Important Changes To Interest Only Loans & Investment Lending
Interest only loans and investment lending have been a hot topic lately especially after the Australian Prudential Regulation Authority (APRA) issued guidelines and rule changes regarding lending practices in March 2017. Things changed rapidly in the mortgage industry following these announcements. In fact, I’ve noticed a bigger change in the six weeks following APRA’s announcement than I did in the six years before the announcement.
In one case, a lender in our market increased their interest rates by 0.8% overnight.
All over Australia, banks that used to be in the investment loan space are turning away potential customers. This is especially true for interest only mortgage lending, which investors in Australia have generally relied on heavily.
The investment lending changes were not all so extreme though, and some groups—most home owners with principal and interest loans—were left mostly unaffected. In fact, home owners might be even better off as more competitive rates are available to them now.
But as a property investor, especially if you have interest only loans, you’re very likely to be affected by these changes.
To help you understand the investment lending maze and the lending policy changes that might affect you–but more importantly what you need to do to continually grow your property portfolio, I’m going to explain in this post:
- What is APRA’s new policy on interest only loans and investment loans
- What the APRA announcement means to investors and home owners
- Reasons behind the changes to investment & interest only mortgages
- Things affecting future investment lending market
- How should investors plan today to prepare for the future. In other words: an action plan
APRA’s Announcement On Investment Lending and Interest Only Loans
In March of 2017, APRA sent a letter to Authorised Deposit Institutions (ADIs) in Australia. The letter was outlined in a press release by APRA. The media release indicated that the following changes and guidelines were given to the ADIs of Australia:
- limit the flow of new interest only lending to 30% of total new residential mortgage lending, and within that:
- place strict internal limits on the volume of interest only lending at loan-to-value ratios (LVRs) above 80%; and
- ensure there is strong scrutiny and justification of any instances of interest only lending at an LVR above 90%;
- manage lending to investors in such a manner so as to comfortably remain below the previously advised benchmark of 10% growth;
- review and ensure that serviceability metrics, including interest rate and net income buffers, are set at appropriate levels for current conditions; and
- continue to restrain lending growth in higher risk segments of the portfolio (e.g. high loan-to-income loans, high LVR loans, and loans for very long terms).
Later in the post, I’ll address these bullet points in more detail. For now, I’ll start with a quick overview of APRA’s guidelines. Then I’ll address how these changes affect individual investors.
How APRA’s New Rules Affect You as a Home Owner
Essentially, the changes and guidance offered by APRA to the ADIs are centered around two main segments of the loan market. Those two segments are interest only mortgages and property investment loans. Home owners whose home loan is for their principal place of residence remain mostly untouched.
In fact, if there’s any effect on home owners, it is a more competitive finance environment. With increased pressure from APRA for ADIs to move away from property investment loans, traditional principal and interest home loans are in high demand. This high demand drives the total cost of home loans down. So it’s a good time to review your home loan and loan strategy to save interest and fees while potentially building a plan to develop a property portfolio.
How APRA’s New Rules Affect You as an Investor
The story changes, however, for Australians who are investing in property or seeking an interest only mortgage, with some exceptions.
Investors with “high-risk” loans (investment loan and interest only loan) will take the hardest hit from APRA’s announcements. That should come as no surprise though, as APRA’s announcements were almost focused on investors.
Principal And Interest (P&I) Investment Loans
Good news! For residential property investment loans with principal and interest payments, the rates are still very competitive. It’s a great time to start looking at a possible refinance on a residential investment if you can handle the principal and interest payments. Banks are still looking for these types of loans as they are less risky relative to other investment loans.
Positively geared investment loans
Investors who are in a solid equity position, with a reasonable income, and stable rent may benefit from talking to a trustworthy mortgage broker to see what’s out there in terms of a possible refinance. Rates for those loans are still hovering around 4%.
Investment loan with bad cash flow / negatively geared
On the other hand, investors whose cash flow is tight are going to face more challenges to find a competitive deal. We’re seeing rates posted by interest only mortgage lenders, even with a Loan To Value Ratio (LVR) of about 80%, in the 4% to 6% range.
If interest rate hikes
You’ve got to be careful planning for interest rate hikes. As I mentioned, we saw one lender increase their interest rate by 0.8% overnight. That sort of rate increase can have serious implications for an investor who is not well-positioned to absorb the extra cost.
To see just how much that 0.8% increase would affect the monthly payments of a $900,000 principal and interest loan with a cash deposit of $100,000 based on a 25-year term and an annual interest rate of 4%, check out the chart below:
With a 0.8% increase in interest rate, you’d be paying $595 more per month in interest alone. Your actual monthly payment wouldn’t change so dramatically, but you would be paying much more in interest.
Of course, this is an extreme example, but it did happen, and it happened overnight to real people. This doesn’t mean that you need to hit the panic button, but this should serve as a cautionary tale to get you thinking. The investment lending rules are changing, but there is still time to talk to a trusted advisor and create a strategic plan so you can adapt to the new rules of the game.
Or request a Free Loan Strategy Session and we’ll analyse your current loans and make sure you have access to discounted rates and conditions. We’ll also dissect your current loan structure and discuss ways to free up cash to grow your portfolio faster. And we’ll explore how different lending options may help you achieve your financial goals sooner.
Financial Impact On Interest Only Loans
This APRA announcement places limits on the amount of property investment backed by new interest only mortgages.
Because of this, investors will see a severe pullback by interest only mortgage lenders. It’s going to be very tough (and expensive) to get an interest only mortgage without an LVR above 80%.
What we’ve seen, and will continue to see, is a movement away from risky interest only loans. For example, banks that would have made an interest only loan with a 90% LVR are dropping that LVR from 80% down to 50%.
I’ve put together this chart below to show you how your cash deposit will increase based on different LVRs on a $1,000,000 interest only loan.
Imagine you were hoping to get a loan of $900,000. At an LVR of 80% you’re looking at a cash deposit of almost $200,000. And, as you’ll see later, with interest rates increasing on these types of loans as well, the higher cash deposit won’t necessarily help you keep monthly expenses down.
Historically, APRA has indicated that 10% is their preferred benchmark for investor loan growth. Despite that, in January of 2016 investor lending in Australia had grown by a rate of 27.5% over the previous year, according to an ABC report.
The previously advised benchmark, however, had a bit less teeth than this one. By announcing stricter limits on high-risk lending, APRA should stand a better chance of influencing ADIs this time around. Additionally, APRA has warned banks that if they continue to exceed the “speed limit” of 10% growth, the banks could be required to hold more capital. And holding more capital increases costs for banks.
Reasons Behind The Changes To Investment & Interest Only Loans
Traditionally, regulators (and banks) have seen property investment loans and interest only loans as a high-risk segment of a bank’s portfolio. Since one of APRA’s functions is to see to it that ADIs are behaving responsibly, these high-risk loans are concerning to APRA.
Left to their own devices in a stable market, banks are generally appropriately strict about investor loans. After all, the banks take on considerably more risk with these loans. Investor loans are riskier for banks because there are far more unknowns.
For example, let’s say you take out a loan to purchase a 10-unit apartment building. Banks see that and get nervous because now they’ve got to rely on you to be a good landlord and property manager. You’ll have to find tenants, deal with maintenance, and collect rent (to name a few of a landlord’s headaches).
What’s more, with traditional home loans, banks can force you to pay with the threat of throwing you out on the street. With investment loans, however, they don’t have the same power to get you to pay them back. Also, in the event of a market downturn, investor loans will be among the first to go into default. Home loans, on the other hand, will be among the last. That’s why investment loans are generally much riskier than home loans.
When housing markets heat up, investor demand for financing heats up, so the mortgage loan market tends to follow suit. As such, banks become increasingly pressed by intense competition to offer cheaper and cheaper loan products. As loans get cheaper and underwriting requirements become more lenient, borrowers get overextended.
The precarious situation that emerges from banks making risky loans and investors overextending themselves makes regulators very nervous. Especially in the wake of the financial collapse of 2008, regulators seek some sort of balance. And that’s exactly what APRA is attempting to do. By tightening restrictions on property investment loans, they hope to gain control of the incredible home price growth we’ve seen in Australia.
The question of whether their attempts have been successful or not may take some time to answer. As of today, home prices have generally stayed quite high. That said, I’d argue that there has been a bit of stagnation in Melbourne.
Understanding The Lending Market In Australia
There are loads of other factors at play from global economic trends to local market changes. Among the most important factors that influence the mortgage market:
1. The cost of funding
In early 2017, The Australian Business Review reported that the big four banks (ANZ, Commonwealth, Westpac and National Australia) have increased their reliance on foreign funders. Banks generally issue debt to raise funds from offshore funders because they can get money cheaper than they can from depositors.
The big drawback is that the reliance on offshore funders leaves Australian banks more exposed to foreign investors’ demands. The cost of those offshore funds may rise unexpectedly.
By the way, this is one of the many reasons that a cut in the RBA cash rate doesn’t necessarily mean banks will lower their rates. But more on that later.
2. The banking business model
At the end of the day, banks are in the business of making money. They will act in their own self-interest. So, while APRA may “recommend” that all lenders reduce their new investment lending to 30% of their total portfolio, many ADIs will sit at a much higher percentage.
Additionally, instead of cutting back on this type of high-risk lending, banks will use this as an opportunity to increase interest rates on high-risk loans.
Personally, I don’t think this is the best way to go about it. Loans should be given based on a customer’s borrowing capacity, not the interest rate that the customer is willing to pay. However, increasing the strictness of lending restrictions does not increase revenue. So, self-interest wins the day and rates go up.
3. The cash rate and the Reserve Bank of Australia (RBA)
The media likes to make quite a stir about the cash rate and RBA’s projections. And, while the RBA certainly influences interest rates and the lending environment, it is not the only factor—as you’ve seen. The cash rate is defined by the RBA as “overnight money market interest rate.”
In other words, the cash rate is the rate of interest that the RBA charges on overnight loans to commercial banks. The RBA uses this rate to control growth in an overheated market and to encourage growth in a recessionary period.
While the cash rate has changed 16 times since 2010, you may not have always seen interest rates go down. This may seem confusing, but when you consider the number of other factors affecting the mortgage market, it makes much more sense.
And even when banks could conceivably pass cash rate decreases onto the consumer, they’ve been known not to.
Ultimately, APRA and the cost of funding have a much greater influence on both investment and interest only loans compared to RBA and its projections. That’s not to say, however, that the RBA and their projections are not useful indicators.
As an investor, the reports and projections that RBA provides are very beneficial. Just don’t waste your time trying to get the best interest rate based on the RBA cash rate.
An Action Plan For Investors With Interest Only Loans
Government actions and changing regulations will always be a huge factor in the business of banking. Whether you think the government has gone too far or hasn’t gone far enough doesn’t really matter. Positioning yourself to succeed and make money under the rules as they are today gives you the best chance to flourish.
The first step to adjusting your strategy is to recognise that these changes have a significant effect on your investment portfolio in the short and long term. That makes it especially important that you speak to a mortgage broker who has a deep understanding of the mortgage market and keep them updated on the latest lending policies.
That way, you can strategise with someone who understands the nuances of these regulatory changes and how they affect your personal circumstances. Starting with your personal circumstances and goals, a mortgage broker can take you through a range of options and advise you on any challenges you might be facing.
For example, you may be facing the end of your interest only period. That means you have some questions to answer. Can you afford to make those principal and interest payments?
Suppose your interest rate increases by 0.1%—do you have the cash flow to handle the increased rate? What if your rates go up by 0.15%, or 0.25%?
Or maybe you have a large portfolio. A good mortgage broker can walk you through the best way to latch on to other properties to achieve the higher LVRs that the banks are now demanding for an interest only loan.
As a savvy property investor, you should constantly be strategising for the long term. That way, you’re not just making it month to month and scrambling whenever new regulations come out. By thinking long term, you’re positioning yourself to move smoothly into more properties and gradually build a strong portfolio. Having everything in place early, even if it may cost a bit more in the short-term, will save you money.
A long-term strategy will also save you the headaches of short-term market changes, such as the ones we’re seeing now. With your strategy in place, you’ll know when it’s time to make a move or if you can ride it out while everyone else is panicking.
Savvy investors make smooth transitions between properties and get creative when they need to. For example, you may want to cross securitise. Cross securitisation is a whole different subject which I’ve written another article on, but it’s an option you may want to keep open.
And essentially, that’s what a long-term strategy does: it keeps your options open.
Match loan structure and strategy
A good mortgage broker will find loans that fit your strategy, rather than simply scouring the internet for the lowest rates. That’s why it’s so important your mortgage broker be extremely familiar with you and your long-term strategy. The more in sync you are with your broker, the more effective he or she will be.
Look out for mortgage brokers who put too much focus on any single number. They should be helping you formulate a strategy first, and finding a loan second.
Moreover, don’t be fooled into chasing low rates and short-term savings at the expense of your overall strategy. Be especially vigilant when it comes to online comparison websites, as they often try to lure consumers with deceptively low rates.
Stay calm in changing times
Considering the recent APRA changes, you may be nervous about more rate increases in the future. This might tempt some investors to move quickly to capture a loan before rates start climbing. Don’t let the short-term fluctuations throw you off a solid strategy. Stay focused and stay within your financial capabilities.
This is another area where a trustworthy mortgage broker is a huge help. Speak to your broker about how much risk you’re willing to tolerate. Your mortgage broker should steer you towards a strategy that puts an appropriate buffer in place so you can avoid drastic lifestyle changes.
Whether it’s new regulatory changes, a slowdown in the market, or global economic troubles, you should have enough of a buffer that short-term fluctuations don’t create too much financial stress for you.
Seek out help from the experts
As you’ve probably noticed, there are a lot of nuances to the mortgage market in Australia. With so many moving parts, you’ll want to include an expert mortgage broker on your team of advisors.
Property investment loans are always going to be an integral part of property investment loans. Having someone on your side who knows how your strategy fits into the current mortgage market is integral to your long-term success. Additionally, a good mortgage broker can anticipate future market changes and help you tailor a personalised loan strategy to adjust to those changes.
There are still opportunities out there, but it’s going to take creative, customised loan solutions to take full advantage of those opportunities.
To request a customised loan solution, click the link below. You can book a Free Loan Strategy Session with me or a loan specialist from the Mortgage Corp Team. In this free session, we’ll analyze your personal circumstances and goals, research finance solutions, and devise a strategy for you to flourish in the regulatory environment of today and tomorrow.
At the very least, you’ll receive free strategic advice, so why not give it a go?
Take advantage of our Free Loan Structuring Strategy Session today and let us guide you to not only getting a loan but building a solid property portfolio.
About Mortgage Corp
Based in Wantirna South, right opposite the Westfield Knox Shopping Centre, Mortgage Corp is the most loved mortgage broking firm in Melbourne with consistent 5 star customer reviews. Mortgage Corp specialises in helping successful professionals and property investors maximise their return and strategically structure your loan for long term investment success.
While most banks and brokers focus on merely getting you a loan, Mortgage Corp is committed to getting you a comprehensive investment result. Request a Free Loan Strategy Session with our senior mortgage strategist Neil Carstairs today!
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About Neil Carstairs
Neil is the founder of Mortgage Corp, an active property investor and awarding winning MFAA accredited finance broker with more than 10 years’ mortgage broking experience. Currently, Neil is one of only few MFAA Certified Mentors in VIC/TAS region.
He is known for his strategic approach to investing and ability to reach fast, successful outcomes for clients where his industry peers could not. Connect with Neil on LinkedIn.