On the age old topic of paying IO or PI

Hi Steven,

the reason that it suits many investors to pay IO is to reduce the monthly holding costs and ensure all outgoings are 100% tax deductible (principal payments are not tax deductible). If at the end of the 5 year IO period your lender will not extend (I know some of the larger banks are not extending at the moment due to the APRA restrictions) I would look to refinance with another lender. There are still great rates out there for IO loans.

If you are after specific advice relating to your situation please get in touch.

IO all the way!

Hi Steven,
I guess you might be one of the younger members of our society. Those of us with some grey hairs well recall how the passage of time plays its part. e.g. If you can find some old magazines, or Google for historical figures, do check out the median values of homes in (say) Sydney from the 1970’s through to present day.

You will see that the values do climb, while the need for a higher mortgage does not if all you are doing is refinancing. Of course, you might be drwaing down equity to allow you to purchase more – but, for the sake of this exercise, let’s say you weren’t.

So, back in 1985, your parents (who were investors) took out a loan to buy a house in Sydney. At that time, the median price of the average home was $70k – they took out a loan (IO for $60k as it was for investment purposes). Five years later, the median value in Sydney was $100k – they wanted to stay IO, so they went to another lender and got a $60k loan on IO. That lender actually asked if they wanted to increase the loan to $80k, but they said no.

By 1995, the Sydney medians has climbed to $150k and they still owed $60k – they refinanced once more to keep it IO – in fact, they didn’t have to, as their current bank saw their LVR was just 40% ($60k / $150k x 100) and they wanted to keep them on their books. By 2000, prices were starting to surge once more in Sydney and medians were now $250k. Your parents had NO trouble getting a loan for $60k IO as its LVR was now just over 25%. As values rose, and their needs remained minimal, banks would fall over themselves to keep them on an IO loan – the Interest is where the Banks make money – why not keep good payers on THEIR books and not have your parents go off to another bank ?????

Now, Steven, the amounts quoted might bear some resemblance to reality – I was watching as prices hit certain levels in certain years, but really, the figures I used are not accurate. But perhaps near enough for the purpose of the exercise. If nothing else, I think you can see WHY property investing can be so beneficial over time? And the issue of IO does not always need to be an issue. That said, at some times, banks’ lending rules do change from time to time. In the 1970’s getting loans was nowhere near as easy as it was in the 90’s.

The above also tends to point toward WHY so many investors do not concern themselves with paying ONLY IO – as really, there is no concern. Over time the mortgage value drops relative to the value of the property. So, “your parents” in the example above might have bought a $70k house in 1985 with a $60k mortgage. And, in 2003, they sold the house for $350k, paid off the $60k mortgage, paid a bit of CGT, and pocketed around $200k for themselves. Meantime, all of the Interest and costs had been paid by the tenants. Keep in mind, though the mortgage hadn’t grown, the rents WERE growing over time. Cool?

QED. ;)

Benny

Hi Steven,

The example you gave relied on a few things:
1. Organic capital growth which is difficult to come by now days compare to 30 years ago

Really? What has Sydney been doing the last 3 years, and Melbourne too? Brisbane is likely to be next…. all part of the cycle, but then each cycle is different to the one before.

2. Rental incomes are growing to the point of catching up or exceeding the amount of loan / repayment that is needed to “feed” the bank, which again is not the case now days. Housing price has gone to the point where the rate of loan repayment are increasing faster than the rate of rental income can catch up.

Certainly with wages not growing as quickly as in the past, it becomes more difficult to afford a place. That (I believe) has ties to the excesses of immigration and/or overseas investors who are buying up the farm. While ever supply is kept low, demand remains strong. Then Govts. tinker around the edges to endeavour to be “all things to all people” – whack investors (reduce IO loans), because FHB’s are crying at not being able to afford a place (like, do investors perpetually overpay to get a place???? Thus driving up those prices? :P)

3. Government is tightening regulations and banks are tightening IO lending, compare to
the old days.

Even “the old days” had times of tight bank regulations. Everything is cyclic. Small example:-
a. We struggled to buy our first property – money lending was tight in 1973 (gold through the roof, petrol too) – a lot of FHB’s were wanting to get into a house. We bought through a wrapper, secondhand, and re-financed out of the wrap within a couple of years (I worked a second job).
b. Six months after we bought it, we were offered 50% more than we paid for it. Just 6 months….
c. We did sell, about 7 years later, and got THREE times as much as we had paid. Prices then stagnated for about 7 more years.
d. We moved and bought into a Brisbane house in 1984 for the same price we sold in 1980. Prices screamed upward after Expo – doubled between 1987 and 1990.
e. Then they went backward – four years later (after the “recession we had to have”) our place had dropped by 20% in value.
f. Prices then STAYED lowish for another 6 years, until 2000 when the gun went off and we were racing.
……

Times change – buying possibilities change. Govts change legislation. RBA’s play around with Interest Rates. Re that, the Interest Rates have (I believe) played a major part in defining many of the current events. e.g. When paying between 11% and 17%, you’d better NOT have a big mortgage, unless you also have a commensurately big wage. Today, with IR’s around 4%, values have been allowed to scream upward as demand continued to grow. Folks on even an average wage can yet afford a hugely expensive house.

Seems rules are now changing and we need new solutions.

Pretty much right there, Steven. I think lessons from the past can be tailored to fit a new world too though. While ever supply and demand continue to play their part, making decisions based on their relativity will continue to make a lot of sense. e.g. If demand is high, and prices have become too high in an area, think of how those prices could be lowered. Old wisdom might say “go buy in next suburb or next city” – and that might still work. Or look to new ways (e.g. sharing homes to get multiple incomes from multiple renters). Student accom. airbnb.

To be able to make the best choices, one must be “a full bottle” on the possibilities around them. An understanding of this new world becomes mandatory. Keep on reading – if wanting “How to” stories, buy YPI magazine or similar, and read !! Early days are hard, but with each investor person you meet, and each story you read, the path becomes a little more well-lit and easier to navigate.

Benny

By itself it is true, but when coupled with my second point, that is just unsustainable.

Fair comment. The answers though still lie within that supply/demand curve. Remove demand, and prices will drop. Or wait a few more years and rents/wages will close the gap once more.

Values don’t grow linearly – they grow more like a staircase in real estate. A couple of years of booming, followed by a flattening off for several years (and yes, even dropping in that time) until things “catch up” then another boom period. And the staircase is not linear either – unless we used a logarythmic scale which would tend to show similar trends over successive cycles.

The lowering of Interest Rates fueled this most recent boom. What will fuel the next one? I don’t know. Or will there be a massive worldwide crash in values? It is possible, and yet I think unlikely. Whatever upsets the supply/demand curve will tend to dictate the results.

e.g. Watch what happens with units in major cities over the next couple of years. They were over-built to supply anticipated influx of overseas investors (many from China, a relatively new demand source) – and then that demand dried up even as apartments were being planned/built to cater. Now the Govt has tinkered a bit more to further dissuade foreign investment – turning the supply demand curve on its head. This will end badly for apartment values in those areas. Watch it unfold.

Could that spill over into housing too? Yes, it could – if apartments become a lot cheaper, FHB’s might choose to buy an apartment as their First Home rather than a house. This weakens the housing s/d curve, AND removes them from the pool of renters. Rental demand can therefore weaken too (if enough FHB’s do that), forcing rents lower as demand drops, which has an impact on investors buying more housing (as returns now not so good). The lower rents begin to stabilise the exodus over time and, as wages tick up, so too do house prices once more, leading to more demand for rentals, hence rents rise again……. and the beat goes on.

It is true what you say re yields dropping – I have watched that happen over the last 17 years. I believe that went hand-in-hand with the ease of borrowing after banks became de-regulated in Keating’s time (I think). So, OK – we adapt – we change our methods to accommodate this.

Steve found his initial successes became unable to be repeated in Ballarat after a time – he moved into apartments, then to NZ housing, then to USA housing, and even later, shifted gears completely into US Commercial property via his Fund. What will be his next move once “the old way isn’t working so well any more”? I don’t know, but stay tuned – I am sure he will already be eyeing up his next opportunity.

If one way becomes unsustainable, find another way that fits within your skillset, risk levels, and leads to your goals. Keep on reading Steven – and well done for pursuing your path via questioning. Your challenging questions have been good to ponder on. Alternate views often lead to learning, and I need to learn as much as anyone else. So, well done – shows you are thinking around the whole subject.

Benny

IMO what limits business growth (property or other) is available cash, if you can preserve your cash (and buffers for less stress) using IO lending you have free cash to grow your business – eg. the next deposit, to pay for the reno etc. It doesnt have to cost a lot more (like ING 2yr fixed IO investor rate 4.19).