Finance risk while growing a large portfolio

Discussion in 'Property Finance' started by Redom, 6th May, 2015.

  1. Redom

    Redom Mortgage Broker

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    One of the least sexy parts of growing a portfolio is managing the risks associated with holding large exposures to mortgage debt. The most commonly talked about risk is interest rate rises and what sort of a 'buffer' investors should hold.

    However, a risk that often doesn't get enough attention is the potential for interest only terms expire and reverting to P&I repayments. This is particularly relevant when purchases are being made in a historically low rate environment.

    Many investors, particularly those in the process of accumulating a large portfolio, may not actually intend to pay down debt. If not considered properly, investors could find themselves in a situation where they are unable to extend their interest only terms. Here are some of the potential scenarios where this risk could crop up:

    1. Changes to your income/expenses - At the time of the purchase, your situation may have allowed you to borrow. Family planning comes to mind here, or perhaps switching to self-employment.

    2. Changes to serviceability calculators and interest rates over 5 years. Borrowing power assessment can be very different over that time period, particularly if interest rates normalise. A 2% increase in rates can lead to a very different borrowing power.

    3. Changes to the lending environment that restricts the ability to extend I/O terms. Right now the increase in I/O loans and investors not paying down their debt is one of APRA's primary concerns. Rates, policies and appetites for term extensions can change over such a long horizon. This uncertainty is beyond an investor's control.

    4. For the PPOR home - extending I/O terms for PPOR homes are likely to become more difficult to obtain than for an investment loan.

    To give a bit of an example, there's plenty that'd be obtaining loans right now with lenders that only allow 5 year interest only terms (NAB, Macquarie, etc). Right now, you're likely to be paying around 4.5%. If for example, you've got a $2 million exposure to debt at I/O terms, your repayments are around $90,000 per year. If this were to revert to a P&I repayment with a 25 year term remaining, the yearly interest bill would hit around $134,000 - a 50% increase in repayment and a very large hit to cash flow.

    How best to manage this type of risk:

    Realistically, the option to extend interest only terms or refinance out to another institution is available for most situations as long as servicing is OK and valuations hold up.

    Its also helpful to be with lenders that don't require full applications or reassessments for interest only term extensions (CBA, Westpac). Some lenders better than others in the I/O space - there are some that offer 10 or even 15 year I/O terms.

    With the latest rate cut, and the inevitable spurt in confidence that's likely to flow. I think it is worth keeping risk management in the front of mind for those investors aggressively accumulating properties.

    Cheers,
    Redom
     
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  2. skater

    skater Capitalist

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    Yep! Onto that! Currently refinancing some to CBA and all new lending with CBA. Maxed out with WPac.
     
  3. jerrybee

    jerrybee Member

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    Very good post, thank you.

    This very topic has been weighing on my mind recently because I have a few high quality, low yield CG properties that would really bleed me if I were to get stuck on P&I. The problem is I can't go with CBA or Westpac because I share a few properties with my brother which means I need to stay with my current banks as they don't count the full debt against me.

    I also plan on taking a few years off to travel - because after nearly a decade without ever taking a day off, I need it...and I'd like to finally do a few life-things that I've been delaying for so long now. On my return, this will kill my ability to refinance and also affect my chances of finding a new job quickly, so this is my strategy - let me know what you think. Currently, I've hit my borrowing limit, but in the new financial year I will have two tax returns that demonstrate a 40-50k increase in income. I'm going to use this to draw equity from my properties. I'm hoping this boost in income will allow me to draw up to 300-500k in a LOC? This income boost may also qualify me to switch two properties that I hold exclusively to my name to CBA or Westpac. Two is better than none. But even if I can't, I figure a 300-500k buffer should be more than enough should things turn sour, and it'll also give me plenty of time to find a new job on my return.

    What do you think? Are there any other strategies I could use to minimise my risk, given my situation? I should also note that my risk tolerance level at this point is low to medium.

    (I also have about 100-130k in cash and shares but I'm not counting this as I'm making the assumption that I will deplete this in my time off / traveling etc.)
     
  4. Redom

    Redom Mortgage Broker

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    Thanks jerrybee. In this type of scenario i'd just be building in a buffer to handle the potential to having to pay down some of the debt for a period of time.

    IMO, the best handling method is to have a buffer when you think that the above may happen to you. Identifying it early and planning for it really helps, given its still a period of years away.

    At present, some are unaware that this may be a risk and are aggressively accumulating to their serviceability wall right now - this wall moves back with rate rises with the potential for some investors to have already moved past the 'future wall' without realising they may have to climb over it again at the time of an interest only term extension.

    Cheers,
    Redom
     
  5. j_p

    j_p Member

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    Thanks Redom, I hadn't really considered the possibility of all IO loans getting stuck on PI. Risk mitigation is taking up more of my thoughts.
     
  6. truong

    truong Member

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    Even a bigger hit if you have refinanced all your loans at the same time and they come out of I/O together. Or if it happens while you're retired!

    Excellent advice Redom
     
  7. Paul@PFI

    Paul@PFI Tax, SMSF & Planning

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    I have a tax client who realised his PPOR was on IO well beyond the 5 years. He queried the bank and they agreed. And then demanded he pay the loan down as if it has been P&I for several years. Problem he had around this time was a default caused by a failed tax scheme and its associated loan. (He sued CBA who are also his lender on home !!). He couldn't refinance as a default was on his credit file. So the bank was starting to talk about calling the loan in.....Fortunately they didn't and all was settled out of court and default lifted from his record under the agreement.

    Message in this
    - Manage your IO loans / dates. It can be a ticking bomb.
    - Circumstances can change hampering refinance.
     
  8. jerrybee

    jerrybee Member

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    Great thanks. Good to know I'm on the right track. I wish there was more I could do but it is what it is. This is one of the perils of buying property with others. On the one hand it allows you to do so much more, but on the other it makes financing such a PITA.

    I was going to buy one more but I think I really need to stop right now, it's too dangerous without a buffer, given my objectives.
     
  9. jerrybee

    jerrybee Member

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    Yes also another very good point. When it came to refinancing each of my loans I've tried to stagger them all out by at least 6 months so I have some breathing space when I have to do it all again.
     
  10. Peter_Tersteeg

    Peter_Tersteeg Finance broker/strategist

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    I think the problem of I/O loans expiring to P&I is a bit over rated if structures are applied correctly from the beginning. I'm still in touch with some of the clients I set up loans for 10 years ago. Their I/O periods would have expired twice since then but it's rarely a problem. In practice one of several things usually occurs.

    1. They access equity from that IP within 5 years. In this process we usually end up renewing the I/O period anyway. In practice most loans for active investors rarely last out the I/O period in their original state.

    2. Some people aren't trying to build their portfolio as aggressively so they're not trying to access equity. In this scenario, after 5 years their cash flow has increased significantly in that time, usually as a result of both rental and salary increases. As a result renewing the I/O period is rarely an issue.

    3. There are people that really aren't that bothered. We've seen plenty of people simply allow the loan to revert to P&I and they're happy to pay off the loan over time.

    If you're an aggressive investor, you'll likely avoid the problem completely. It's not likely to be an issue for other investors either.

    The more likely risks that some people may be seeing in the future is more likely to be around increasing interest rates from their existing low point. Eventually economies will recover and rates will rise as a consequence. We may also be approaching a peak in the market. Rental vacancies are also on the increase in some areas and certainly lenders policies are trending towards the more conservative.

    Combine all of this and some people may find themselves under increasing financial pressure. Fortunately mitigating this risk is fairly simple in most instances.

    * Fixing interest rates. As rates increase, the obvious thing to do is to fix some loans. Whilst this does reduce flexibility of the loan (restricting ability to move lenders and make extra repayments), it does lock in repayments for a period of time. It's also good to manage this by not locking everything so all fixed rates don't expire at the same time. A strategic combination for fixed periods between a few years and 5 years can ensure you don't find all your rates increasing substantially in a short period of time.

    * As rates increase, so will income sources. Increasing rates are a sign of a stronger economy. With this will come increases in peoples income which will influence rental income. Frankly this solves a lot of problems. The catch is that there is often a lag between rate increases and income increases, so...

    * ...Have a contingency fund. It's foolish to believe rates will stay where they are forever. They will go up. Whilst money is cheap, people should be accumulating as much of it as they can. Having $20k set aside often be plenty to cover shortfalls in cash flow for a significant period of time. A contingency fund effectively buys you time to either deal with or recover from a tough period, or to liquidate assets where necessary.

    * Understand that rates can't increase that much that quickly. We've all heard stories about rates at 18% in the 1980's. In 2007 rates rose to between 9% - 10%. The economy ground to a halt as a consequence. The RBA was very quick to respond and dropped rates by about 5% within 4 months. Nowadays the economy would have trouble dealing with 7% - 8% interest rates. Rates will increase, but there are limiting factors on how far they can go in the foreseeable future. They probably will hit double digits again someday, but a lot has to happen in the meantime which will mitigate higher rates for people investing today.

    The solutions are simple.
    * Don't over extend yourself. You don't need to conquer the world in one market cycle. There's a different between being active, aggressive and outright reckless. Understand your limits.
    * Be aware of the market. Keep an eye on your finances and be proactive when things start to move.
    * Have a contingency fund. When times get tough, cash is king!
     
    Last edited: 6th May, 2015
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  11. perthguy

    perthguy Member

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    This is not a minor point and I just got caught out with this one. I see a lot of people looking at low fixed interest rates, like me bank, thinking they will just re-fi out at the end of 3 years. It won't necessarily be that easy.

    I just tried to re-fi out of AMP to ING in Melbourne. Even though the sale price of comparable properties in the area has increase significantly, my Melbourne property came back with a low valuation, so I would have had to kick in some of my own funds to re-fi to ING or pay mortgage insurance. My situation was a bit unusual because comparable properties in the area are selling in the $600k range but for some reason my neighbours sold their similar property late last year in the high $400k mark. That certainly influenced the low valuation on mine.

    In the end I was happy to stay with AMP for that loan, so it worked out well for me this time. It's still something to consider when choosing a lender.
     
  12. jerrybee

    jerrybee Member

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    Thanks Peter. Some good tips and reassuring words.
     
  13. almostthere

    almostthere Member

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    Hi Peter, could you please explain this a bit further ?
    How can accessing equity renew I/O period of the existing loan ? Is it applicable for loan top up or also for the split ? Any other requirement for this to be applicable ?
     
  14. Jamie M

    Jamie M Mortgage Broker - Oz Wide

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    Hiya

    I'm not Pete - and hopefully he doesn't mind me jumping in.

    When applying for an equity release - it generally involves a full application process. That application process present an opportunity to also extend the existing IO period.

    Cheers

    Jamie
     
  15. jerrybee

    jerrybee Member

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    Is this the case with all banks? My friend is with...Westpac I think. He said they have a feature called "equity topup" or something along those lines, the name seems to imply it's an easy process like topping up credits on your phone:p ...or is the name misleading?

    Also my mortgage broker says he increase his LOC every time there's a price increase and the way he said that seemed to me it must be easy, if it was an entire loan reapplication every time prices went up you'd be going through the whole painful ordeal every second week!! Is it safe to assume some banks make this a piece of cake or is it pretty much the same across the board?
     
  16. Peter_Tersteeg

    Peter_Tersteeg Finance broker/strategist

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    Often you can do this with Westpac. The last one we did however, required a paper based form to be filled out along with payslips and rental statements as supporting documents. It was significantly more work than a regular application. This was about 6 weeks ago.

    I do know what you've referring to with the topup feature at Westpac however. When they do it as advertised it's quick and easy, otherwise it's an insane process (seems to be one of extremes). Most lenders do require a full application however, and in that process we simply renew the I/O period from scratch.
     
  17. jerrybee

    jerrybee Member

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    Ok so in general, it's no more or less work than a regular application. Dammit! I have so many different loans...it'll be a real pain.
     
  18. jerrybee

    jerrybee Member

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    What was different about this one?
     
  19. Peter_Tersteeg

    Peter_Tersteeg Finance broker/strategist

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    To this day I have no idea. It was within all their policy parameters for top ups, they simply told me they require a particular form to be filled out and certain documents to be supplied. They also performed a full valuation.

    The only thing that was a bit out of the ordinary is this client has borrowed about $2M+ with Westpac, that may have triggered something.

    It was essentially the same information in a regular application, the process was a bit like submitting an application back in 2006.

    Next time they start asking for additional paperwork, I'll cancel the top up and run it as a regular application.
     
  20. jerrybee

    jerrybee Member

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    Oh, so it ended up being even more work than a regular application? Geez..