Beware the 2020 interest-only danger zone

For the average investor or owner-occupier, that means a pretty significant hike in your repayment, or what the Reserve Bank of Australia (RBA) has called a “non-trivial” sum of about $7,000 per year.

And 2020 (as shown in the chart below) is the year that most of these at-risk IO loans will reset.

Once seen as somewhat of a magic bullet by Aussies, IO loans at their peak accounted for 40 per cent of all loans. With lower repayments, they allowed home owners to finally get a foot in a tightly held property market. For investors, it was a way to maximise tax deductions, enhance cash flow and build up their property portfolios.

But this traditional way of investing just won’t fly anymore. Lending standards have seen a significant amount of scrutiny by banks, which has impacted the approvals of new interest-only applications (see chart below).

Last year, the Australian Prudential Regulation Authority (APRA) gate-crashed the party with a 30 per cent cap on new interest-only loans to try to address booming house prices and household debt concerns.

The impact of this is now starting to be felt. The balances of the IO loans written historically are due to mature from their initial IO terms in the next three years. And this is when the big wave of challenges will arrive for mortgagors.

According to APRA statistics, the “big four” banks have reduced their share of new IO loans to 15.53 per cent, down from 38.43 per cent in March 2017. As seen in the charts below, effectively the banks have controlled the market with borrowing capacities dropping by close to 20 per cent in some lenders’ calculations.

With this fall in investor lending, we’ve also seen home prices in our major east-coast housing markets take a noticeable dive. At the end of July, CoreLogic reported that national dwelling values were 1.6 per cent lower over the past 12 months, the largest annual fall since August 2012. 

As a mortgage broker, I have seen first-hand how tough lenders have become compared to more lenient standards between 2014–2016, with some borrowers not being able to extend or refinance their IO loans.

Not drowning, waving

Those who are ahead with their repayments and have built up savings in the form of offset accounts, redraw balances or other assets should be comfortable when it comes to covering the increased payments. 

But there are some borrowers that the RBA states may struggle because they have less than one month’s prepayments in their accounts. My concern is directed at home loan newbies and investors who could experience little or no capital growth. 

I see a combination of three factors that could impact capital growth between now and 2021:

• Stunted wage growth, the impact of inflation and increased cost of living: Considering inflation, the wages of most Australian workers have been flat over the past 12 months
  
• Rental income softening: CoreLogic has reported the rate of annual rental growth is slowing fairly rapidly, particularly within the combined capital cities
• Increased supply: Record levels of dwelling construction are being completed (above 200,000 per year), which may lead to an oversupply in some states

So, given these factors affecting capital growth, and the fact you may soon be facing some financial headwinds, the question begs: what do you do? Well, for starters, take a deep breath and remember it’s not the end of the world. I have referred to it as a “danger zone”, not a “catastrophic zone” for a reason.

There are many ways to overcome and prevail. The answer lies in taking action now, not waiting until the issues are well and truly on your doorstep.

Options to make it through the danger zone

2. Make peace with P&I: Do the sums and decide whether it’s best for you to switch to a P&I loan now or wait for the loan to reset. And while you may not like it, you need to find the extra cash flow. Could you pay off your car loan earlier? How about culling some of your luxuries? Get serious about revamping your budget and make yourself accountable to someone else so you stick with it (no matter how hard it hurts).
3. Sell up: Selling in the current soft market is not an ideal strategy, especially when you consider what you originally paid in stamp duty, legal fees, basic renovations and then sales agent’s fee. It would be better to find a way to weather the cycle, and even be prepared to hang onto it for longer than you originally intended.
4. Increase the rent: Rents have remained relatively flat in most capital cities over the last decade, and we also hear regular talk about an apartment glut across major cities. Talk to your property manager as this may or may not be an option for you depending on vacancy rates and location.

Reviewing your game plan

In the face of changing loan conditions, this is a perfect time to reassess your game plan and remind yourself why you bought the property in the first place, i.e. what was it meant to deliver for you? 

Once you are clear about your goals, seek out professionals. You need to surround yourself with a team of trusted experts, not rely on the opinions of family or friends. 

An investment-savvy mortgage broker can guide you through your choices, keeping you two to three steps in advance, knowing that bank policies will continue to change. Your broker should be aware of the changes that are coming. 

My suggestion is that while it might be tempting to refinance and chase a lower rate, you may actually wind up paying more interest over the life of the loan if you keep extending the 30-year loan term each time you refinance.

At the end of the day, the goal is to create wealth, not create more household debt. Now is the time to act and consider your options so that you can avoid the danger zone financially intact.