06 May 2015
First posted on Somersoft.com.au
One of the least sexy parts of growing a portfolio is managing the risks associated with holding large exposures to mortgage debt. The most commonly talked about risk is interest rate rises and what sort of a ‘buffer’ investors should hold.
However, a risk that often doesn’t get enough attention is the potential for interest only terms expire and reverting to P&I repayments. This is particularly relevant when purchases are being made in a historically low rate environment.
Many investors, particularly those in the process of accumulating a large portfolio, may not actually intend to pay down debt. If not considered properly, investors could find themselves in a situation where they are unable to extend their interest only terms. Here are some of the potential scenarios where this risk could crop up:
1. Changes to your income/expenses – At the time of the purchase, your situation may have allowed you to borrow. Family planning comes to mind here, or perhaps switching to self-employment.
2. Changes to serviceability calculators and interest rates over 5 years. Borrowing power assessment can be very different over that time period, particularly if interest rates normalise. A 2% increase in rates can lead to a very different borrowing power.
3. Changes to the lending environment that restricts the ability to extend I/O terms. Right now the increase in I/O loans and investors not paying down their debt is one of APRA’s primary concerns. Rates, policies and appetites for term extensions can change over such a long horizon. This uncertainty is beyond an investor’s control.
4. For the PPOR home – extending I/O terms for PPOR homes are likely to become more difficult to obtain than for an investment loan.
To give a bit of an example, there’s plenty that’d be obtaining loans right now with lenders that only allow 5 year interest only terms (NAB, Macquarie, etc). Right now, you’re likely to be paying around 4.5%. If for example, you’ve got a $2 million exposure to debt at I/O terms, your repayments are around $90,000 per year. If this were to revert to a P&I repayment with a 25 year term remaining, the yearly interest bill would hit around $134,000 – a 50% increase in repayment and a very large hit to cash flow.
How best to manage this type of risk:
Realistically, the option to extend interest only terms or refinance out to another institution is available for most situations as long as servicing is OK and valuations hold up.
Its also helpful to be with lenders that don’t require full applications or reassessments for interest only term extensions (CBA, Westpac). Some lenders better than others in the I/O space – there are some that offer 10 or even 15 year I/O terms.
With the latest rate cut, and the inevitable spurt in confidence that’s likely to flow. I think it is worth keeping risk management in the front of mind for those investors aggressively accumulating properties.