Borrowers with interest-only loans may face some serious challenges in 2020 if they don't take steps to prepare themselves for a compulsory refinancing of their interest only loans.
According to comparison site Finder, 730,000 interest-only loans will expire before December, and their lenders will be contacting them to renew their arrangements.
Almost certainly the borrowers will be given no option but to convert their loans to principal and interest (P&I). This may well mean a substantial jump in their monthly repayments.
Think about Kerry, who is aged 50, and has an interest-only loan of $400,000 for an investment property. The loan is secured by a mortgage over Kerry's home, as well as a mortgage over the investment property. The loan was taken out five years ago with an interest rate of 5% fixed. Monthly payments were $1667 ($20,004 a year). As the loan was interest only, and for investment purposes, all payments were tax-deductible - the debt remains at $400,000.
The five-year term ends this year and Kerry is facing refinancing. Given the present lending conditions and the general reluctance of banks to assist borrowers, almost certainly the bank will require the loan be renegotiated on a P&I basis, and probably will restrict the loan to 15 years as Kerry intends to retire at age 65.
The extra payments will have to come from after-tax dollars.
The comparison websites display a wide range of interest rates, but for this exercise let's assume that Kerry refinances on a 15-year P&I term at 4% variable.
The monthly payments will be $2960; an increase of $1293 a month or $297 a week.
And here's the rub, the extra payments will have to come from after-tax dollars because only the interest is tax-deductible.
The interest for the first year of the new loan will be $15,368 - that's a reduction in Kerry's interest deduction of $4636.
After five years the interest will be down to $12,197 and be starting to reduce rapidly.
The good news for Kerry is that the loan will be paid off at age 65, the bad news is that the after-tax dollars required to pay the monthly payments will be increasing faster and faster every year.
But, these figures are based on the assumption that Kerry is on good terms with the bank and has a secure income that will support the increased payment.
But not everybody is in that fortunate position.
Think about another couple who tend to let the future take care of itself and whose credit position has declined because one of them lost their job, just after they had borrowed heavily for a new car.
If they leave refinancing to the last minute, they may well find the bank will not extend the loan and their chances with other banks are remote due to their bad credit score.
Their only option may be to dump their property and lose money if it was a bad deal, or pay capital gains tax if it was a good one.
The lesson is clear - if your interest-only loan is expiring this year you should be exploring your options right now.
I am told that it takes at least eight weeks to get most loans approved and by delaying you lose your chance of shopping around for a better deal.
Mortgage brokers tell me that banks vary widely in their criteria for loan assessment, as well as in the rates they will offer.
Probably your best option is to go to a mortgage broker and start work now on a loan that will work best for your budget and your financial goals.
- Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. firstname.lastname@example.org