Why Interest-Only Rates Are Soaring and What You Should Do About It
Interest only rates have risen significantly this year, around 0.5% on average, despite the RBA cash rate remaining stable. This has provoked some unrest amongst investors, many of whom have watched their interest costs rise for no obvious reason. However, for once, this is not the fault of lenders, and particularly not of any one lender.
The Australian Prudential Regulation Authority (APRA) has ordered banks to lower the proportion of new interest-only lending to 30%, forcing them to increase the relative cost of these products to dampen demand. While non-banks are not technically obligated to adhere to the same standard, you can be certain they have experienced back-door pressure from APRA to follow suit.
The goal of our regulators in taking this action is to diminish investor appetite for property, in the hope of avoiding further inflation of the perceived property bubble without raising interest rates.
What APRA’s Latest Moves Mean for You
There are many in the industry who think the differential between rates is now so large that IO loans are no longer viable; however, I disagree. When considering how to best structure loans, it is wise to look at the long-term, after-tax cost of that structure, as well as its effect on the flexibility of how you can use and access your money.
Every dollar you use to pay down an investment debt is a dollar that you cannot use to pay down a personal debt. This means, as in the case where an investor also has a loan on their personal residence that is not tax deductible, every payment against an investment debt increases the future after-tax cost of their overall debt.
It is necessary to make a calculation, including tax effects, as to whether the lower rate is less expensive now and, even if it is, will it continue to be the case into the future? It will be heavily dependent on the income generated by your assets and the level of your other income.
Paying off principle, rather than storing cash in an offset account or Line of Credit (LOC), also makes cash more difficult to access. It puts you in a position where, if your circumstances change, you may not be able to access the equity on your investment properties at all. There is potential that, in the future, you might miss opportunities you would have taken up if you had access to capital.
You must also recognise there is somewhat of a finality relating to paying off an investment debt. Once you pay it down, any new borrowings against that property will likely only be tax deductible, if you use it for further investment. You will have to take out a loan with no tax deductions allowable on the interest to pay for that new car or dream holiday. And if you’ve stored those same repayments in an offset account, you could pay cash and potentially maintain the tax deductibility of all the debt against your investment property.
Notably, while the current trend is towards the pricing differential becoming larger, between IO and P&I loans, this is only a new phenomenon. It may not last. Switching to P&I may save you a small amount of money now, but it is far from certain this will still be the case in 12 months, let alone in 5 or 10 years.
What Should You Do?
It is sensible to periodically consider your loan portfolio to make sure you are minimising your costs and maintaining the level of flexibility you are comfortable with. Given the rather significant changes in rates of some mortgages recently, it is most definitely an opportune time to reassess your current situation. But, you should consider all the factors we mentioned above, and not just the percentage rate of your existing loans compared to other products.
If you would like one of our lending experts to assist you in assessing your current situation and/or if you would like to know what options are available to you, please fill out the form at PropertyInvestingFinance.com, or email me directly.