I read an interesting article recently written by Noel Whittaker, where he talked a bit about how Interest only loans have seemingly become public enemy number 1, or at least as far as APRA and ASIC are concerned. Is that really justified though? What is it that the APRA and ASIC have against interest only loans and what really are the risks?
The argument being put forth is that interest only loans are a risk because none of the principal is being repaid and unless the property goes up in value, then there is little to no equity. When we talk about risk, who is that a risk to? The banks, not the individuals borrowing the money. So while APRA and ASIC are couching this crackdown on lending practices by the banks as a ‘consumer protection’ measure, it’s not really. It’s about protecting the banks.
Noel, in his article proved this brilliantly with a great example. The example he gave was of a typical couple, called Jack and Jill, approaching retirement age, currently 55 years of age, who had built up substantial equity in their home and want to borrow $300,000 for an investment.
Given their proximity to retirement age it’s like the banks would insist on a shorter than usual loan term, perhaps as low as 10 years taking them through to age 65. If they secured an interest only loan at 5% interest, repayments would be $1,250 per month. However, if the banks insisted on say a 10 year P&I loan (used in Noel’s example), then repayments would be $3,182 per month, a massive difference, added to by the fact that interest repayments can be paid with pre-tax dollars being tax deductible and the principal portion of the loan must be paid with after-tax dollars.
In this scenario the interest only option keeps their repayments a lot more affordable, allows them to retain more cash as a buffer and maximise their deductible debt. Any surplus funds can be put towards their principal place of residence to pay that off while continuing to carry the deductible debt.
If they were forced to get a P&I loan, over 10 years as could be the case with the APRA and ASIC rules coming in to place they may not even be able to afford the P&I repayments, but if they could, they’d be faced with 10 years of large repayments that become more difficult each year as the after-tax component being repaid (i.e. principal) falls.
So what do all the numbers mean? Initial repayments on the P&I loan would be $3,182/month of which $1,250 is tax deductible interest and the balance $1,932 is principal and non-deductible. That non-deductible payment is equivalent to $3,168 pre-tax dollars (for these clients in their tax bracket, as per Noel’s example). Let’s say they manage to make the payments, they arrive at age 65 with the $300,000 loan paid off, great right?
What if they’d been able to use an interest only loan? Taking on the same financial obligation say they pay the bank the $1,250 in interest each month and salary-sacrifice a total of $3,168 (the amount equivalent to the pre-tax principal payment) into their superannuation fund. After contributions tax (for these people) the actual amount credited to their super is $2,693 per month.
What does that look like after 10 years? The period it would take to pay off the P&I loan. Their superannuation is boosted by an extra $491,000 which would allow them to withdraw $300,00 to pay off their loan, leaving a tax-free bonus of $191,000.
They could push this even further however. If they could secure another 10 year interest only loan at age 65 they could withdraw $15,000 per year from super to make the interest repayments leaving the balance to continue to grow in their super fund. After a further 10 years the balance could be worth as much as $950,000 leaving a surplus of $650,000 if they then repaid the $300,000 loan.
Please don’t take this article as financial advice, it’s not, it’s intended as thought provoking information to encourage you to think about your own finances and how you approach them.
So what’s the take home message here? When seeking finance, use the services of a competent mortgage broker, talk to your accountant or financial planner about structuring options and tax saving options then take the time and effort to try and find the financing structure and lending partner that will give you the best option.
Do what’s right for you, the banks and APRA and ASIC aren’t necessarily looking out for you, they’re looking out for the system.