There’s been much brouhaha about people coming off interest-only loans of late. The Reserve Bank has voiced concern that almost $500 billion in interest-only mortgages (or 200,000 loans) are set to expire in the next few years – and that some people will be ill-equipped to start paying off their loan. The RBA estimates the median payment increase will be around $7000 a year.
Investor research company Moody’s has also warned that the number of missed mortgage repayments will increase in the next two years as borrowers convert from interest-only to principal and interest loans.
While it’s generally investors who are in IO loans, 1 in 4 are actually taken out by owner-occupiers, according to the Australian Securities and Investments Commission (ASIC). It’s these people who are most at risk. According to UNO Home Loans adviser Tian Liu, some owner-occupiers consider their interest-only loan repayments a bit like paying rent and don’t want to pay more. Others are convinced they can keep extending the interest-only loan period and never pay off debt – believing capital growth in their area will see them through. But, with house prices starting to drop across Australia, this strategy could now prove to be very risky.
If you are in this boat, have a chat to uno about your options. We’ve also laid them out below:
Many lenders will try to keep their customers and offer them a few options. One is to refinance to another interest only product which, from an investor’s perspective, could be the best option for tax purposes. With the Australian Prudential and Regulation Authority’s (APRA) tightening of regulations around interest-only loans in recent years, it’s not uncommon for lenders to stop rolling over interest-only loans. The other issue is, with a decline in property prices, lenders are more likely to want customers to start paying off their loans.
Pro: If you can get your lender to agree to it, this one’s the least hassle.
Con: You’re delaying paying off the principal on your loan and, in doing so, stretching out your mortgage, which might not be the best financial option – this is the reason many lenders won’t agree to it. Plus, regulatory measures introduced by APRA have made it increasingly difficult for borrowers to extend the IO period on their loans for another term.
With eight investment properties, including one commercial property in Sydney which hosts a cafe, Suzy had all her loans with Westpac Private Bank and says the bank got in touch with her at the start of this year to talk about her options. She’d already extended her interest only loan term a couple of times and was told that to extend them again was not an option.
With her current salary, Suzy knew she would struggle. Plus, with her daughter starting high school in 2019, she had increased school fees to consider.
“The bank suggested I sell a property or two but I didn’t want to,” she says. A more lucrative job came up at work and Suzy applied, moving into a role that provides commission and covers the cost of the principal she now has to start paying.
“I’m giving myself six months to see how things go and will re-evaluate at the start of next year,” she says. If she feels the financial burden is all too much, she will look at selling some assets then.
When your interest-only term has ended, you will most likely be switched automatically by your lender to a standard variable rate on a principal and interest loan. This means your repayments will rise. Despite paying a higher rate on an interest-only loan, you likely wouldn’t have been paying back the principal, so your repayments would have only had to cover the interest on the loan. Paying back the interest plus principal means your loan repayments will rise.
Pro: In order to keep you as a client, your lender might offer you a great P&I rate. It’s worth asking them or threatening to leave – you never know what they might come up with!
Con: If you’re automatically put on a standard variable rate by your lender, it’s unlikely to be the best rate on the market.
Shawn, a small business owner of GroceryGetter.com.au, realised he had about a year left on his two interest-only loans with AMP, so got in touch with his bank and had a chat. The bank had sent him a letter and said they would waive the $350 fee and offer a discounted rate if he switched. He found out there was a 50 basis point difference between his current loan and switching to a principal and interest loan (he used to work at AMP so is entitled to special rates).
He will actually be paying less on one loan once he switches to principal and interest. “Which is huge, right? 50 basis points cheaper and i’m paying off principal as well.” The only catch is he has to write a signed letter asking them to switch him over, and hasn’t got around to writing it yet. He plans to drop an extra $20,000 onto his two loans and his P&I repayment on the second loan will work out to be only $25 extra a month.
If your lender won’t let you extend your interest-only loan term, another option is to refinance to an interest-only loan with a different lender.
Online mortgage broker UNO Home loans can search through thousands of home loan options and find other lenders and rates suited to your needs. At the moment, owner-occupiers will have to meet certain requirements and you’re going to need a very strong case.
It all comes down to the policy of the bank. If you’re looking to do some construction and will have less cash flow as a result, or need cash out to renovate, this might get you over the line. Another good reason might be if you’re going on maternity leave or about to take carer’s leave, both of which will reduce your cash flow. Otherwise, lenders will be reluctant to extend the loan as it’s harder for the customer to service (afford) an IO loan overall than it is a P&I loan because your serviceability is calculated over the remaining principal and interest term.
Pro: You can continue to make interest-only repayments and keep your costs down.
Con: You need a very strong case to argue for another interest-only loan these days.
UNO customer and Queensland investor Bill* had 28 years left on an interest-only loan with NAB. He was able to refinance with Homeloans Ltd to another 28-year loan term with 5 years of that interest-only (leaving him with 23 years to pay off the principal). On the other hand, NSW-based owner-occupier Kevin* has a business loan with a big 4 bank and is trying to refinance to an IO with another big 4 bank but it is pretty unlikely he will be approved. He is 67-years-old and does not have a strong exit strategy.
With interest-only loans, borrowers often think they’re getting a better deal because they pay less per month and their repayments are 100% tax deductible. But paying off the principal part of your loan means you’re reducing the debt you owe to your lender. If you’ve just been on an interest-only loan for five years, you will switch to a 25-year principal and interest loan. However, to keep payments down, some lenders will let you switch to another 30-year loan term which, essentially, stretches out your repayments and may be more manageable.
Pro: You can potentially negotiate a better rate with a different lender, even if it means refinancing your loan over a longer period.
Con: Your repayments will increase as you will be paying back principal as well as interest. You’ll probably have to do more paperwork and pay government fees to discharge and register the mortgage.
Investment property owner Karl was on an interest-only loan for five years with Commonwealth Bank of Australia, making interest-only payments of approximately $1,780 a month. CBA wanted him to go on a principal and interest loan for 25 years, which would have meant making extra repayments of $767 a month. When he wasn’t able to extend his interest-only loan with that bank, he refinanced to a 30-year loan with St George in order to start paying back the debt on his loan. Because he extended his loan term, he actually reduced his payments by approximately $212 a month, which suited him well as he couldn’t afford to pay more than he was already paying.
If there is an affordability issue, you can speak to your lender about your struggles. They will ask for an update on your income, liabilities, dependent status etc. (If the lender is making any changes to the product you’re signed up to, they should be asking these questions anyway).
If a customer genuinely can’t afford their home loan repayments, the lender can look into hardship debts. They may extend the loan by 12 months to give you time to get your funds sorted. If that fails, the extra time will give you more time to sell the property if that’s the only option for you.
At the end of the day, it’s the lender’s responsibility to come up with a plan.
Pro: You get to keep your house and hardship doesn’t last forever – a few months to 12 months for example. You won’t go into default, so your credit rating won’t be affected.
Con: If you don’t let your lender know about your struggles and miss a few repayments, you’ll get letters and and threats from the bank about possibly losing your home. If you default on your repayments, it might affect your credit rating in some circumstances.
Patricia*, single, had an accident at work and was involved in a worker’s comp claim. This disrupted her household income and meant that she couldn’t make her home loan repayments for two months until she settled her claim. She contacted her lender and advised them of her situation and sought a repayment plan. Her lender was able to grant a repayment holiday (break from repayments) for three months. After that three month period, she started receiving income protection payments and was back on track with her repayments. By informing her lender of her situation prior to missing a repayment, Patricia avoided delinquency.
As much as lenders don’t like to force people out of their homes, another option for people who can’t afford to make their loan repayments and start paying off debt is to sell or downsize. Families go through ups and downs and unforeseen circumstances, such as ill health or injury, which can sometimes get in the way of a family and their mortgage.
But, UNO Home Loans adviser Tony says other people just want more money in their pockets: to pay less each month and to go out to restaurants and enjoy life more. In this situation, a lender is not going to extend an interest-only loan, especially when it’s in the borrower’s best interest to pay the loan down. What will you appreciate more in 30 years? Those countless plates of lobster thermidor or a sleeping in a house you can finally call your own?
Pro: If house prices have increased, you might make some money from the sale and save yourself from ruining your credit score.
Con: You lose the house you bought. If your goal is to own property, then you’re back to square one.
Even though you’ll get short-term gains paying off interest-only, paying down the principal on your loan (which means paying off your debt) is the more sensible option for many owner-occupiers. It gives you a safety buffer in case something unexpected happens, such as ill-health or injury, job loss, etc. It also holds you in good stead if house prices do drop across the country.