Will moving some investment loans from IO to P&I reduce serviceability ?

Hi Deepak

Much of a muchness as the majority of lenders service based off a sensitized rate (circa 7-7.25%) on a principal & interest basis irrespective of what you are actually paying or being charged.

Cheers

Yours in Finance

Hi Deepak,
The loan amount must have a bearing too – e.g. if you changed a 30 year IO loan for $800k over to P&I, the payback of the $800k must be taken into account. It would increase repayments by an average of $2200 a month. But if the loan was just $300k, then less than $850 a month is added to IO payments.

Also, what interest rate difference would be needed to offset this increase in repayments? If the loan interest rates were to reduce by 3.3% or more, then it would make going to P&I monetarily worthwhile. Is that possible? The 3.3% comes from this being a 30year term. (30yrs x 3.3% = 100% = you have paid it off)

So, based on that, I am struggling to see how it can make your serviceability better by going P&I no matter what size loan – as I doubt the P&I rates are going to be 3.3% less than IO rates. Of course, there can be other reasons to go P&I – but to my mind, serviceability wouldn’t be one of them.

Benny

Hi Terry,
I see what you mean, where a shorter term is increased to a longer one. But I think we are walking up different roads here nonetheless…. The point I was aiming at is that a PI loan REPAYS the total over a defined period. True? Now, if it 20 years, your repayments must be larger, or less if a longer term loan (30 years).

But while Interest Rates are SO LOW today, the principal repayments now make up a WAY BIGGER portion of a mortgage repayment than they used to. e.g. 20 years ago, a $200k loan taken over 30 years is repaid at 3.3% pa (so, Principal repayments averaged out to $6,666 per annum, while Interest back then might have been at 9% – so Interest was $18,000 per annum). Interest is near 75% of the mortgage payments, and principal repayment only 25%.

TODAY, it has all changed surely (???) Let’s say a $500k loan over 30 years must be repaid at $16,667 per annum but Interest is currently only 4.5%, so Interest paid is $22,500. Near enough?

This must surely mean that Principal repayments are now taking up nearly 45% of the repayment amount (coming close to doubling the payment that IO alone would be). Doesn’t this mean then, that any change from IO to PI must come with a whopping lift in repayments, thus affecting serviceability?

It is that huge shift in amounts (Interest Only vs P&I) that is having me thinking IO must surely be cheaper. As you say, making a shorter term loan into a longer term one WILL have a positive effect on serviceability – but will it make up for that huge jump (going from 25% to 45% of total repayments?)

Anyway – I’m not a MB, and you are, so I am likely missing something else. I hope you can help to clear my mind re what I have shown above – am I missing something there?

Regards,
Benny

Hi Terryw,
Well, I didn’t know the following – suddenly what you say makes sense.

Yes the cash flow consequences would be entirely different, but here we were discussing serviceability. The lenders will treat any IO loan as if it was a PI loan.

So, if a lender treats either loan similarly from a serviceability perspective, then that changes lots of things. Does that mean they DON’T look at actual cashflow, but treat both loans as if their mortgage cost is identical? Seems weird to me – it seems there is a very definite meaning of “serviceability” that the average layperson is unaware of. I suspect Deepak might have thought along the same lines that I did.

Anyway, thanks for the “behind the scenes” look at things. Would you humour me a little more, please, by outlining what effect the “cashflow consequences” might be in a case where one goes from IO to PI? If it doesn’t affect serviceability, where does it “show up”?

Surely such a huge jump in an investor’s outlays must have an adverse effect on their ability to refinance…. or show up in some way.

Thanks,
Benny

Terryw wrote:

No it will improve

I think this is where it can potentially get a bit confusing.

While the serviceability “will improves”, but if the repayment (P&I) is high enough and to the point where your monthly repayment + other expenses are high and your combined income doesn’t cover, then banks will still not lend to you.

It is not like banks will say “OK, out of $3000 repayment, only $1000 is interest, so let’s approve the loan based on $1000 interest + other expenses”. They will still say “let’s approve the loan based on $3000 + other expenses”.

This is why we need to look for bargains rather than the typical “let’s spend 5 years pay it off before start moving again” approach.

Thank you, gents.
With the extra help from you, I think I now “get” the whole picture. And, reading back, the first two replies said it all anyway – i.e. that even if you are paying IO currently, the initial borrowing was only granted because the lender deemed your total “free” income allowed you to make repayments even when you later change to a PI loan. And at the higher qualifying rate too (7%?) rather than the actual rate.

Now, knowing that, it helps me to realise there would be other outcomes that could become pretty hairy based on that. e.g. Given my earlier point, that ACTUAL expenses increase markedly if changing to PI, all of a sudden a bunch of other thoughts hit me:-

1. We had better be VERY mindful of the need to revert to PI when “Sizing up” a potential purchase (like Steven said) as any change from IO payments to PI payments will increase our day-to-day costs out of sight. Our mortgage costs are likely to almost double if my earlier comments are anywhere near correct. (addendum – in earlier days it was simply “Oh, no worries… just refinance with another lender and get a fresh 5 years of IO” – that may not be so easy in this current climate! Ouch !!!)

2. The change such as Deepak is considering – going from IO to PI – WILL add hugely to his monthly outgoings, and hitting his cashflow hard. Does his current situation allow for this? Or was his earlier loans formulated at a time where things were far less restrictive? Could it be that Deepak might not have got such a loan based on today’s criteria? If that happens to be correct, then it would be worthwhile to sit in front of a Broker to get a clear picture BEFORE any changes are made.

3. If one WERE to go PI from IO, and still have sufficient capacity to pay the extra repayments, that’s great – but suddenly a previously positive cashflow will have taken a huge hit. Is the investor now depending on Negative Gearing tax advantages to offset some of that extra cost? If so, where are they at if we have a change of Govt next year and Neg Gearing goes away? Hmmm?

4. When “running the numbers”, do we allow for “future PI repayments” that can cruel our income after 5 years? Or have we been basing the numbers only on actual expenses here-and-now? Five years can come around quickly. Further to that, we must be VERY mindful to not over-commit to extra IP’s without having taken future “IO to PI changes” into account.

5. How much have things changed since you bought your IP’s? Were the loans taken out in a time of “easy loans”? How would you be if you had to refinance today – do you KNOW? Did you know that above extra data about the huge cost increases when going to PI from IO loans? How will your portfolio stack up under that bright light?

6. If you have been considering buying more, have you really thought the above through with respect to YOUR current IPs? Can you really afford to go again – or is discretion the better part of valour?

What this topic shows me is how MY lack of knowledge in that area could have been quite damaging. I guess that shows we must depend on professionals – and we should refer to them (more) regularly, and not just when we think they are needed !! This recent tightening of rules (APRA induced) will have laid traps for many who are already in heavily mortgaged situations but who aren’t yet aware of all those points above.

What’s the time then?

Time to take a long hard look at our own scenarios with some of the above uppermost in mind. And maybe time to sit down in front of our favourite adviser.

Thanks to all who have contributed thus far, and I look forward to more input on this thought-provoking scenario,

Benny

So who else spotted my earlier mistake?

Back a few posts I had said this:-

TODAY, it has all changed surely (???) Let’s say a $500k loan over 30 years must be repaid at $16,667 per annum but Interest is currently only 4.5%, so Interest paid is $22,500. Near enough?

This must surely mean that Principal repayments are now taking up nearly 45% of the repayment amount (coming close to doubling the payment that IO alone would be). Doesn’t this mean then, that any change from IO to PI must come with a whopping lift in repayments, thus affecting serviceability?

Well, I was right, and yet I wasn’t… The first paragraph is pretty much OK. But the first line of the 2nd paragraph is not quite right. Here’s why:-
1. It is the “repayment amount” comment that is incorrect – what happens in P&I is that, as Principal payments are made, the Interest payments decrease. As well as that, when calculating repayments, first the total payments (Principal and Interest) over 30 years are calculated, and then divided into the required number of monthly payments. So in the example given, though the principal repayments DO make up a huge %age of the total amount to be repaid over 30 years, the actual MONTHLY payments are nowhere near the 45% increase above IO payments that I had first said…

The IO payments were $1875/mth. After calculating the total repayments required over 30 years (with the Interest payments diminishing to zero over that time) the 360 equal payments for P&I come to $2358/mth. So, not a 45% increase after all, but a 26% increase – still substantial, so a point that should receive due consideration.

Benny