Here are two facts to consider together…
1) The Australian property market is (finally) showing clear signs of weakening.
2) Two thirds of property investment loans are ‘interest only’.
What could possibly go wrong?
More importantly, what should you do if you have an investment property funded with an interest only loan?
First up, is the property market really weakening? And will it crash?
As we pointed out in August property prices can and do fall and for years now, some market commentators have talked of a ‘property bubble’ and forecast a crash. There’s no sign of this happening any time soon though, and many economists expect supply constraints and strong population growth to underpin prices
Nevertheless, there are reasons to be cautious:
- Auction clearence rates have been falling for 10 months in Sydney (to below 60%) and for around half that time in Melbourne. These rates tend to foreshadow price movements.
- Nationally, vacancies have been steadily rising since 2008 – from just under 2% to nearly 3% now.
- Rent growth has fallen from over 8% per year in 2008 to under 2%.
- Prices are at painful levels, particularly in Sydney with houses fetching 12 times annual income and apartments reaching 8 times. Even with rock bottom interest rates, these mortgages soak up 50-70% of household income.
- Banks are responding to regulatory pressure by reining in property lending; increasing rates, reducing discounts and rebates, and tightening up borrowing limits.
- Apartment building approvals have rocketed over the last few years suggesting that significant supply will hit the market over the next two years.
This data has led Macquarie Bank to forecast a 7.5% fall in apartment prices over the next two years, and Citi to forecast price growth of 0-5% over the same period.
Overall then, its sensible to expect an extended period of weak property prices (but probably not a crash).
So what’s the problem with interest only finance?
Interest only finance is attractive because repayments are initially lower, which allows greater borrowing. Its also attractive for negative gearing investors as the entire payment is tax deductable.
It’s dangerous for the market though, making it more sensitive to interest rates. Gearing is higher, because people have borrowed more. Also, because all of each monthly repayment is interest, it all increases when interest rates increase (whereas in a principal and interest loan the principal component of the repayment doesn’t increase).
At the level of the personal investor, the problem is that the principal does not reduce over the interest only period. This means you pay more interest over the life of the loan and repayments are higher when the interest only period ends.
In a weak property market, it also means that you may not increase your equity, even after years paying tens of thousands of dollars in interest. Down the track you could have made nothing, or even have lost some of your initial equity and be facing both higher interest rates and much higher payments as your interest only period ends.
So, what should you do if you have an investment property funded with an interest only loan?
The answer is: take advantage of low rates by starting to pay off the principal. This doesn’t necessarily mean refinancing your loan. If you don’t have one already, talk to your lender about a mortgage offset account, which is like earning high interest tax free. Pretend that interest rates have already gone up, or that your interest only period has ended. The sooner you chip away at the principal the less interest you will pay over the life of the investment – regardless of what the property market is doing.
PAY $73,000 MORE
In 2014 alone 332,000 investors borrowed an average of $430,000 in interest only loans to buy Australian real estate.
Over a typical 25 year loan* those investors can expect to pay an extra $72,953 dollars each in interest on average.
[* assuming 5%p.a., a 10 year interest free period and $10 per month fees.]
What are your thoughts?
Do you have an investment property? If you do, and it’s funded by an interest only loan, are you concerned?
Join the conversation — leave a comment below and let us know what you’re thoughts are.