Following a strong pick up throughout 2016 in investment lending activity, on 31 March 2017 the banking regulator ‘APRA’ imposed new lending guidelines in an attempt to slow the volume of new interest only loans in Australia.
What impact will this have for home buyers and property investors?
What are the smart things you can do now as a borrower to position yourself accordingly?
These are the questions I want to answer in today’s post.
Banks to curb interest only lending
A strict cap has now been imposed by APRA whereby no more than 30% of new loans can be interest only (rather than principal and interest), and in addition to this the following orders have also given to the banks:
- Limit the volume of interest only loans for loan ratios above 80%; and
- Scrutinise and justify all interest only loans for loan ratios above 90%
The reason interest only loans have been targeted is because they were tracking at around 45% of all new loan originations, whereas 30% is considered a level more in line with historical and international norms.
Interest only loans make sense for property investors, whom they were designed for, but less so for owner occupiers.
Generally speaking if you’ve bought an investment property then only your interest repayments are tax deductible (not your principal repayments), and keeping your repayments low can make cash-flows more manageable until such time that you’re likely to move your investment on.
But interest only loans can be more dangerous for owner occupiers, particularly when they’re used incorrectly.
Take for example the couple who can’t actually afford the principal and interest repayment option. There are various ways they can still get a loan, so they pursue this and then take up interest only repayments simply as a way of getting into the market.
The risk here is that in 3 or 5 years the interest only period comes to an end, and then the repayments increase 20-40% because the principal eventually needs to be paid back over a shorter period of time (e.g. the remaining 25 or 27 years), or worse still for the borrowers… interest rates rise too.
Potential impacts
What if the interest only period can’t be rolled over, and then for whatever reason (e.g. loss of income, or stricter bank policies) the borrowers can’t refinance their loan?
Without any cash lying around the borrowers may find themselves in a position where they’re all of a sudden forced to sell their property, to avoid defaulting on their loan(s). I think this type of scenario will become more common under the new rules.
Say the borrowers had taken out a $900,000 interest only loan plus lenders mortgage insurance of $15,000 to purchase a $1.0 million property. If the home had substantially increased in value then the higher repayments after say 3 years would not be such a problem. If the couple couldn’t afford the repayments they could always sell, retire the debt, and move on.
But what if they were forced to sell and the market had pulled back 10%? Now the home’s only worth $900,000. The loan balance is $915,000 (e.g. the original 900k loan plus insurance), and after the sale they may only be left with $882,000 (e.g. the 900k sale price less say 2% selling agent’s fee).
Not only have these borrowers had to spend approximately $55,000 buying the property (e.g. stamp duty, transfer/registration and conveyancing fees), they now have to find a further $33,000 simply to get out of their mess. They would have lost $88,000 in total and unfortunately not everyone can afford this. Can you imagine the stress if they didn’t have the $33,000 on hand to actually go through with the sale?
So now that APRA has intervened the way they have, in the current market if the borrowers in my example wanted a 90% interest only home loan to purchase the property (to live in), it’s highly likely that the bank would only approve the loan on a principal and interest (not an interest only) basis.
But with interest rates at historical lows, this isn’t such a bad thing. I’m generalising here but many owner occupiers would be very well served taking advantage of this low interest rate environment to reduce their debts. If they can’t afford to do this now, how will they cope if interest rates rise again?
And one has to ask… if they can’t afford to pay down any principal, should they really be taking on such a large home loan debt in the first place?
Also by paying interest only borrowers aren’t building up equity in their properties. Again not the end of the world if cash-flow is strong and house prices are rising, or perhaps if there are plans to upgrade into a new house soon (and keep the first home as an investment property), but if the market turns and one has to sell quickly, then those scenarios are unlikely to be pleasant for anyone involved.
As I have said before mastering the property game is all about i) buying assets that will increase in value; and ii) borrowing safely. This latest APRA intervention is being implemented to protect Australia’s banking system, and to slow price growth in Melbourne and Sydney, but in my mind it’s also protecting Australian borrowers from taking on too much risk and/or too much debt.
If certain markets do pull back then having less leverage in the ‘system’ will be good for everyone.
My personal view is that if these lending curbs take some heat out of Melbourne and Sydney property markets, then that would be a good thing too. If Melbourne and Sydney were to keep blazing away like they have over the last few years (over 12-15+ % p.a. growth in certain areas), then the likelihood of there being a protracted period of lower or even no growth afterwards is higher. Hopefully this will be averted now, and growth can continue at more sustainable levels (e.g. more in line with rising incomes).
What should you be doing?
Gone are the days where you can rely on there being one bank alone to best support all your borrowing needs. We’re now in an environment where the bank you have in mind might be ‘open’ for business one day, but then literally be ‘closed’ for business the next.
It all depends on i) the personal characteristics you have as a borrower; ii) what specifically you’re trying to achieve; and iii) where each bank you’re looking at stands on policy when it actually comes time to you putting forward your application.
At the moment we are seeing some good windows of opportunity with many of the non-bank lenders who aren’t regulated by APRA in the same way that the major banks are. Borrowers have increasingly been driven to these funders since December 2014 when APRA first attempted to slow investment lending and I see this trend continuing for the foreseeable future. For the most part their interest rates are cheaper and if you search broadly enough you can generally find one willing to support certain lends that major banks are shying away from due to the restrictions from APRA.
In recent weeks/months a lot of my clients have also been proactive in releasing equity from their current properties.
The strategy of releasing equity now while you still can
For those of you who aren’t clear on how this works, it’s the process of using the equity in your property to get more money from the banks.
For example if your loan balance was $600,000 and you owned a property worth $1.0 million (loan ratio 60%), you could apply for say an extra $200,000, taking your overall borrowings up to $800,000 (loan ratio 80%)… and by placing these funds into an offset account you wouldn’t have to pay any interest on the additional funders until they were actually used. It’s akin to establishing a line of credit, only cheaper.
The view here is that this process of releasing equity (a.k.a. “cash-out”) may become more difficult in the months ahead with certain banks.
Depending on the clients’ circumstances a cash-out now could have the benefit of:
- setting the client up for a future purchase, e.g. the cash-out could be used to fund a future deposit, or it could mean that the new loan for the new property is smaller in size and therefore easier to obtain; or
- it could act as a ‘buffer’ or safety net, so the borrower doesn’t have to be as reliant on their own personal salary or business income to support their debts.
Note that equity releases or cash-outs are already becoming more difficult though.
Depending on the lender and the relevant circumstances we’re already seeing requirements for strong justifications, or for having associated pre-approvals in place which make it more difficult to demonstrate servicing. In certain circumstances some funders are already even restricting cash-outs to a percentage of the asset value (e.g. max. 20% asset value on new cash-outs where the loan ratio is above 80%).
With all the changes occurring in the lending space it’s a good time to sit down with your mortgage broker and get them to sort through all the lenders for you. More so than ever I think having a finance strategy in place and having access to a variety of lenders is going to be critical in terms of ensuring the best outcomes for you.
