What happens when the Interest Only period expires on your investment property loan?

Investors with existing portfolio appreciate the importance of Interest Only (IO) loan on their portfolio. These IO loans not only reduce holding costs and enable investors to grow their portfolio, but also preserve the max tax deductibility of the interest repayments on the investment loans.

Generally the entire loan term is 30 years, with 5 year IO term plus 25 years of Interest and Principle term.

With the recent APRA policy changes, existing investors already experience squeeze on their serviceability to grow their portfolio. To make the matter even worse, these investors might face the challenges of holding onto their existing portfolio, or losing part of their portfolio. Here is why

1. Investors who built their portfolio pre APRA changes may not be qualified even for same loan under the new lending policies. Thus the possibility of refinancing is very limited.

2. Majority of existing investors relying on IO loan to manage their cash flow, however majority of IO loans only have 5 year term. Some loans are well into the 5 year term, or even close to the end of 5 year term.

3. What happens if an investor is unable to refinance to other lenders ( due to serviceability issue under the new lending policy), and the 5 year IO term comes to the end. This is what happens: these investors will have to pay Interest and Principle on a 25 year term. The monthly repayment could increase significantly.

Let’s use an example to illustrate the potential problem:

Tom, a property investor, has 5 investment properties, each property has $300k loan with 5 year IO term. He is paying 4.5% interest rate across his portfolio.

• He is currently paying $1,298/ for the $1.5 mil loan ($300k * 5 = $1.5 mil).

• At the end of the 5 year IO term, he unable to extend IO term with the same lender, he has to pay Interest and Principle at the same interest rate of 4.5%, on 25 year term, the repayment is $1,922/week
  
  
• The difference is $624/week ( $1922/wk - $1298/wk)

The $624/week extra repayment will make a huge impact on Tom’s life style.

In addition, Tom actually only has $1.5 mil loan. Lots of investors from major capital cities would easily have double the amount of loan, which will in turn have double the extra weekly repayment, a shocking $1248/week extra repayment.

Can you fork out extra $1,248 /wk extra cash on weekly basis? If not, speak to your banker, or your mortgage broker, or an invest savvy mortgage broker to review your current loan and portfolio before it too late.

It is better to be prepared than distressed.

 

Will the best solution for this scenario be to extend the loan to 30 years, consider possible fixed loans, move the loans to another bank, take on a second job, use the equity lease to weather the storm, demand a pay rise from your employer and reduce your spending?

 

The problem with extending the loan back to 30 years or moving to another bank (these are essentially the same solution) is that post APRA, many people simply don't qualify for the loans they've got. This means that you can't extend or refinance, unless you're willing to move to one of those few lenders that still have decent servicing profile (and are also at least 0.5% more expensive).

I've seen a number of scenarios where people are able to extend another 5 years, but that only leaves them open to a 20 year P&I period. If you think there's a payment shock for 25 years, the 20 year repayment is significantly worse.

My advice would be if you're intending to extend a 5 year IO period for another 5 years, do it as a refinance so you can avoid the 20 year P&I period. If you're facing down a 20 year P&I period in the near future, perhaps consider the merit of a strategy where you sell a property.

What many investors need to come to terms with however, is that eventually they'll have to start paying off debt. Perpetual IO terms simply aren't feasible anymore.

 

Is it a good idea to stop getting IO loans for us newbies who are only onto 2nd or 3rd IPs?
Should we just be going P+I so that we are covered if there ever was a crash and if we can't extend IO terms? Seems to be safest option for us since its the only way to guarantee we will own the property in 30 years, and we won't be caught out when IO terms expire?

 

I read about the mining town crashes just last night- properties bought for 550k in 2011, being sold for 135-200k this year. I expect Melbourne won't ever crash to this extent, as I think the overpriced properties would be hit first, (e.g. $1.5m+,) I don't think this could happen when buying sub 500k here, but still very scary.

 

Not if you have nondeductible debt. I would suggest going for IO loans as per normal. But just assume you cannot renew them (but do everything you can do)

 

A very relevant topic in the current environment. My broker is a magician and I am sure he'll find a way. But I hear what @Peter_Tersteeg is saying above, because of the stricter borrowing rules, we may not qualify for re-finance if we want to maintain the loan as an I/O. Would fixing the loan as an I/O for a few years delay the inevitable?

 

Not sure if this may answer your question but for one of my interest only loan, I was into my 2nd year and NAB only allowed me to fix the loan for the remaining time left only.

 

Fixing the loan means you lock in the interest rate for a period of time. If the loan type is I/O the bank will require the fixed rate period not exceed the remaining I/O period. If it does, then the I/O period will need to be extended to match. The process of extending that I/O period will depend on the banks policy at the time.

I've got one of my own loans as a good example of this. The property was purchased 3 years ago with a 5 year I/O period and I recently decided to fix for the next 5 years.

As there was only 2 years I/O left, the I/O period had to be extended to the end of the 5 year fixed period.

The loan is with the CBA. At the time (last November) their policy on I/O extensions under these circumstances was very easy, they did it without any real questions. I fixed at 4.09%, the 5 year rate increased significantly a few days later.

Had the loan been with the NAB, a new application would have been required, taking several weeks.to get approved. They would have required all my tax returns (being self employed), rental statements and loan accounts. Under these circumstances I probably would have requested the loan be switched to P&I and fixed at the same time - they can do this fairly efficiently.

 

If you have non deductible debt and deductible debt with the same bank and the IO deductible debt comes to the end of the IO period, rather than having a turn the IO into P&I, would you be able to negotiate with the bank to increase the amortisation of the non deductible debt?

Would the answer be different if the loans were/weren't crossed?

 

Interesting solution, but I don't think the banks systems would be able to cope with this. There is a logic to their policies, this would not be consistent with that logic.

 

agree with @Peter_Tersteeg , the door is not completely closed yet, but it is clearly closing. so act faster. nobody wants to sell part of the hard earned portfolio.

 

It’s definitely happening. My parents couldn’t refinance IO due to age/APRA, I had to bail them out with cash transfer to bring down LVR, they got 2 year IO instead of 5. Don’t know what going to happen when the 2 years are up, I’m putting aside some money just in case.

 

With all these comments from brokers about IO extensions coming to an end, mines end in about 2yrs.

I would like to consider extending it now.

But i would like to know, if anyone knows, how CBA would reassess my income.

What is the formula they use, as I would like to do an assessment myself to determine if I can keep extending IO?

Thanks, k.

 

It's not a simple formula. If you want to determine your current borrowing capacity, you need to contact a broker or the lender. Your complete financial circumstances will need to be taken into account.

 

I have IO loans with AMP, and have another 2.5yrs left. Anyone know what their position is in extending the IO period?

 

Well written article
This is all reality and is happening
Moved from less than $10k principal to $95k pm moved my cf+ to cf-
But the banks did say it is reviewable after 36mths

 

Great post and very relevant to the changes around lending. I myself recently extended an IO and couldn't get 5 years as I requested, settled for 3.

I would like to throw in some other thoughts on the numbers used in the OP.

Assuming all the properties were purchased at the same time and locked in at 4.5% for the 5 years...
5x375k properties (80% loan of 300k) may rent for $375/week so $1875 (more than the IO payments of $1298)
At end of 5yr term rent may be $425/w so $2125 and P&I payments kick in at $1922 (rent still more than repayments)
That extra $250 rent brings that original repayment jump of $624/w in P&I essentially down to an extra $374/w, still significant but usually a few other things may have happened over those 5 years...

The PPOR may have been paid down/off freeing up extra cash flow
Salary should have had slight increases
The portfolio has gone from $1.875m to $2.6m
You've been stashing the extra cash in an offset (the $577+ difference between rent and repayments is 150k+ over those 5 years)
Your LVR is much safer

Yes there are other management/maintenance costs I haven't included, but there are also many deductions not included, evens out, or may be better numbers.

I agree with the OP in that you must be aware and prepared for this, especially if heavily negative geared in Sydney etc. I just wanted to throw up another example to show that it can be much less of a hit when you factor in rental increases and growth and a more CF+ portfolio. Also wanted to say it would be very unlikely to have 5 loans come off IO at same time. A more realistic scenario would be 1 converting to P&I each year so instead of that $624/w increase it comes back to $125/w each time a property ends IO.

Thoughts?

 

I've extended 2 loans with CBA in the last month for another 5 years. Simply done over the phone no assessment.

 

It's not uncommon to have I/O periods come off st the same time.
When you purchase an inv property you refi for the equity release resetting the IO period and purchase loan same IO period.
If you have a portfolio of 8, maybe they aren't all aligned. For most investors equity was the thing holding them back pre apra, so they would refinance capital growth out of all their properties, resetting IO terms when growth allows, over most of their portfolio.