For many Australians wanting to get into the investment property market, interest only loans have provided a convenient and affordable way to leverage the equity in their principal place of residence. This type of loan has been the choice of many investors over the past decade, with around 40% of all mortgages being interest only at their peak. While this type of loan has been particularly popular with investors, it’s estimated that owner occupiers still account for around 20% of interest only loans. Whatever the reason for choosing an interest only mortgage product, with around 30 per cent of all mortgage debt subject to an interest only reset between now and 2021, a reckoning is coming and for many investors. Selling now before a potential increase in distressed sales may be the best course of action for some.
The period of lower payments in the first few years of an interest only (IO) loan can be deceptive, if home owners don’t effectively prepare for the increased payments, once the IO period of their loan ends. The theory behind IO loans is that buyers have access to finance when needed, to facilitate the property purchase and can then ‘ease themselves in’ to their mortgage so to speak, by just paying the interest on their mortgage in the first few years. This period then gives them time to prepare for paying the principal in the years ahead – through savings, working towards increasing individual income or even sending a second income earner to work as children go off to school. Others never intend to pay any of the principal back, planning instead to sell their property and take any capital gain that has occurred. This of course relies entirely on the market always rising. However, many ‘lose track’ of time and find the interest only reset on their doorstep before they know it. Some can struggle to switch to the higher payments once the requirement to pay principal kicks in – an issue that is even more concerning considering a large number of mortgages will reset from interest only to principal over the next 4 years.
It is this that partially motivated the RBA to implement risk reduction measures last year, by cutting back on lending opportunities. It also promoted a warning from the Reserve Bank of Australia (RBA) earlier this year. The RBA estimates around $120 billion in loans will reach reset and the majority of those homeowners will experience up to a 40% increase on their mortgage repayments. As interest only loans reach their term over the next four years, it’s expected that interest rates will rise, putting further financial pressure on mortgagees. It’s this financial pressure that is of greatest concern, with homeowners still having no equity in their home at this point. If mortgage repayments become unmanageable, the obvious choice for many will be to sell and cut their losses, however that’s when there are likely to be plenty of others in the same boat. If the majority of IO investors follow this course of action and rush to sell, the market will be flooded with stock, forcing property prices down.
So what is the way forward? If you are at all concerned, you should immediately seek professional financial advice. Depending on your circumstances, it may be possible to re-finance more suitably. Alternatively, you could bite the bullet, tighten your budget now, and convert to a principal plus interest loan as an alternative. If it’s going to happen in a few years anyway, why not start now and focus for five years or so on throwing as much as you can at your mortgage. It’s akin to jumping in a boat and rowing towards the storm but at least you’ll be more prepared than everyone else when the eye comes around. But if your personal financial situation is tenuous at best, selling now may be the smartest move you could make. Getting out sooner than you planned may not be that appealing but a small gain is better than making a loss when everybody is scrambling to sell for the same reasons.