Around 200,000 interest only loans, totalling $480 billion, are set to revert to principal and interest (P&I) by 2020, according to estimates by the Reserve Bank of Australia (RBA).
If you have one year left on your IO period, extending your term may not be an option for all borrowers so what steps can you take to prepare for the switch?
Why won’t the bank extend my interest only term?
The Australian Prudential Regulation Authority (APRA) is forcing banks to reduce interest only approvals because they ultimately want more borrowers to be paying down the principal, not just the interest, on their home loans.
The most common reason you’ll be declined is that you don’t meet the bank’s borrowing power or serviceability requirements, especially for interest only loans coming to the end of a 5-year term.
A lot can change with lending policies in 5 years.
Lenders apply higher interest rates and a higher assessment rate to interest only mortgages, and they also assess your borrowing capacity over the entire loan term minus the interest only period.
For example, for a 30-year loan term with a 5-year IO term, you will be assessed over a 25-year for the same loan amount.
This increases your mortgage repayments in their calculation, reducing your savings buffer and making you a higher risk to the bank than if you were to make P&I repayments over the life of the loan.
Want to know if you can extend your interest only term?
Our mortgage brokers can properly assess your situation and let you know whether you qualify so call us on 1300 889 743 or complete our free assessment form today.
A specialist lender may still be able to help
A specialist or non-conforming lender may still approve your interest only loan where a major bank declines your application.
You’ll pay a slightly higher interest rate, but it may be a cost worth bearing depending on your overall investment strategy.
Many of our customers who have decided to pay a higher rate with a non-conforming lender are typically at the early stages of building their portfolio with a 10-20 year plan.
For cash flow purposes, paying the higher interest rate may still be advantageous.
Conversely, it may not always be in your best interest to pay a high specialist rate for an interest only loan if you’re planning to sell the property in 3-5 years’ time.
Speak with your accountant and then give us a call on 1300 889 743 or fill in our online enquiry form. We can help you make the right decision when your interest only term is coming to an end.
Should I make the switch to P&I today?
Not qualifying for another interest only term is not the end of the world.
You may be better off making the switch to P&I now depending on your goals and investment strategy.
If you own one or two properties, you may better off switching to regular mortgage repayments now in order to get a lower interest rate.
It’s also beneficial if you plan to sell one of your properties soon because you increase your capital gains and return on investment by reducing the principal on your mortgage.
Alternatively, there may be greater tax benefits for borrowers with a long-term investment strategy to simply wait until the term ends. Ultimately, it will be better for your cash flow if you’re negative gearing.
Have a chat with your accountant or financial professional to calculate how much extra your mortgage repayments will be when your home loan switches.
Discuss with them the changes you may need to make to your financial situation to prepare for principal and interest repayments.
We can help refinance your home loan to a lender that has a lower P&I interest rate than what your bank is offering.
Build up your cash buffer
Whether it’s minor lifestyle changes or a major overhaul of your financial situation, using the next year or two to build your cash buffer is usually a smart move, especially if you’ve been aggressively pursuing a negative gearing strategy.
If you’re paying $5,000 a month interest only and you find out that your P&I repayments are going to be $8,000 per month, instead of taking that holiday or buying a new entertainment system, put that extra $3,000 aside.
A common strategy is to put those savings in an offset account so you’re offsetting the mortgage interest knowing that you can still access those funds if and when you need them.
Of course, increasing your income will improve your borrowing power and qualify with more lenders.
For example, you may be in a position to ask your employer for a pay rise or find a new revenue stream by getting a second job.
Can you increase your rent?
Reducing your spending and living expenses alone may not be enough to prepare for the switch back standard home loan repayments.
One possible solution would be to increase the rent on one or two of your properties but be warned.
Rents have remained relatively flat for the past 9-10 years, particularly in east coast capital cities where vacancy rates have been steadily increasing.
It’s all well and good to say that you want to increase the rent from $400 to $450 per week, but you risk losing a long-term tenant in a location with high vacancy rates. All for an extra $20 to $50 per week!
If you can find another tenant who is willing to pay an extra $50 per week, but it takes you two weeks to find that tenant, it will take you a total of 16 weeks to make up the lost rent.
On top of that, you’ll have to pay a letting fee, which can be upwards of $200. In this example, you’re really looking at about five months of paid rent to realise any benefit from raising the rent.
It’s certainly worth having the conversation with your property manager and undertaking your own market research but tread carefully.
Reduce and consolidate your existing debt
If you find that the switch from interest only to principal and interest will put you a tight financial position, you’ll want to look at reducing any high interest loans or credit card balances that you have.
Depending on your Loan to Value Ratio (LVR), a common solution is to consolidate your debt when reverting to principal and interest.
For example, if you have a $20,000 car loan paying $450 per month at 9.00% per cent per annum, you can consolidate this debt into your home loan at a rate of 4.00-5.00% per annum.
Debt consolidation can be a viable short-term solution to improve your cash flow but reducing your spending and building up your cash buffer by reducing your living expenses is usually the first logical step if P&I is looming.
Last resort: consider selling a property
If you own five or six properties and your predicting tight cash flow when your investment loans revert, you may want to look at selling one of your homes.
It’s important to consider current market conditions for your local area and use reliable data like Core Logic and Australian Property Monitors (APM) to make an educated decision.
Even if you’re in a healthy market, you also need to factor in the upfront costs of buying the property, any renovation and property maintenance works, and the costs of selling.
Most people choose to sell the property with the biggest difference between their rent income and their expenses. This will obviously have the biggest positive impact on your cash flow.
Alternatively, be prepared to hold onto the property longer than you expected and consider making extra repayments if you find that you’re in a market downturn.
Are you eligible to extend your interest only term?
If you’re coming to the end of your interest only term, speak with one of our experienced mortgage brokers about your situation and your future investment plans.
We can find the right home loan solution for your needs.
Call 1300 889 743 or fill in our online enquiry form today.