101 Uses for a Dead Interest-Only Loan

Since time immemorial humankind has been plagued by the question "What do you do with a dead interest-only loan?" Actually it's dead cats that are the immemorial plague, dead interest-only loans are a more recent phenomenon. With apologies to Simon Bond (author of 101 Uses for a Dead Cat) and all cat lovers (my daughters have two); interest-only loans have only recently started dying. This mass extinction of flexible finance was triggered by ASIC's 2017 review of interest-only lending, prompting panic and uncertainty among property investors. In this article I will share my experiences and thoughts of interest-only lending, but please note these are my observations only and seek your own independent financial advice prior to taking any action.

So what is an interest-only loan? An interest-only (IO) loan is a loan structured for repayment of the accrued interest but no repayment of principal. The repayments on an interest-only loan are lower than on a principal and interest (P&I) loan, assuming the interest rate is the same on both loans. More on that subject later. Over time, the loan balance on an interest-only loan remains the same. By contrast, repayments on the traditional principal and interest loan reduce the loan balance over time.

Why would a property investor want an interest-only loan? There are many sensible economic reasons to only pay interest on investment borrowings, but they all have a central theme. Control. Available investment capital is scarce, and borrowing on an interest-only basis gives the borrower control about where they allocate funds. The automatic allocation of capital to reducing an outstanding housing loan balance is the safest option for the average borrower, but not necessarily the best choice. P&I is designed for stock-standard wage and salary earners who are not trusted by lenders to make their own financial decisions. For above-average borrowers, better uses of principal might include paying off personal (non-tax deductible) loans, renovating property (with likely rent increase), or purchasing alternative investments. Think of it this way - if you are a serious investor building a property portfolio, you want to channel scarce capital into property acquisition, renovation and development, and not into repaying the principal on existing loans. Every principal and interest loan takes a small piece of cash flow out of the investor's circulation and directs it to loan balance reduction. Why would an expanding property investor want to be allocating $408 a month to property A's loan balance and $192 a month to property B's loan balance and so on, rather than combining all the small amounts into one large cash flow stream which may be enough to fund the purchase of another property?

Back to the original question - what do you do with a dead interest-only loan?

1. Do nothing - this is the default position and likely what most borrowers will do. If nothing is done, the loan will continue upon its original term (most commonly five years from initial draw down) and then the repayment method will change to principal and interest. Will changing to principal and interest repayments be bad for an investor? Not necessarily. Over the last two years the banks have increased risk margins on interest-only loans by around half a percent. For example, at time of writing the NAB base variable home loan rate for investing is 4.65% for P&I and 5.18% for IO - a whopping 0.53% penalty for property investors wanting interest-only. But in our do nothing scenario, we are going to see the reversal of this penalty as borrowers switch to lower rate P&I loans. For example, an investor who borrowed $300,000 would have been paying $1295 per month as interest-only. Reverting that same loan to principal and interest and the repayments only increase by $252 to $1547 per month. Breaking down the new P&I payment, it starts with $1163 of interest and $384 of principal. In other words, reverting the loan to P&I costs the borrower's monthly cash flow $252 but reduces the outstanding principal by $384. Not a bad investment really! Are there any other guaranteed investments where you can put in $252 per month and get $384 back? If the increase of $252 per month is a bridge too far, at the moment many fixed-term P&I rates are less than the variable rate and will reduce the cash flow gap.
2. Apply for a new interest-only term - requesting an interest-only home loan is not forbidden or impossible, it is just very difficult to obtain. Borrowers with strong credit who are matched with a flexible lender will likely be able to obtain a renewed interest-only term - a five-year reprieve for good behaviour! Renewing your interest-only loan with your existing lender has the advantage of saving re-finance costs, paperwork and time. This may be a good option for you if you have multiple loans with a lender that you want to continue to use; and in particular if only some of your loans are currently interest-only with the balance on a principal and interest basis.
3. Re-finance - the knee-jerk reaction by borrowers is to re-finance your loan to another lender who is willing to offer interest-only. While this will give the borrower the satisfaction of punishing their intransigent former lender, it will come with a cost. Financial costs may include fees for application, valuation and legal services. Further, due to tighter lending criteria, the massive quantity of paperwork required to submit a loan application will necessitate the purchase of a wheelbarrow. Your refinance request is increasingly likely to be rejected. However borrowers in a strong financial position will still have options for their repayments. There are good rates and terms on offer, but weigh the costs and benefits carefully before continuing down this path.
4. Pay off the loan - the ultimate in principal and interest payment! Understandably not all investors will have the cash available to make this large payment. But some people will, in particular investors with long-held loans where inflation has made the remaining balance relatively small. Such long-term investors may also have surplus cash sitting elsewhere, perhaps in superannuation available for withdrawal. After repaying the loan you will no longer have tax deductions for interest payments, but possibly your earning situation has changed and you do not have high taxable income any more. Repaying home loans and holding a portfolio of debt-free rental properties is a solid retirement plan.
5. Sell the property - if you want to pay off the loan but don't have the cash at hand, you could sell the property that the loan was used to buy. At first glance, investors compare the market value of their property with their outstanding loan balance, and see that they could sell and maybe even have some cash left over. But on closer inspection, there may not be as much cash available from sale, due to a range of complicating factors. The available cash from a property sale can be reduced by the following factors:

• Market value of your property may be less as the market in much of Australia is falling at present. Properties regularly sell for ten to twenty percent less than their original listing price. Even worse, in the current weak market some agents have been given incentives to convince you to reduce your list price. A reduced sale price may be necessary to close the sale, but can leave you with zero equity released.
• Capital gains tax (CGT) may be payable, depending on the sale price. The exemption from CGT applies to your main residence, but the tax applies in full for rental properties. There are CGT discounts available when you hold the property for more than twelve months. But be aware that you may need to pay more CGT due to the claw-back of your previously-claimed depreciation deductions. Bet they didn't mention that sting in the tail at the property investment seminar! Timing can be important for CGT, so if you anticipate a capital gain from the sale you may wish to look closely at your overall taxable income and the anticipated sale of any capital loss making investments in the same financial year. Definitely ensure you do some calculations with an accountant prior to deciding to sell your property.
• If your rental property is the subject of a long-term lease, sale does not automatically extinguish the lease. Most potential buyers will be wanting to move into the property. Further, emotion-driven owner-occupier buyers will usually be willing to pay more than a calculator-driven investor would. You may consider offering a financial incentive to the tenant to move out early, remembering that mutual consent will be required for this.
• Deferred maintenance may cost you the sale price premium, and cause your property to sit on the market for a long time. Some owners choose to save cash by not maintaining their properties, which can lead to a tired appearance. If your property is long overdue for refurbishment, allocate some funds for improvement prior to sale. The current weak market will not give you a return for substantial renovations, but the basics of garden clean up, painting, floor and window coverings are worthwhile for almost all properties bar the pre-demolition sites.
• Cross-collateralisation of your sale property as security for other loans may mean you receive zero cash from the sale. If you have a portfolio of linked security properties with the same bank, sale of one property may trigger a revaluation across all properties. If the market value has deteriorated since the date that the original valuation was obtained, your portfolio may now fall outside the lender's security requirements. Consequently the lender could demand all surplus sale proceeds be applied to debt reduction to reduce your loan to value ratio.

Dead cats and interest-only loans are best removed before they start to smell. I recommend all property investors with interest-only loans review their original loan contracts, expiry dates and financial position. Ensure your 2017/18 financial statements and tax returns are done so they can be called upon if needed. If you need to take action, then start early. Don't wait until you are dictated terms by a lender and forced to take unpleasant actions.

So will interest-only loans go the way of the dodo rather than the cat, and become extinct? The blanket recommendation and sale of interest-only loans to every mum and dad investor who could scrape together a (home equity withdrawal) deposit was harmful to the financial soundness of both borrower and lender alike. But the inappropriate use of a tool does not mean that the tool itself is defective. Interest-only loans are a valid financial tool for property investors who are proficient at managing their own finances. By denying interest-only to all, lenders are failing to serve the borrowing needs of sophisticated property investors.

Widely used in other areas of business finance, interest-only loans have an enduring place in a lender's product suite. What bankers need is a more nuanced understanding of borrower profile to match to product. For instance, a borrower who has demonstrated the ability to build a property portfolio of five or more investment properties is not the same as a home owner purchasing their first rental property. Nevertheless the wheel of lender credit policy will continue to turn, and some day in the latter half of the next property boom we will see interest-only loans again offered to all and sundry!