Interest Only……… If Only!
In August last year we published an article contemplating credit challenges ahead. I point this out with no great delight because, for once, it seems we had it right. Drop me a line if you want a copy of the original article, it’s on our web site.
Anyway, one of the key points I raised a year ago was the expected pressure on lenders to reduce interest only lending. That prediction has most certainly come home to roost. In the past few months we have seen a range of major and second tier lenders bring in restrictive lending standards for interest only property finance and we have seen a number also increasing interest rates on interest only finance. To be sure interest only finance presents a higher credit risk to a lender so I don’t necessarily have a problem with differentiated pricing to reflect that risk. The obvious question is “Will there be a flow on effect for business and commercial finance? ”.
You can download the information detailed on this page (‘Interest Only……… If Only!’) as a printable PDF for future reference. Click here to access the PDF document.
The answer is already with us and unfortunately it’s a Yes. There are already major lenders out there whose credit policies do not allow for interest only management rights finance. I should clarify that by saying that this policy applies to borrowers chasing maximum gearing. Go for lower gearing and the interest only option can be available. I should also make it clear that while some lenders are going down the P and I route others seem comfortable with interest only, even at 70% gearing ratios.
As we pointed out in August last year there are good reasons to go with interest only finance and certainly strategies for presenting your plans in a favourable light with the banks. Having said that there are two strategies that we strongly suggest you don’t use. The first is the main reason borrowers seem to ask for interest only and it’s got very little to do with tax planning. I want interest only so I’ve got plenty of money left over for good times, travel and lifestyle. Sorry, the bank doesn’t care and if you can’t repay debt due to lifestyle choices that’s probably not a good look for any applicant. The second reason is even more concerning. I want interest only because I can’t afford P and I. Again, sorry, no dice on this one either.
Let’s have a think about that last reason in the context of debt servicing. Banks lend money over a specific term. Let’s say it’s 15 years. The borrower requests the first 2 years interest only. At the end of that 2 years we need to be able to show the bank that the borrower can afford to repay the loan over the balance term of 13 years. Just to make that calculation a little more challenging we also have to demonstrate that the borrower can meet that P and I obligation at interest rates 2% to 3% above current levels. You can see where this is going…..I hope. Essentially the longer interest only period you ask for the tighter the debt service numbers get.
Incredibly banks have not always assessed debt service capacity in this manner but I can tell you that they all do these days. Given the current demeanour of regulators and ratings agencies we expect debt service guidelines to become more conservative and onerous over the next 12 months for both personal and business borrowers. In particular we expect lenders will place less reliance on tax savings through negative gearing on property, will make higher allowances for living expenses and will test debt service capacity sensitivity at even higher rates.
I know what you’re thinking. I’m on interest only finance right now and it’s coming to an end. I want more interest only, I like interest only, I am addicted to interest only and my finance contract says I am going to P and I. Please don’t take my interest only away. How do I restart the interest only clock. There are certainly strategies for achieving this outcome, the most obvious being to simply refinance to another lender. However, there are also good arguments you can put to your current lender to negotiate a further interest only period or indeed to restart the entire loan term clock.
One of the better strategies to achieve initial interest only terms or further terms on existing finance is to argue the notional amortisation strategy. We have just used this strategy successfully for a new applicant and achieved great results for a number of clients who wished to roll interest only loans for a further term.
So, what the hell is notional amortisation. Sorry, I can’t give that one away.
Gratuitous plug……………………for all these reasons use an industry expert finance broker!
Mike Phipps F Fin
Director | Phippsfin Pty Ltd
ACN 139 124 673