The dust now appears to have settled after the latest round of interest rate volatility which we have seen during the course of the past 4 months.  All major lenders have made dramatic changes to interest rates and lending criteria for new and existing borrowers preferring interest-only loans.  These changes have been applied even more severely to property investors.

Almost across the board, interest-only loans have risen by 50 bps (0.50% pa) or more, and some lenders have even decreased rates (slightly) for Principal and Interest loans.  Overall this means that irrespective of the lender, interest-only loans are now between 50 and 60 bps more expensive than P&I loans.

Historically, interest-only loans have been used mainly by investor borrowers, to build in flexibility when structuring their debt financing.  Coupled with an offset savings account it enables borrowers to prepare more quickly for their next property investment by directing all of their surplus cash flow towards saving for their next property, rather than repaying the debt they already have.

Further, where borrowers have non tax deductible and deductible debt, an interest-only loan enables them to direct all of their surplus cash towards retiring the non-deductible debt first. 

What is Driving the Change?

These changes are another example of the Australian Prudential Regulation Authority (APRA) intervening in the market where it sees unacceptable risks developing.  They have instructed the banks to:

• Limit the flow of new interest-only lending to 30% of all new loans (currently it is running at 40%)
• Place strong curbs on interest-only loans provided at LVRs > 80%
• Apply strong scrutiny and justification of interest-only loans where LVRs are greater than 90%
• Restrain lending growth in higher risk segments; e.g. high loan to income ratios and high LVR loans

The APRA initiated changes are in response to a flattening in the property market, low inflation and all-time low interest rates.

Some banks have also sought to limit LVRs on interest-only loans, or to introduce new loan to income ratio limits for borrowers seeking new loans.

How Will Borrowers Respond?

With such a rate differential there is a strong case to be made that borrowers with interest-only loans should consider switching to P&I repayments.  Research by Macquarie Bank shows that the economic rationale for investors to adopt interest-only loans has evaporated.  They provide an example whereby a borrower in the highest income tax bracket with a $500,000 interest-only investment loan will be $6,000 better off after 5 years if they switch to Principal and Interest repayments.

Of course, every borrower’s individual circumstances are very different. Some may also consider switching to a fixed interest rate so that they can lock in some stability for a given period.  In some cases lenders are still offering attractive fixed rates to investors with interest-only loans.  Borrowers just have to be careful that there is no sting in the tail when the loan reverts to a variable rate.

In other cases it may be beneficial to refinance to another lender if your current lender is not prepared to remain competitive in the current environment.

In most cases lenders are waiving fees for borrowers wishing to switch from interest-only to P&I repayments so it appears that the banks are genuinely trying to rebalance their lending portfolios rather than simply looking to improve their margins. But they will benefit substantially from borrower inertia as they know a large proportion of their loans will remain untouched.

If you need assistance in deciding how to best structure your loan facility please contact our office and we will assist you with a review of the existing structure and repayment type.  If changes are warranted we will help you with their implementation.  This is a free service for all Loanscape clients. 

Written by Bruce Carr

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