There are many ways to skin a cat (apparently). If you’ve been reading the press lately when it comes to interest only interest rates that old adage just doesn’t apply.
It seems as though the only way to change people’s behaviour is to charge them more. That’s just not true. There are other ways. But before we get into that let’s first delve into the reasons why people take out an interest only loan.
When clients get in touch with us we try everything to talk them out of it. The reality with interest only loans – and I know I’m stating the bleeding obvious here – is that you never pay them back. So, even though they cost you less on a monthly repayment basis, you’ll be making those monthly repayments forever and the bank will have a claim on your estate when you die (through the mortgage on the secured property).
So why do people take them out?
Well, the number one reason is cash-flow. People believe that when they take out a home loan that it will impact their cash-flow – and it will. What they fail (or choose not to) take into account is that they’re usually replacing another form of cash out (like rent or an existing mortgage).
It’s human nature to want to minimise your monthly expenses. This applies to investors as well. They too want to minimise their monthly expenses and maximise their income. So, if increasing interest rates for interest only loans will hurt these people why are lenders adopting this strategy? What impact will it have on borrowers? What options are available to borrowers and what other strategies are available to lenders?
Firstly, let’s get the lenders piece out of the way. Lenders will always charge more for home loans if there is a reason to. It provides an immediate boost to their net interest margin – a cornerstone of their annual profitability. In fact they have a duty to their shareholders to maximise their returns. The obvious option available to borrowers is to pay principal and interest right from the very beginning. Yes, it’s tough and it will impact your cash-flow more significantly than interest only but the savings over the life of the loan are demonstrated below for a $500,000 home loan.
| Principal | $500,000 | |||
| Term (years) | 30 | |||
| Interest rate (P&I) | 3.85% | |||
| Interest rate (IO) | 4.34% | |||
| Monthly Repayments (P&I)/balance at end | $2,344 | $843,854 | $0 | $843,855 |
| Monthly Repayments (IO)/balance at end | $1,808 | $651,000 | $500,000 | $1,151,000 |
| Difference | $192,854 | ($500,000) | ($307,145) |
The above shows that while you’re paying $536 more per month for a P&I loan you are reducing your principal balance each month. But with interest only, you still owe $500k at the end of 30 years. Most people just re-finance this amount (if they’re not too old) and just perpetuate this awful financial strategy. So, if you have a spare $500k at the end of 30 years you would’ve paid $307k more to the lender. Not sure about you but for me that’s a lot of money.
Alternate Solutions
There are other options available to lenders to limit the use of interest only loans (particularly to owner occupiers) and these include:
- greater stress testing that includes using principal and interest repayments as part of the stress test to ensure potential borrowers can repay the debt if required.
- reducing the amount they lend against properties by having a maximum LVR which is considerably lower than 90% (in some cases). I believe that having a lower maximum LVR option (of say 70%) will immediately reduce the number of potential borrowers by well over half.
- Return to the good old days of a second mortgage. Where the first mortgage (up to say 70-80% LVR) is priced at P&I rates and the second mortgage (above 70-80% LVR) can be priced at a rate that encourages a faster pay down of this expensive debt.
This Week’s Top Changes in the Home Loan Market
Most banks have now raised rates for interest only – by between 0.34-0.50%. Those that haven’t are the hold outs. They will eventually have to raise rates to comply with the regulatory edicts issued from APRA.Similarly, most banks have also decreased rates for owner occupiers (but by only around 0.04 – 0.08%).