For many of us we have seen everything from the high interest rates in the 1980s, to the low interest rates of now. For every scenario there are winners and losers, Low interest rates means cheap money but as we have seen in the last 4 years it pushes up the price of property, likewise those with cash in the bank are getting little interest. One of the looming issues we will need to face is the problems associated with Interest-Only home and investment loans.
Since the de-regulation of the financial markets in the early 1980s we have seen initially very volatile interest rates and the high mortgage costs associated with this to the winding down of interest rates over the last 25 years. In the early 1990s the Reserve Bank board effectively regulated interest rates and at its monthly board meeting sets the rates. The current rate of 1.5% is the lowest in decades, and is the result of global action by national banks to stimulate the economy following the GFC (now 10 years ago).
The problem is that the Reserve Bank can’t raise rates to where they should be because there is now excess debt and the economy could not afford the pay, and secondly if there is a financial downturn they can’t reduce rate much further to stimulate the economy.
The correlation between falling interest rates and rising property prices can be seen in the chart below.
Source: Reserve Bank of Australia, ABS (normalised to 1985 starting point)
Whilst there is not much we can do about this, there is a looming issue for those with Interest-Only loans from the banks for either their home or investment property.
We are in a cycle of tightening credit brought on by normal cyclical issues but more important is the regulatory pressure on the banks. This means that the banks are going to demand the Interest-Only Loans be converted to Principal and Interest, meaning you will have to pay the loan down. In a conversation with Westpac last week they advised me that the maximum Interest-Only Period is now 10 years.
The sting in the tail is that the banks want the principal paid back in the remainder the initial loan period. This means catching up on past payments.
In the loan we discussed with Westpac last week, the $325,000 investment property loan was taken out as Interest-Only 20 years ago now needs to be paid off in the next 5 years, this means monthly expense going from Interest-Only of $1,500 per month to Principal and Interest of $7,153 per month with only the $1,500 being tax deductible the remaining $5,653 being after tax money.
The impact of this can be seen in the chart below.
The impact of this will be dependant on each borrower depending on their circumstances etc. In the case above the loan was refinanced by another bank on a Principal and Interest basis for another 25 years.
If you or your family has Interest-Only loans it would be prudent to look into your circumstances and how you will manage this, either by paying off the loan, seeking alternative finance sources and so on. The problem is if you wait until you get notified by the bank, you face the risk that credit maybe tighter and refinancing may not be an option, likewise your circumstances may have changed making refinancing harder.
In summary, it is worth remembering that loans can only be paid off with cash/income. Rising prices increases equity but unless you sell the property, the rising value will not pay the loan off.