To switch to P&I or not to switch
Author Matthew Kerr, Hudson Financial Planning Finance Manager
As the Greek Philosopher, Heraclitus once said, “change is the only constant in life” and there hasn’t been any shortage of change in the world of lending and finance over the last 18 months.
I won’t bore you with the APRA story about what they have done and what they are seeking to achieve by getting banks to tighten up on lending standards to investors as I’m sure you’ve all read enough about it now. Instead I’d rather focus on what you can do as an existing investment borrower to improve your current position and also to give you an update on whether the banks are still open for business to investors.
DO YOU HAVE AN EXISTING INVESTMENT LOAN?
Recently I’ve been doing a lot of finance reviews with members who I haven’t spoken to for some time and in a lot of cases I have found that most don’t know what their current rates are, let alone what they can do to get a better rate and save some money. This is partly because the interest rate changes have been slow and steady over the last 18 months so the rates have gradually crept up but we are now at the point where the difference between an interest only rate and a P&I rate is quite large. The other part to that is that you aren’t likely to receive a phone call or email from your bank to give you ideas on how you can save interest. This is where you have an advantage by dealing with the Hudson Finance department.
I want to show you a common scenario that I have come across recently and break down some numbers so you can clearly see what it means to start paying P&I on your investment loans. This will tell you whether it might be an option for you or not.
$500,000 investment loan that is currently interest only and the rate has slowly crept up to 5.10% p.a. (Remember that 2 years ago the rates were the same whether you had a home loan or investment loan or were paying Interest only or P&I)
Current Repayment = $2,125 p/m Interest only
SWITCH OPTION – 2 year fixed P&I @ 3.88% p.a.
For illustration purposes, we will assume the rate of 3.88% p.a. for all future calculations.
FREQUENTLY ASKED QUESTIONS
QUESTION 1 - My repayments will go up a lot and I won’t be able to afford the repayments though will I?
REPAYMENT = $2,352 p/m
ANSWER: Your repayments will increase by $227 per month
QUESTION 2 - How much interest will I save?
ANSWER - $6,258 p/a
QUESTION 3 - If I sell the property in 10 years time, how much will I still owe on the loan by paying P&I? – (remembering we are using the rate of 3.88% p.a. as the example to show where the debt would be in 10 years)
ANSWER: The outstanding balance in 10 years time will be $391,230, as opposed to $500,000 if you remained Interest only. Therefore you are making an extra $227 per month in repayments, which equates to $27,240 over 10 years yet your debt has reduced by $108,770. ….not bad.
QUESTION 4 - It’s an investment loan so I have always been told to make Interest only repayments by my adviser, Accountant and Sunday BBQ experts
ANSWER: By paying down the debt you are missing out on an interest deduction of $6,258. If we were to assume you were in the 39% tax bracket (inclusive of the medicare levy), it means that you miss out on $2,440 in your tax return giving you a net saving of $3,818 by employing this strategy.
This can get a little complex to follow so included below is a table showing the differences between the 2 different repayment options.
@ 5.10% p.a.
@ 3.88% p.a.
in year one
|Total annual repayments||$25,500 ($2,125 pm)||$28,224 ($2,352 pm)||$2,724 higher repayments|
|Interest component||$25,500||$19,242||$6,258 saving|
|Principal reduction||NIL||$8,991||$8,991 lower debt|
|Tax Refund (39% MTR)||$9,945||$7,504||$2,441 less refund|
Overall, by contributing an extra $2,724 in repayments towards the loan you will have a net saving of $3,818 across the year. This represents a 140% return after tax which is a great investment.
As with anything tax related please consult your registered Tax Agent or Accountant for advice.
ARE BANKS STILL OPEN FOR BUSINESS?
I would forgive you for thinking they were not but they most definitely are. There has been a raft of changes that have included the rate increases, policy changes to make serviceability tighter and loan to value ratio restrictions. This seems like a lot of change and it is but for the average borrower, they have been largely unaffected. Those who have been impacted the most are borrowers who were very tight with being able to afford a loan in the first place and existing borrowers with a decent amount of existing investment debt. How this debt is expensed by the bank has changed a lot and this is the big negative of these changes in that experienced investors who know how the cash flow of an investment property works and those with a great repayment history are being told they can’t continue to invest for now.
When I say the "average borrower" I mean the borrower with an existing home loan and some equity in their home who are looking to purchase an investment property. They haven’t really been impacted by the changes. You can still get an investment loan at 3.88% p.a. to purchase an investment property and the assessment of this type of transaction is not dis similar to what it was prior to APRA flexing their muscle.
As always, if you are unsure about your borrowing capacity please make an appointment to have a chat with your adviser or myself to see what options you have. It only takes 5 minutes.
Likewise if you want to have a chat about whether you should look to change your repayments to P&I please don’t hesitate to schedule an appointment so we can look at your specific situation and whether it makes sense or not.
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