Will Being Forced Out Of IO Repayments Destroy Your Portfolio?
Residential investors with interest only (IO) loans must address their lending options or face a dangerous refinancing situation once their initial IO periods end. Stricter measures introduced by the Australian Prudential Regulatory Authority in 2017 restrict IO loans to no more than 30% of new lending, leaving banks unable to simply extend IO repayment periods. For those who’ve financed investment properties during the past two to five years, many will struggle to refinance or be forced to move to principal and interest (P&I) repayments, with potentially significant impact on cashflow. With no other options, they may be forced to sell (despite their investment strategy) and potentially face hefty capital gains tax.
How could this happen?
Previously the strategy for many investors was to buy and hold with an interest only product, which minimised repayments and preserved cashflow. This allowed investors to gear up with only ‘tax deductible’ repayments across multiple investment properties. The IO period was often five years and when it expired, the investor simply extended the term or refinanced to another bank (along with cashing out equity for further investment). APRA’s 2017 changes meant this model was no longer scalable.
What are the options?
Investors with multiple properties on interest-only loans in their portfolios should immediately evaluate their situation. It’s essential to be aware of the IO expiration dates and whether they can afford the burden of moving to principal and interest repayments. Take the example of an investor who has borrowed $500K with a 30-year loan and 5 year IO period at 4%. The initial IO repayments of $1,667 per month will increase to $2,639 per month after 5 years (with P&I repayments). How would that impact your own cashflow?
Assess your serviceability
Investors must look at serviceability under today’s tighter lending restrictions to see whether they would be able to refinance IO loans elsewhere if required. As the impacts from APRA’s changes kick in, forecast ahead to what your serviceability will look like in subsequent years. If lending policy contracts further into the future, how will that impact your portfolio? Given investor loans have fallen at their fastest rate in 18 months, it’s fair to say APRA’s policies have served their intended purpose. This, however, doesn’t guarantee there won’t be more changes in the future.
Revisit your exit plan
Now is a good time to reassess your original investment exit plans. For many, plans will have to change as strategies such as ‘living on equity’ have been made redundant. Will you now need to sell some properties to ensure your cashflow is protected? It could be a good opportunity to sell down some poor performing assets in your portfolio, but issues like potential Capital Gains Tax need to be carefully considered.
Consider non-bank lenders
This new environment has seen the emergence of non-bank and non-conforming lenders, which can present a genuine lending solution for many. These lenders can often be more flexible for borrowers who are after IO lending. In some instances, these lenders offer finance where nobody else will, but this can result in higher upfront fees and/or interest rates.
Look at Principal and Interest options
All said and done there are benefits of moving to P&I, provided you can afford the additional repayments. P&I rates are generally lower, with the gap being typically anywhere between 0.2% and 0.6%pa. For some existing investors, there could be an even more significant discount in moving to a new lender, as long as there is sufficient serviceability. When paying down principal, investors are actually deleveraging and reducing risk exposure which is the ultimate goal of the APRA policy changes. With reduced principal also comes savings in interest costs over the life of the loan.
Whatever you are thinking of doing as a next step, now is the time to take action. Investors who’ve not thought ahead may already be in a difficult position with limited options. It’s best to get on the front foot now and work with your mortgage broker and accountant to workshop long-term scenarios. Positive action will ensure you have the most effective plan in place to overcome these new hurdles and safeguard your portfolio.
* Please note this post does not constitute financial advice and does not take into consideration your specific situation. Please seek specific advice before acting.