5 years, but it would be unlikely they will increase by as much as 42%.


Others say it doesn’t matter because you will be paying down debt. It is a good thing to pay down debt but the extra cash flow could hurt people. Imagine those retired suddenly having to find an extra $30,000 or so per year to pay back to the bank. This could be enough to force you to work!


The main problem as I see it is that the repayment of the non-deductible debt will be delayed because funds will be diverted to the paying down of the investment debt. This will result in less tax efficiency which means more tax will be payable. In turn, this means less money to pay off the non-deductible debt. It could lead to debt recycling in reverse.


Add to this the effect on a macroeconomic scale. Probably about 95% of investors will not realise or forget their loans will revert to PI and of the 5% that do remember, I expect 95% of those will probably not plan for it. This could lead to a large number of people being suddenly hit with unexpected extra expenses.


This could ruin retirements for some and for others it could cause them to want to start selling one or more properties.


Plan for the year 2021.


What can you do to limit the effects or delay the inevitable?

1. Pay off your non-deductible debt within 5 years (or before your investment loans revert to PI).

2. Extend interest only periods as long as possible now – 10 years if you can.

3. Extend loan terms whenever you can.

4. Build up cash in offsets of IP loans where you have no non-deductible debt.

5. Pay IO on a PI loan perhaps, see Tax Tip 46: Want to Pay IO on a PI loan?

 

Thanks @Terry_w This is just the impact of IO to PI. On a time scale of 6 years, there might be other compounding factors requiring additional payments:

• Interest rates calculated at 4.5% and 5% for OO and IP respectively are on a RBA rate of 2%. The RBA rate will not remain on historical lows forever. Another 2% rise in interest rate will add 30,000 per annum to the 1.5 mil portfolio
  
• Banks might increase the variable rates on their own, or on external factors like:
  • Basel : Increased capital reserve ratios and more conservative risk calculators
  • Increased cost due to switch to longer term funding.
  • Downgrading of AAA rating of Australia or Australian Banks.
• There are at least 2 elections and an elimination/reduction of NG a strong possibility, although grandfathering might take the sting off a bit.

 

Could be alot of fire sales in the near future.

 

IO periods are great for increasing ones cashflow over the first few years of a property purchase. But I've always been cautious with them reverting to P&I loans with a shorter loan term after the IO period expires. This would drastically increase ones monthly repayments.

It seems the general response to an IO period ending has been to simply refinance the loan and start again. This has worked fine in the past.. But given today's lending climate is changing rapidly, with lending criteria and serviceability requirements really tightening. A simple refinance may not be so simple.

I've used LOC facility's for every IP I've purchased since 2003. I've never once had to stress about a refinance or IO period expiring as the loans only require only Interest payments over the life of the loan. The longest loan has been active since then.

There are drawbacks though. You do need to be disciplined to use LOC's. LOC's can create a tax nightmare if not used correctly.
Also fees and rates can sometimes be alittle higher, but these can be reduced or waived as you establish a relationship with the lender.

Just thought I'd share what I do to overcome IO terms expiring.

 

That is the worry one can have, with no income from a full time job.
Otherwise, I believe that sort of difference of 30k-40k can be offset by improving your pay income. I personally have achieved a 40K increase in pay in last 5years and have the ability to do the same in coming 5years.
However when I plan for future i always plan on my income 2 years ago.

 

Keen observation
Lawyers sharpen their pencils as apartment market turns

 

Hi wylie. What do you mean by IO period is 30 years?

 

Hi Connor. I thought LOC comes with its own risk, ie banks can demand full payments at anytime? I know this has never happened in the past (or at least, since in the last 10 years), however I would probably prefer the certainty for 5 years I/O rather than worrying about bank demanding full payments

 

LOC

 

Banks don't generally ask you to pay the loan in full, but they cancel any outstanding limit you might have at any time.

Who's the lender and what's the actual name of the product. The longest IO period I'm aware of is 15 years.

 

Westpac's Rocket products have a maximum IO period of 15 years. It's one of the more flexible products available.

Indefinite IO periods is specifically one of the things APRA has expressed concern about. About the only way to enjoy an IO period indefinitely is to refinance periodically.

You generally need to move to a different lender these days, as many existing lenders will simply extend the IO period but not the loan term. Thus a 5/25 IO to P&I loan becomes 10/20 IO to P&I loan. Renewing within the same lender only delays the problem making it worse. By moving to a new lender you can completely reset the loan term.

The easiest way to mitigate the risk of all this is to run your budgets on the assumption of a 30 year P&I loan, then use the savings during the IO periods to actually pay down debt into an offset account. The extra cash saved gives you a lot of options as an IO period expires, including lowing mandatory repayments if necessary.

None of this is a big deal if you prepare properly for it, which is something 99% of people won't do.

 

Equity Access Loan is Westpac's LOC product.

 

As servicing tightens this will be an issue for some that can't refinance back onto interest only.

How much we roughly talking here, how much difference will it make to your serviceability falling short to be able to just refinance PI.

Say you were maxed out on your serviceability, then in a few years time serviceability tightens again. Or use the last couple years as an example since changes have already taken place.

Thanks

 

You won't be able to extend IO periods if you are maxed out or can no longer service - with most banks.

 

Yes correct, but if you could increase your income that would mean your no longer maxed out with serviceability right?

How much additional income would you need to roughly earn, to not be maxed out with the new rules.
10k, 20k per year?

 

I'm talking about serviceability income, not equity.

 

That would entirely depend on the circumstances. impossible to answer as it would depend on total debt, lender, etc