Interest Only Loans: – Is it a ticking bomb?

Why are APRA and the RBA so concerned?

The common aim with property investors is to create long term wealth by amassing a property or few then allowing the real estate market to increase whilst keeping expenses low. An easy way to attack this strategy is by structuring the investment loan as interest only (keeping the loan repayments to the bare minimum) meaning that the principal remains the same with the forecast that house prices will continue to rise. With paying off only the interest portion of the loan, if the trend on increased housing prices continue to rise, then so will the equity in the property (equity is the difference between the value of the home and the amount owing on it).

Ok, so this common investment strategy seems to make sense, right?

This can be a good strategy to work towards and with high tenancy rates, increasing property prices and historical low interest rates all looks good.

The concern of The Australian Prudential Regulation Authority (APRA) which oversees banks, credit unions, building societies, general insurance and more, is one of a market where many investors potentially could fall into mortgage stress and overall financial difficulty. You might be asking yourself how could this happen with high property prices and low interest rates?

If property prices started to decline (like they have done in a few mining towns and regional areas around the country), depending on the loan amounts, we could see people left with properties which are worth less than what they owe on them. Not to mention in a negative market comes an increase in tenant vacancy rates which obviously makes it more difficult to rent out the investment home let alone with a decent rental agreement.

Now the issue is that if the above scenario occurred (which it has done in certain areas) and we’ve had people who’ve used the majority of their equity to purchase another one or two properties, along with the reduced property prices and a slowing rental market, could see these investors potentially fall into some financial difficulty and this is where we start to see an increase in mortgage stress.

Let’s not forget that the principal does need to be repaid at some point in time and will see an increase in repayments going from interest only to principal and interest, which can be a challenge in a declining market.

On a $400,000 investment loan with a rate of 4.5% (over a 30-year term) and an interest only period of 5 years has a monthly repayment of $1,500. When the interest only period ends, the repayments change to include the principal which increase it to $2,283 per month. That’s an increase of $783 extra per month that needs to be accounted for to start reducing the principal portion of the loan. What if interest rates increased by 1%? Well that then adds an extra $334 per month that needs to be repaid, just in interest!

Dino Pacella