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What happens when your home loan repayments change to P&I?

A major conversation topic for home loan borrowers right now is… Principal & Interest (P&I) or Interest Only (IO)..?  As boring as the topic may sound, it’s very important to address it given that ~75% of the Australian population has a home loan or an investment loan.

Over the next few years there will be thousands of home loan customers coming off an IO term, and if the IO term cannot be extended, some mortgage customers may experience financial stress.

Over the past two years interest rates have been a hot topic.  I wrote a blog this time two years ago providing an outlook for mortgage customers and a warning that significant change were on the horizon in light of credit changes which had started to appear.  Fast forward two years and it’s been a turbulent time for borrowers.

Two years ago APRA (the regulator) issued a mandate to banks and lenders that things had to calm down and that lending volumes, particularly to investors, had to be tamed to ensure a healthy and stable financial economy.

One of the most significant changes over the last 6 months has been the loss of appetite for IO home loans as a result of APRA’s mandate, issued late 2016, instructing banks and lenders to limit the volume of IO home loans approved.  Refer to a blog I wrote explaining the changes.

P&I home loans are the new flavour of the month at the expense of IO home loans. IO loans have become much more expensive, and credit assessment a lot more stringent.  In fact, going to the dentist and having a tooth pulled out is less stressful and less painful than being approved for an IO loan nowadays.  Refer to a recent blog I wrote on this very topic (i.e. about IO loans not about dentistry!).

I see some dark clouds on the horizon for many home loan customers who have enjoyed IO repayments for a number of years.  Soon, these customers may come under pressure to meet their “higher” loan repayments once their IO term expires.

Could this spark a sell down of property? Perhaps of certain property types like high rise apartments? Personally, I think it will be the latter.

Some lenders will allow borrowers to enter into another IO term after their current one expires. However, APRA has flagged that it will be carefully scrutinising IO lending by banks in an effort to curb investor lending. This means IO borrowers may not be able to count on extending their IO period in the future.  Ouch..!

If a home loan customer is unaware of the change in repayment type, cash flow issues will appear suddenly. Typically investors will want to pay down any non-deductible debt (owner occupied) whilst maintaining their deductible debt (investment). They may also wish to set aside the additional funds into their offset account for future potential purchases.

Let’s look at a scenario and the cash flow difference for an IO loan versus a P&I loan:

IO Scenario P&I Scenario
Loan term
30 years
30 years
Loan amount
$500,000
$500,000
Interest rate
4.50%
4.50%
Repayment frequency
Monthly
Monthly
Repayment type
IO
P&I
Monthly repayments
$1,875
$2,533

As you can see above, this amounts to an additional $658 per month, or $7,896 per year.

The above comparison assumes the same interest rate for simplicity only, but the reality is that IO home loans are priced higher nowadays.

In some cases, when the IO period has expired the loan term will have shortened. For instance, if a borrower takes out a 30 year home loan with a 5 year IO period, at the end of the five year period the loan could revert to P&I with a loan term of 25 years. This could push monthly repayments even higher, for example:

  • Loan term: 25 years
  • Loan amount: $500,000
  • Interest rate: 4.50%
  • Repayment frequency: Monthly
  • Repayment type: P&I
  • Monthly repayments: $2,779

This would amount to an additional $904 per month, or $10,848 per year. If you haven’t budgeted for this change, it could be quite a financial shock when your loan reverts to P&I.

Timing is another key consideration.  It’s important for you to know when your IO period expires for tax purposes. If you’re an investor, an IO loan can help you maximise your tax-deductible debt. Knowing when the period ends means you’re better informed to make decisions on how to manage your non-tax deductible debt.

Whether or not you choose, or are able, to extend the IO period on your loan, knowing when your home loan is due to revert to P&I repayments can help you budget, plan ahead and avoid unwelcome shocks.

Like I’ve said before, when it comes to finance, change is the only certainty.  In this new environment we find ourselves in, it’s important to plan ahead.

For home owners, cash flow is of utmost importance to ensure you can maintain your home loan repayments and to ensure you continue to enjoy your family home.  For property investors, cash flow is the lifeblood just like any other business.  You also want to ensure your financial buffers are loaded to give your property (or properties) the time to compound in value over time.  Time is the secret ingredient to create massive wealth through the power of property.

A trusted Finance Strategist is the best person to have in your corner right now.  Plan ahead to avoid nasty surprises down the track.  If we can help in any way, please contact us for a confidential chat.

Disclaimer: This information does not take into account your individual objectives, financial situation and needs. You should assess whether the information is appropriate for you and seek specialist advice from a qualified and licensed advisor.

 

 

 

 

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