Interest-Only Loans: Why You Should Still Chase One Despite APRA Tightening Guidelines
2017 signalled the start of some bad times for property investors. The APRA introduced guidelines that had a serious impact on interest-only loans. But that doesn’t mean that property investors shouldn’t still chase them.
Let’s face it. The property market hasn’t been favourable to investors during 2017 and the early parts of 2018. Most of this comes down to a set of guidelines created in March 2017. The Australian Prudential Regulation Authority (APRA) made things tougher for investors.
They asked lenders to limit their output of interest-only loans. In particular, it asked for a 30% cap on such loans. The APRA likely wanted to achieve a sense of balance in the property market with these guidelines. And they’ve certainly had a cooling effect. Property prices in Sydney and Melbourne have fallen. Plus, first-time buyers and owner-occupiers account for more house purchases now than they did in 2016.
But where does that leave property investors? In particular, where does it leave investors who want an interest-only loan?
The good news is that such loans are still available. You’ll just have to work harder to get one. This article examines the reasons why it’s still worth fighting for an interest-only loan.
What Are Interest-Only Loans?
Interest-only loans are a type of home loan product that lenders make available to all types of buyers. The key to understanding them lies in knowing how regular home loans work. With a normal home loan, you repay part of your principal each month. The principal is the amount of the loan. So, a $300,000 home loan would have a principal of $300,000. With each monthly repayment, you make a dent in this principal. Over the course of your loan, you’ll repay the principal in full. You also pay interest each month that’s based on the remaining principal.
You cut out the principal repayments with an interest-only loan. Instead, you only pay the interest owed on the principal sum.
Of course, you still have to repay the principal at some point. That’s why such loans come with limits. An interest-only loan will have a maximum limit of five years. After that, the loan goes back to being a principal and interest (P&I) loan. But for those five years, you benefit from lower monthly outgoings. The trade-off is that you’ll pay more over the lifetime of the loan.
As a result, they’re not recommended for most types of borrowers. Interest-only loans carry a lot of risks. When they revert to P&I loans, your monthly outgoings shoot up. In some cases, you may end up paying double what you paid before the end of the interest-only period. Unprepared borrowers run into problems at this stage. In the worst cases, they end up defaulting on their loans. This leads to problems for their lenders and potential bankruptcy for the borrower. At the very least, you’re likely to lose your property in such a situation.
That makes such loans seem very unappealing. But there are reasons why investors, in particular, tend to use them. Most investors can claim the interest they pay on such loans as a tax deduction. As a result, they drive down their yearly tax bills. This is particularly important for property investors who have large portfolios.
Furthermore, an interest-only loan means lower expenses. Of course, this eventually ends. But savvy investors can use this to their advantage when it comes to cash flow. House flippers would aim to sell the property for a profit before the end of the interest-only term.
Simply put, they’re a useful tool for investors. Moreover, they weren’t previously too difficult to access. That’s why the APRA felt it necessary to place restrictions on them.
The Problems You May Face When Applying Today
Lenders have had to slam the brakes on their interest-only lending. While this impacts some owner-occupiers, it’s more of an issue for investors. Since the announcement of the limits, some lenders have shelved their interest-only loans. Those that still offer them impose tighter restrictions than before.
Perhaps the most important of these comes down to your deposit. Previously, property investors could access interest-only loans with as little as 5% for a deposit. Today, you’re very unlikely to get such a loan if you have anything less than 20% for a deposit. This is because the APRA asked lenders to restrict lending to those who can’t raise substantial deposits. A smaller deposit means you present more risk, which is exactly what the APRA wants to avoid.
On top of this, you’re unlikely to get the same interest rates that you would have gotten in 2016. Lenders have increased the rates attached to their interest-only loans. This is likely to further ward off those who want to use them, thus helping the lender to stay within guidelines.
Additionally, you’ll face tighter criteria when applying for such loans. Many lenders now consider a smaller percentage of your rental income as usable income for their loans. They’re also more likely to use a higher interest rate when assessing your serviceability.
Finally, lenders are also less likely to allow you to refinance a property to fund such a loan. This presents problems for those with large property portfolios. You may be able to do it if you can prove you meet more stringent serviceability requirements. But many will see their requests refused by their lenders.
Here’s the simple point. You face an uphill battle in today’s market when it comes to interest-only loans. Current restrictions make them more difficult to access than in previous years. But that doesn’t mean that you shouldn’t consider them. Interest-only loans offer a range of benefits for investors. Moreover, it’s possible that the investment climate may change during 2018.
A Changing Investment Climate
Before digging into some of the benefits of interest-only loans, let’s look at some other good news.
The APRA has recently made an announcement that has a huge impact on property investors. You see, prior to implementing the 30% cap on interest-only loans, the APRA had another cap in place. It had told lenders to limit investment growth to no more than 10% per year. Even before the newest cap, lenders were starting to offer harsher terms to those looking for investment loans.
In July 2018, that’s all set to change. The APRA has announced that it’s getting rid of the cap. However, this doesn’t come without its caveats. For a lender to no longer have to abide by the cap, it must meet the following conditions:
- The lender must have fallen below the 10% cap for a minimum of six months.
- The lender must commit to strengthening policies if needed.
- Their current policies must match the APRA’s current serviceability guidelines.
Regardless, this is still good news for property investors. Granted, it doesn’t impact the interest-only loans cap. But investors who want P&I investor loans should see banks actively chasing their business again. They’ll benefit from lower interest rates and more loan features.
Why is this important?
It shows that the APRA may be in the process of softening its policies for investors. Perhaps we’ll see the organisation lift the 30% interest-only cap in short order.
But what about accessing interest-only loans right now? Here are some of the reasons why you should still fight to be a part of the 30%.
Pro #1 – Easing Your Monthly Burden
There’s no getting around the fact that investing in property creates a lot of monthly expenditures. At the very least, you’re repaying a mortgage. But those who invest for yield must also spend money on maintenance and other issues. This can make it difficult to save money, particularly in the wake of buying a new property. You may have to pay the mortgage for several months before getting a new tenant.
Having an interest-only loan eases that burden. For a maximum of five years, you can pay less to own the property than you normally would. Of course, you face higher repayments down the line. But by that time, you should have tenants in place and be in a better financial position. At the very least, an interest-only loan gives you some breathing space, thus allowing you to move money around.
Pro #2 – More Cash in Your Pocket
Having an interest-only loan means you could save tens of thousands of dollars over the course of a year. That’s money that you can put back into your investment portfolio.
A short-term interest-only loan can help you save enough money to complete a deposit on another purchase. It also means that you have more money in your pocket to put towards expenses that you can’t deduct. This may include several of the costs of running your business.
It simply leaves you in a better short-term financial position. Again, this comes with the caveat of having to prepare for later. But the short-term influx of cash can help you to get your bearings again after a major property purchase.
Pro #3 – Bigger Tax Deductions
Many investors claim the interest that they pay on their investment properties as tax deductions. When you have a P&I loan, the amount that you can deduct decreases over time. That’s because you’re repaying the principal, which means you’re paying less interest.
But an interest-only loan maximises your interest payments. This may not seem like a good thing at first. But many investors can use this to maximise the deductions they make on their annual tax bills.
This isn’t an easy strategy to follow. It’s best to speak to a professional tax advisor before taking out an interest-only loan for this purpose.
The Final Word
The key thing to remember is that the interest-only cap doesn’t make such loans impossible to get. You just have to work a little harder to get one. Don’t give up on the idea until you’ve explored all of the possibilities. It’s still possible to use such loans to your benefit in the current climate.
Before you can do that, you need to find a suitable investment property. That’s where Cohen Handler can help. Our team of buyer’s agents can help you to find a property that will generate solid returns. Call us today to learn more.