What are your options if your interest only term is expiring?

By October 23, 2019 November 13th, 2019 Mortgages

interest only expiry

Most investors and some homeowners have interest only loans. However, the option to repay interest only doesn’t last forever. Most mortgages have a term of 30 years. Typically, the first 5 years is interest only. After that term has expired, repayments automatically convert to principal plus interest.

If you have an interest only loan that is approaching the maturity of its term, what are your options?

The government forced banks to curb interest only loans

The volume of interest only mortgages peaked in early 2017 when they accounted for approximately 40% of all new mortgages. The government (APRA) then stepped in and introduced a new benchmark which stipulated that the proportion of new interest only loans provided by banks must be less than 30% of all new loans. Most banks achieved this target by mid-2018 and currently only 20% of all new loans are structured with interest only repayments. As such, APRA subsequently removed this benchmark in December 2018.

The banks dissuaded borrowers away from interest only loans by doing four things:

  1. They increased variable interest rates. Until recently, variable interest rates for interest only loans were 0.42% higher than their principal and interest counterparts. That gap has only recently reduced to 0.34% because most of the banks passed the full 0.25% October RBA rate cut. I predict that this cap will continue to reduce over time.
  2. Banks made it more difficult to roll-over to a new interest only term by requiring borrowers to go through a full application process.
  3. Almost all banks reduced the maximum interest only term to 5 years. Previously banks would offer interest only terms of up to 10 years – and a few banks even offered 15 years.
  4. Lenders tightened credit parameters e.g. they have become very reluctant to allow interest only repayments for owner-occupier loans.

The banks are starting to loosen up on interest only

Over the past few months, we have noticed that some lenders have marginally loosened credit policies in respect to interest only loans. Some lenders no longer require borrowers to go through a full application process if they request a second interest only term. Also, some banks will now offer interest only terms of up to 10 years to investors only.

Do interest only loans still make sense?

Interest only loans increase your flexibility. Whilst the minimum payment is limited to just the interest, it does not mean that you are not allowed to make principal repayments. In fact, you can make principal repayments at any time. Better still, attach an offset account to your mortgage and your cash savings will reduce the interest cost too.

Investors are particularly attracted to interest only loans for two primary reasons. Firstly, if they have a (non-tax-deductible) home loan, they can direct all their cash flow towards repaying it first, before they repay any investment debt. Secondly, it reduces the monthly cash flow cost of their investment. This means that have more cash to invest in other assets (or service higher levels of borrowings).

The additional benefit of an interest only loan is that your monthly repayment amount is directly linked to your net balance. Therefore, if you have repaid a portion of your loan principal or have monies in offset, your repayment will reduce accordingly. However, the dollar value of principal and interest loan repayments are fixed as they are calculated using the loan amount, not the actual balance. Most people prefer the flexibility that interest only loans provide.

So, are you suggesting that we never repay an investment loan?

No, not necessarily. Of course, you must consider debt repayment/management when formulating your investment strategy as I have discussed here.

One factor you might like to consider is that inflation will naturally eat away at your loan balance over time. Most people would consider a $1 million mortgage as a big loan. However, based on inflation data, a $1 million loan is equivalent to a $205,000 loan 40 years ago (in the late 70’s, $205,000 was a lot of money!). So, a $1 million loan in 40 years probably won’t seem as a big a deal as it does today.

Now, I’m not saying this to suggest you don’t need to worry about debt levels. Of course, you must be prudent with debt exposure. But my point is that inflation expectations is a component of the loan’s interest rate (high inflation equals high interest rates). This means you are essentially paying for the “inflation” cost each year and the real value of your debt is therefore reducing.

If your interest only term is approaching its expiry, what are your options?

You typically have three options.

(1) Rollover onto another interest only term

We can ask your bank to roll your loan over onto another interest only term. Typically, this is possible as long as your loan was established less than 10 years ago. If your loan is more than 10 years old, it is unlikely the bank will allow another interest only term.

(2) Refinance your loan to a new lender

If your current lender is not willing to offer another interest only term, we can refinance your loans with another lender. Of course, this will require you to go through an application process, which is quite an arduous and time-consuming task these days. If you have not done this for many years, you will need to consider whether you are able to satisfy currently tight credit criteria – see here.

(3) Start repaying principal and interest

You could do nothing and let the loan’s repayments convert to principal and interest. One of the advantages of the current low interest rate environment is that principal and interest repayments are relatively low.

For example, on a $500,000 loan, principal and interest repayments would be approximately $2,640 per month. Interest only repayments would be approximately 30 per cent lower at $1,875 per month. However, only 5 years ago, interest rates were circa 6% and as such, interest only repayments would have been approximately $2,500 per month. Therefore, the reduction in rates over the past 5 years has absorbed much of the cash flow impact of principal and interest repayments. That said, you must consider whether principal and interest repayments are still affordable when interest rates do eventually rise.

Avoid expiry with a line of credit

A line of credit (LOC) is a type of mortgage product that does not have a loan term. As such, it does not have interest only period i.e. principal and interest repayments are never required. However, interest rates for LOC’s are around 0.50-0.70% p.a. higher than standard interest only investment loans.

Debt repayment is less attractive whilst rates are low

One consequence of a low interest rate environment is that debt repayment is not as attractive as it once was. If your investment loan’s interest rate is 4% p.a. today, the after-tax cost of that debt is probably less than 2.5% p.a. So, by repaying debt, that is all you are saving (2.5% p.a.)! I would suggest that your money could be invested elsewhere, and it wouldn’t be difficult to earn an after-tax return well in excess of 2.5% p.a. Of course, interest rates will eventually rise so the long-term benefits of debt reduction will still be present. However, today, the opportunity cost is higher than usual.

Please reach out to us if you need help

Of course, we are ready to help should you need it. If you have interest only terms that are coming up for maturity, we would welcome the opportunity to help you find a satisfactory resolution. Click here to find out more. 

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This blog is an edited and extended version of an article written by Stuart Wemyss which appears in The Australian on 27 September 2019 (here).