No need to fear IO2P&I if you have money in offset

Investors have repeatedly been warned that they could be forced to sell their IPs when their IO loans turn P&I at the expiration of the IO period if they can’t refinance due to stricter lending conditions. Well, there’s no need to panic if you have money in an offset account (linked, say, to a PPOR loan).

The idea is you can use this money in offset to pay the extra repayments caused by IO2P&I. As the resulting extra interest on the PPOR loan will be quite small it gives you a lot of valuable time before you have to sell, or even you may not need to sell at all.

Case study (only rough numbers provided here to illustrate the strategy, individual cases may vary). Say investor Bill has 2 loans:

• a PPOR loan, P&I @ 4%, with 50K in a linked offset account
• a 300K IP loan, IO @ 5% that converts after 5 years into P&I @ 4.5% for another 25 years.

At the end of the IO period, repayments on the IP loan jumps from $15,000 to $20,100 pa (an extra $5100 pa), a hit on cash flow that Bill can’t afford. Bill talks to a mortgage broker who tells him he won’t be able to refinance which means he could be forced to sell his IP asap.

Bill decides to pay this extra repayment by taking $5100 from his offset account, resulting in his PPOR repayments going up by $204 pa. He can easily afford this one!

A reduced offset account means Bill’s equity in the PPOR has dropped by $5100, however at the same time he has increased his equity in the IP by about the same amount as the P&I loan is now chipping his IP debt away.

Result:

• cash flow wise, Bill is only worse off by $204 pa
• equity wise, there’s a direct transfer of equity from the PPOR to the IP, meaning Bill’s overall assets remain mostly unchanged
• tax wise, the impact will be minimum
• with 50K in offset Bill has plenty of funds available to repeat this exercise next year and then for a few years more till his offset runs out, with the PPOR interest bill increasing by $204 every year.

So for a very small cost Bill is now free to sell his IP at the most favourable time of his choosing, and with luck his financial circumstances may improve enough in the following years (e.g. better salary, more savings, better borrowing environment,…) that he may even not need to sell.

For Bill the dreaded IO2P&I cliff has turned into a small bump on his investment journey.

Not advice.

 

when you look at it like that the effect is minimal isn't it.

What Bill could do instead is to pay down the PPOR loan by say $10k to $20k and split it and redraw this money and use it to pay the principal component of the investment loan. Bill wouldn't be worse off, but would probably be better off as the rate is likely to have dropped when going to IO.

No capitalising of interest involved.

But get tax advice as untested.

 

... and if the IO loan that is being forced to convert to P&I has a fully chocked Offset, then there is NO bump. The only change for the investor is that:

1. The investor’s debt level is slowly reducing.
2. The investor’s cash buffet (the Offset) is slowly being reduced.
3. The investor’s Net Worth is unchanged.

I never understood what all the hullabaloo was about with IO2P&I that some members on PC as well as the media kicked up.

If one borrows so much that your total ar$$e is exposed, then a million things could bring you unstuck and one probably deserves it .

@truong, thanks for the effort you made to explain this issue so clearly.

 

The problems can occur if enough people are overexposed and trying to sell into a market where no one is buying .
You only really need 3 or 4 things to go wrong around the same time frame and their losses are even greater , which in turn also depresses their asset value.

There are pretty good odds that negative gearing may soon disappear which also may help push down prices.

A sudden spurt in wage growth could see the RBA suddenly push up interest rates( although a low probability), but still a possibility.

If the Australian economy gets more bad news , the AUD may see some good falls, as all the other levers (RBA interest rates) have already been used.
Which also pushes up the cost of everything that is imported, including money.

In a worst case scenario how would the Sydney and Melbourne property markets handle neg gearing being axed , a 100 point rise in interest rates and the AUD falling down to the low 60s v USD ,(or even lower) all at the same time as many investors are being pushed from IO to P&I in 2019 and 2020.

 

... which will NEVER be a problem for an old-fashion B+H investor like me .

 

I thought there was an inherent assumption that only those investors who can't afford to repay the increased repayments due to IO2PI switch had the risk to be a forced seller. Isn't it quite obvious If one has cash in offset or anywhere the 'forced to sell' warning doesn't apply to them as they can afford to repay?

I think forced sale risk would be concentrated around high debt to income portfolio investors with IO loans set to expire in next three years and has not enough cash buffer to afford increased repayments till credit market normalises back or market recovers quickly.

I don't think there was a dispute on this.

The difference between PC posters was how many of such investors exists who can't afford to repay, The consensus amongst bulls is that there would be insignificant numbers who will be forced to sell. @Redom s model projects it will be 1% of total expiry,
and newbies like me think it will be much more (at least 10/15% of total expires), no data to back this just a hunch, as majority of those who could have would have switched by now due to penalising IO rates.

There is a total of 380 bn + 85 bn of new IO loans set to expire in next three years (excluding the preemptive switches like many on this forum did)

PS: the above assessment is based on assumption that Credit environment remains tight,
if credits are loosened all bets are off

 

I think you are missing the point. You don’t even need to have/use a cash buffer to fund the increased payments.

YOU JUST NEED TO MEET THE INCREASED PAYMENTS WHEN THEY COME DUE.

Taking @truong’s example above where the payments increase by $5,100 pa (or $100 pw), some of the options (in no particular order) are:

1. Sell some the “junk” around the house. My wife did this earlier this year on FB and raised over $5,000 in six months. Plenty more “junk” to go.

2. Rent out a room to a boarder for $100 pw.

3. Get a second job. Working 5 hours/week on the basic wage will do it. Most investors have the skill set to be an Uber driver, a delivery driver, a shelf-packer, ...

4. If partner is not working, partner gets a job (casual, part-time or even full-time).

5. If partner is working, partner gets a second job. Working 5 hours/week on the basic wage will do it.

6. Start a home-based and/or online business, especially if there is lead time before the loan converts.

7. Work some overtime.

8. ...

Being “forced to sell” should be the VERY, VERY last option as it destroys so much of one’s Net Worth (all the selling expenses for starters).

There are many far better options and I wouldn’t expect many will be forced to use this last option.

 

Most people can refinance though or have access to extension options. That is, of the 380bn, a much much smaller amount will be forced to pay P&I.

Then beyond that, a much much much smaller percentage of those borrowers who are forced P&I are at: high LVRs and little savings/buffers.

That leaves a very small portion of borrowers who are stuffed. That’s the 1% figure explained out at a high level.

While only a small minority would fall in this boat, a lot may choose to sell because they want to. This will be more than 1% of the 380bn. In macro terms...it’s a drop in the ocean though to overall supply levels.

 

You’d be surprised to know the number of people who read the news and believe The Cliff is going to make them bankrupt unless they sell. This was the reason I wrote the OP.

I was visiting a friend yesterday when he mentioned he was worried because 8 of his IPs were due to go P&I next year with 55K pa in extra repayments. He was convinced he was about to lose his portfolio. I tried to calm him down and asked how much offset he’s got. He looked stunned because he’d never thought of it. Turned out he had chunks of offset funds scattered around several banks totalling almost 500K.

For a seasoned investor like him to lose his nerve as he did is symptomatic of the confusion that is out there. The constant bombardment by the media about The Cliff and The Crash has warped his mind and I only provided a bit of balance and some practical suggestions.

That said, there are billions of $ sitting in people’s offset accounts that should affect the outcome tremendously and I’m all ears if someone could quantify it in an intelligent manner.

 

It is estimated that Australians will spend $51B on Christmas this year.

With a population of around 25M, this equates to $2,000 per man, woman and child.

The average household consists of 2.6 people.

So, on average, each household will spend $5,200 this Christmas.

Interestingly, this is exactly the same as the extra funds required in @truong’s original post .

 

I tried to look for an actual national offset accounts a while back with no luck but i did come around two articles that shed some light on the numbers and that are in agreement with @truong post.

Some Innovative Mortgage Data | Speeches | RBA

This article shows LVR data that accounts for offset accounts and that clearly shows that plenty of investors have good buffers. Whether it's enough buffers or not is a different story ...

Below article from 2015 says that offset accounts balance amounts to a figure of 90 B

Box E Offset Account Balances and Housing Credit | Statement on Monetary Policy – August 2015 | RBA

 

One could restructure the IO turned PI loans to extend the loan term to 30 years ( as with CBA), so that even though the loans become PI, the prinpicial amount for each loan is reduced.

 

....if you meet serviceability.

 

Interest Only lending is at its lowest in over a decade. The flow of new interest-only (IO) loans was only 16% of new residential term loans in the September 2018 quarter.

This graph from APRA speaks for itself.

 

I'd be curious to know what the rejection rate is at the moment re IO loans .

 

With brokers submitting loans they will not submit one that is likely to be rejected. If an IO loan is 'rejected' by a lender the IO term could be shortened or the IO changed to PI.

For my clients I'd say the rejection rate is 0.