Interest Only Loans
Was your Interest Only Loan the best or worst thing you ever did?
Currently, the hot topic in the media is the dangers of Interest Only Loans in the current economic climate. Is it time to consider the pros and cons of Interest Only Loans?
The reason property investors prefer Interest Only Loans is they can borrow more when the monthly loan payment is less. Consider buying a $500,000 property with a 20% deposit. You will borrow $400,000 at a loan rate of say, 5.6%. This is the average home loan rate for the last 5-years.
With an Interest Only Loan, your annual loan payments will be $22,400. With a 25-year Principal and Interest Loan, your loan payments will be $29.764. That is $7,364 more in payment costs. If you can afford approximately $30,000 in loan costs, and you maintain a 20% deposit, you could purchase a house worth $660,000 if you use an Interest Only Loan.
What the Interest Only person is doing, is leveraging cash flow to the maximum. If the investor believes the average property increase over the next 5 years is going to be 5% annually, then the $500,000 property will be worth $638,140. In comparison, the second property will be worth $842,345. That is, your potential additional profit is $204,205 more than the property purchased with the Principal and Interest Loan.
This sounds fantastic! What could go wrong?
Fears of housing ‘fire sale’ as Interest-only loans roll into Principal plus Interest
In June this year, the ABC, produced a documentary with this title. A synopsis of the story was:
- In the next three years, some $360 billion of Interest Only loans will roll into P&I loans. This will result in increased loan payments.
- Increased loan payments may force a ‘fire-sale’ of real estate, resulting in lower prices as people are forced to sell.
- Due to government controls, banks are being forced to offer less Interest Only Loans and as loans roll over, the banks are more likely to insist on Principal and Interest Loans.
Part of the show was an interview with a person who described his Interest Only Loan as the
“Worst decision I’ve made in my life”
The person had invested in two properties in a booming mining town. The intention was to secure his retirement from the profits. However, the “boom” turned to “bust”, leaving the properties unsellable. With the loans rolling over to Principal and Interest, he was looking at an additional $12,000 in loan payments which he cannot afford.
The investor’s final summation was that if he could sell the properties, he would still owe the bank about $250,000. A debt of $250,000 with no investment income, is going to destroy any prospect of a secure retirement.
Predicting Future Property Prices
There are no crystal balls when it comes to predicting the rise of either property or share prices. At least with the share market, you know every day the value of your shares. If you want to sell them, they can be sold in minutes at a price the market is prepared to pay.
From my experience of buying and selling real estate, you never really know what is happening in the property market, unless you are an active participant. Any data about prices will be at least two months old. A lot can happen in two months.
The property investor needs to understand what will change market sentiment abruptly. Here are few things to consider:
- Rising interest rates on loans
- Reduction in availability of credit
- Increasing unemployment rates
- Reduction in overseas investors
Taking a view of future property prices
If you read any disclosure statement about the estimation of future prices you will see a statement like this:
“Past performance is not a reliable indicator of future performance”
You need to take notice of this warning. However, to be a successful investor, you have to form a view on the likely future change in property values and act on that view.
The problem with most forward projections of property valuations is that they are usually based on the long-term average. The long-term average of capital growth (Established Houses) for the last 18-years, is 7.65%. However, we all know that property prices do not keep rising year in, year out at the same rate.
Most people rely on the average property price changes for all of Australia. However, there will be marked differences not only in each of the eight capital cities measured by the Australian Bureau of Statistics, (ABS) but also within suburbs of those cities and even different price changes in regional property prices. To make the most accurate prediction you need to find the information which best reflects current prices where you are buying the property.
While the ABS is good for capital cities, you can most likely get more targeted information from websites who study regional prices in more detail and some will include their professional opinion about where to buy property. While generally, this information is not free, the cost could prove to be money well spent.
How can things go wrong?
People who use Interest Only Loans are trying to leverage the profits by borrowing with the least cost. This means if prices rise you will make much more profit, but if prices fall, much more money will be lost.
The following is an example looking at the rise in house prices in Sydney, Hobart, and Perth over the last 5-years. This is an exercise anyone can do, using the statistics provided by the Australian Bureau of Statistics. (6416.0 Residential Property Price Indexes: Eight Capital Cities, Mar 2018)
Consider buying at a $500,000 property. The interest costs are 5.6% on a $400,000 loan, with a net rent of 3%. The cost of holding each property over the 5 years, is estimated to be $37,000 (excluding any tax implications, buying and selling costs)
These two graphs show the change in the Established Houses Index and how that change reflects in the value of a $500,000 property purchased in each of the city’s, 5-years ago.
The graphs display the following information:
- Perth: The $500,000 property would be worth $473,447, giving a loss after expenses of $63,553. The price peaked at $519, 800 in June 2014 and then fell consistently.
- Sydney: The $500,000 property would be worth $783,276, giving a profit after expenses of $283,276. The price peaked at $844,700 in June 2017 and fell for each quarter for the last year.
- Hobart: The $500,000 property would be worth $666,908, giving a profit after expenses of $166,908. The property rose consistently over the 5-years, reaching its highest price in the last quarter.
As you can see, property prices do not always rise at the rates we would like. Australia really has been the “lucky country” when it comes to real estate. We missed the catastrophic fall in property prices experienced in the USA and elsewhere after the GFC. We have had a growing influx of population to fuel demand and our property has been very popular with overseas investors. Our taxation rules are very generous to property investors.
When you are looking to invest in real estate, you need to consider your exit strategy. Do you plan to keep the property for the medium or long term? High buying and selling costs prevent property being a short-term investment unless you specialize in property renovations with quick turnaround. This is a business model rather than an investment strategy.
Long Term Property Investors
One of the things I love about real estate is that if you never sell the property, you never pay capital gains tax.
So if you are a long-term investor, think about the total cost of the loan. Below are the costs for two 25-year loans. The first has a 5-year Interest Only Loan followed by a 20-year Principal and Interest Loan. The second is a 25-year Principal and Interest Loan.
You can see from the graphs, that the Principal and Interest loan will save you $33,718 ($377,806 – $344,088) in interest. However, your loan payments are significantly higher for the first 5-years.
As an investor, you need to decide, are you better, to pay more interest over the long term, but have the advantage of getting into the property market sooner. The Interest Only Loan for the first 5-years makes the payments affordable. You may believe that in 5-years, you can afford the higher payment costs of $33,290.
If however, you can afford, the higher payment of $29,764 from the beginning of the loan, you will save significant interest costs.
If you are planning to invest in property in the near future, you should consider all the factors before you embark on your property hunt. These are some things to consider:
- What are the prospects for capital growth in the area you plan to purchase?
- What is the likelihood of increased interest rates?
- Is an Interest Only or a Principal and Interest Loan going to suit my investment goals?
Want to understand more about loan types and paying down debt, then watch this video.
Disclaimer: Financial Mappers does not have an Australian Financial Services License, does not offer financial planning advice and does not recommend financial products.