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Australia’s Big Short

ShortIf you have read a newspaper lately, you no doubt have come across the APRA changes that are taking effect in the lending world. If you think APRA have finished with the financial industry, think again. It’s feeling like home loan applications are going to go back to the 1980’s, when you needed to dress up in your best suit to meet with the bank manager, to help make your case as to why the bank should lend you money.

 

One of the most recent red flags that have arisen are the rise in interest only loans. Sydney and Melbourne’s prices have exploded beyond belief and now 5 years later, the lenders are questioning their decisions to allow borrowers to take out interest only loans. The latest stats say that 40% of home loans, not investment properties, are Interest Only loans… yes, that means those buyers have paid those huge prices and budgeted to only pay the interest, not actually repay their loan?

 

Oddly enough, your borrowing capacity is reduced if you decide to take up an Interest Only loan, even though the repayments are considerably less. The reason for this is because the lenders must take into consideration the loan repayment when the loan reverts back to principle and interest. And given you have now paid 5 years as Interest Only, that means that there are 25 years left of your loan term, to repay the full amount, as opposed to 30 years.

 

And it’s this that could become Australia’s Big Short.

 

If you haven’t seen the movie ‘The Big Short’, it tells the story of how one man predicted the US property market crash that then led into a world wide catastrophe. The Big Short, in short, was about what we would call ‘Honeymoon’ or ‘Intro’ mortgage rates that were sold to borrowers who couldn’t afford them. After the 3 year honeymoon period was over, the rate would revert to a much higher interest rate that the borrower couldn’t afford.

 

Then how could they get those loans approved? Because the banks were servicing the borrowers repaying the debt at the intro interest rate and not the ongoing interest rate, which was much higher,  for the next 27 years. This occurred whilst the US property market was Booming, so borrowers would simply refinance their loan to another 3 year intro rate close to the expiry to avoid paying the high interest rates of course… that they couldn’t afford!

 

Now all that makes sense – as long as house prices kept rising and there was enough equity in the property for the new lender to see a good deal.

 

And that’s where the problem started. Prices slowed and started to decrease, so when these people tried to refinance, they was not enough equity in their properties for the banks to do the deal.

 

Whilst the good times were around, millions of people bought multiple houses because ‘everyone was doing it’ and making a killing in capital growth. They all believed that house prices never go down.

 

If you think that – then you’re an idiot! Yes that’s right – an idiot!

 

So house prices decreased, loans reverted to much higher interest rates that the borrowers couldn’t afford and exactly what you thought would happen, happened! Yep, they defaulted and couldn’t repay their loans and so started ‘the crash’.

 

So guess where the Sydney & Melbourne property markets are right now?

 

That’s right – at the end of a massive 5 year Boom where prices have now softened and even decreased slightly and we have thousands of home owners and investors coming off their 5 years interest only period, meaning their repayments are about to jump significantly.

 

The scary part, the catalyst to this scenario, is that APRA have restricted the amount of Interest Only loans that lenders can have. So in response to this, lenders have tightened their lending criteria and more so have made huge restrictions on their Interest Only policies.

 

This now means that everyone with an Interest Only loan is being put on notice. Unless you have 20%+ equity in that property plus have exceptional servicing, you will probably not be able to extend your Interest Only period with your current lender or be able to refinance to another lender for another Interest Only loan.

 

Where this gets scarier and where borrowers may find themselves in financial stress is that when your loan reverts to Principle & Interest, it does so over a 25 years term, not 30 years.

 

Let me explain:

Say you have an investment property loan for $500,000 and your interest rate is 4.5%. Your monthly repayment would be $432 per week. Now when that loan comes off Interest Only and reverts to Principle and Interest, your repayments are not based on the original 30 year loan term you originally applied for. As you have already had the loan for 5 years, you must now repay the full debt over 25 years. Meaning your loan repayments increase to $640 per week.

 

Yes an increase of $208 per week. Hopefully you don’t own several properties or have a home loan that’s interest only also, otherwise you could be up for over $500 in extra payments per week – not per month!

 

Oh and you better hope interest rates don’t increase like they have done recently too. That same scenario as above, but with 6% interest rates would be an increase of $310 per week…

 

For the more reckless, they took out 10 or 15 year Interest Only periods. Ten years make the repayments $730 per week and 15 year = $882 per week.

 

The reason this will hit Sydney and Melbourne the hardest is because they have extremely poor rental yields, meaning that you have to come up with the difference yourself.

 

Now this is only a problem if you have borrowed to your maximum and beyond your financial means. Or your income circumstances have changed, like job loss, job change or started a family.

 

For those who find themselves in trouble, the first thing that they will do is sell their property to get out of financial strife. The issue being that the market is changing and there will be far less buyers, meaning prices will have subsided. As their financial desperation kicks in, they will continue to reduce their selling price until they get a buyer. But there’s a kicker here, if they sell their property below what they owe, then they either need to find the difference, shift the debt to another property or the bank won’t release the title deeds to the new buyers. Unlike the US, Australia does not have a non-recourse loan structure, where you can simply drop the keys on the front door mat and walk away, leaving the house as the banks problem. That doesn’t happen here.

 

Over the years I have been barking on about doing your own servicing at 9%. If you can afford it at 9% – then you should be OK. The higher yielding areas I invest in certainly help, hence that’s why I do it. Reduce risk and diversify.

 

This is one of those times where you’ll thank me for that advice or wish you had listened!

 

But if you think I am a Doomsayer and choose to live in a fantasy world where house prices never go down, then I hope you have the income to support it…

 

 

 

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2 comments…
  • Brendan Merriman May 30, 2017, 8:10 pm

    Great read, just wondering if the bubble bursts in the big cities what will the impact have on the rest of the countr, for example Brisbane and Adeliade were the market seems to be steady if nor still slowly rising.

    Reply
    • Todd May 31, 2017, 12:00 am

      Hi Brendan,

      Thanks…

      Not 100% sure as yet – the impact will be felt more in Sydney & Melbourne due to the much higher prices and much poorer yields- like 2.5%.

      It will affect the borrowers who have borrowed to their maximum, but they were always going to have a tough time in the future whether this occurred or not. Interest rate hikes wold have gobbled them up anyway.

      Cheers Todd

      Reply

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