Any advantages of funding property portfolios with popular interest-only loans are rapidly disappearing as lenders hit the red alert button by raising rates, tighten terms and offer lucrative incentives to pay down debt.
Trend-setting big banks are responding to regulatory pressure by hiking rates on the loans, which are used by 70 per cent of investors, by up to 50 basis points and encouraging switches to principal and interest loans by reducing rates by about 50 basis points.
Other lenders are following the lead by requiring bigger deposits and tougher scrutiny of income.
An investor with a $3.5 million portfolio and 70 per cent loan-to-value ratio will have to find another $1500 a month in repayments, or about $18,800 a year, if interest-only repayments increase by 50 basis points, according to analysis by finder.com, which monitors prices and costs of financial products. Lenders from the big four are already paying higher rates.
The same investor on a principal and interest loan would have to pay an additional $1100 a month, or $13,200 a year, if rates rose by 50 basis points because these loans have become more attractive, says finder.com.
Traditionally loan repayments have been cheaper on interest-only loans — both because repayments don’t include principal and rates have been lower than on principal and interest loans.
Rate blow out
But moves by the big four lenders and their subsidiaries, which provide the vast bulk of loans,are changing this. During the past 12 months, for example, CBA interest-only loans have risen by more than 30 basis points to 5.94 per cent as principal and interest loans have fallen 10 per cent to 5.25 per cent. That’s based on a borrower with a $500,000 loan and 20 per cent deposit.
The average Australian property investor has two properties, says Digital Finance Analytics’ principal Martin North, with the bulk of the remainder having between three and five.
North says the “striking observation” about households with large numbers of investment properties is the size of their debt, preference for interest-only loans and smaller number of quality portfolios. Many “serial” investors rely on multiple lenders and rely on rental income to repay interest.
Annual rents are falling in Perth, Brisbane and Darwin by between 1 per cent and 9 per cent, according to SQM Research. They are rising in Hobart by 11 per cent, Melbourne 5 per cent and Sydney 3 per cent.
Investors with high debt and falling income, says North, are the most vulnerable to a rapid interest rate increase or a downturn in property values, which is likely to impact lower-quality properties first.
Warnings of bigger falls
Investors dumping property on to the market will trigger bigger falls, analysts warn. They are also being squeezed by recent federal budget restrictions on travel concessions for inspecting investment properties and cuts to depreciation claims for rental property furniture and fixtures.
Navid Guia has three investment houses, each with an attached granny flat — two in St Marys, 45km west of Sydney’s central business district, and one in Sacramento, in the US, close to his family.
He purchased the two- and three-bedroom Australian properties for between $249,000 and $310,000 during 2011 and 2012. The Sacramento house, which cost $117,000, was added last year.
All the properties are interest-only with a loan to value ratio of between 10 per cent and 20 per cent.
He is protecting his portfolio from rising rates and peaking prices by positive gearing, ie, income from the investments is higher than interest and other expenses.
Guia, 30, who trained as a civil engineer, says: “To me it does not make sense to buy a property and then negatively gear it. I have a cash flow from the rent that can be used for investing and buying other properties.” Negative gearing uses borrowed money for an investment whose losses can be offset against the investor’s income.
Guia says reliable, well-priced rents means he can comfortably absorb recent rate rises.
Other portfolio investors, such as Mario Borg, finance strategist, with Mario Borg Strategic Finance, says: “There are many home owners making interest-only home loan repayments, not realising that they could be paying a much lower interest rate if they choose to make principal and interest repayments.”
Regulators, including the Reserve Bank of Australia, are nervous about the rapid growth in interest-only loans in the absence of clear evidence borrowers have a strategy to repay the principal and have put pressure on lenders to raise rates and toughen terms.
The big fear is that static and falling incomes combined with rising rates, fewer tenants and increased supply of apartments and houses will cause widespread financial stress, which could lead to defaults, weaker consumer confidence and lower economic growth.
Fund managers, whose investment strategies can profit from volatile and falling markets, are warning high levels of personal debt could cause “Australia’s sub-prime crisis”, a reference to the US mortgage crisis that accelerated the slide into the global financial crisis.
Wayne Byres, chairman of the Australian Prudential Regulation Authority, says: “If we are going to put an increasing number of eggs into a single basket, we had better make sure that basket is an unquestionable strong one.”
Pressure on lenders
Byres has imposed an interest-only lending limit of 30 per cent of total new residential mortgage lending and is pressuring lenders to manage tightly new interest-only loans, particularly those with high loan-to-valuation ratios.
Analysts and mortgage brokers expect rates on interest-only loans to continue rapidly rising.
Christopher Foster-Ramsay, of Foster Ramsay Finance, reckons the difference between investor interest-only loans and owner-occupier principal and interest rates will blow out to 100 basis points by the end of the year.
DFA’s North says key market indicators, such as the yield curve, which reflects expectations of future returns, suggests fixed rates will rise by 50 basis points in coming months.
The need for lenders to control loan growth and wanting to deter “risky” loans will add to the pressure because stressed borrowers will have fewer options.
Falling rents or loss of tenants could jeopardise the financial viability of nearly 36,000 property investment portfolios around the country, according to North.
More than one in three portfolios with Sydney property would be at risk, he says, compared with Melbourne where one in four properties could be impacted. These are investors who would not have income or savings to pay for their property investments if rent were to stop, he says.