Investment Mortgages and Interest Only

In recent years, the Reserve Bank has been working on reducing the amount of Interest Only mortgages in New Zealand. In the article below, we look at how it affects you as an investor.

Why don’t the banks like Interest Only mortgages?

The answer is largely to do with responsible lending.  It’s not a good financial decision to still have a large mortgage as you approach retirement, so the Reserve Bank wants to see customers paying down their mortgage.  To appease the Reserve Bank, most banks limit the amount of time you can have an Interest Only mortgage to 2 years for your own home and 5 years for your investment properties.

In the past, we have looked at the latest statistics out regarding Interest Only vs P&I mortgages.  In May 2020, Interest Only mortgages made up 29.8% of the existing mortgage market.

The Reserve Bank’s requirements to reduce Interest Only have worked to a certain extent.  In August 2016, Interest Only mortgages made up 38% of new lending.  Just 2 years later it is 31%.  You would expect new lending to be higher than existing because of the time limits placed on Interest Only loans (see below).

Is an Interest Only mortgage a good idea?

Interest Only mortgages aren’t inherently bad.  Take the example below of an investor that has a $300k mortgage against their own property and $600k mortgage against their investment property.

They have 2 options for paying down their mortgage over 30 years:

• Option 1, the one denoted by a big red cross, is to pay all accounts down via Principal and Interest payments.  Over the term of your mortgage (in the example, 30 years), you will slowly reduce these accounts down to $0.
• Option 2, handily marked with a glowing green tick, is to place the investment mortgage on Interest Only and pay down the personal mortgage at an increased rate.

What is the outcome of structuring your investment property correctly?

If the total mortgage payment is the same, the result is the same.  You will pay your mortgage over 30 years under both options, however in option 1 you are reducing your tax deductible interest payments which means you could be missing out on tax refunds.  Option 2, however, keeps the maximum tax deductions in place as long as possible.

These tax expenses can add up to thousands of dollars every year.

The problem with the green tick

But there is a problem with option 2.

In the example above, the investor is going to take about 14 years to pay down the personal ($300k) mortgage and the remaining 16 years will pay off the investment ($600k) mortgage.  But banks these days only allow you to be Interest Only for a maximum of 5 years (2 years on your own property).  After that, you are required to start paying all accounts on Principal and Interest even if you are over-paying other parts of your mortgage (as in option 2).

And plenty of our clients are striking this problem.  As they approach the 5 year mark, banks are demanding the clients begin to pay Principal and Interest.

If, after an explanation of your "option 2" strategy, the bank refuses to extend the Interest Only period, the only way forward is to refinance your lending to another bank which allows you to reset the 5 year Interest Only period.  This is not the optimal outcome but is something we're seeing more and more.

Refinance your mortgage for the right reasons

If you are going to refinance to another bank because your Interest Only period is up, you must make sure that the structure at the new bank is correct.  In the example above, this client would refinance after 5 years but must continue to pay down the mortgage over (now) 25 years.  Any other outcome is worse for the mortgage holder.  Always remember that you may need to factor in break costs if you are changing banks too (here's an article on calculating break costs)

What happens at the end of an Interest Only period?

For almost all the banks, when your Interest Only period finishes (either after 2 years for your personal mortgage or after 5 years for your investment property), the loan simply automatically converts to a Principal and Interest payment. 

ANZ are the only exception to this where a brand new account must be created otherwise their system tries to pay off the mortgage (and you end up hundreds of thousands of dollars beyond your approved limit).  This is a bug in their computer system and is not meant to force you to pay off your mortgage any faster.

Are you affected by this?

If your mortgage is:

• a mix of owner-occupied and investment and the investment portion is on Principal and Interest or,
• you are about to be moved from Interest Only to Principal and Interest

you need to speak to your mortgage adviser and your Accountant.  The review will take around an hour and the whole process should take about 3-5 hours of your time.  If you can save a few thousands of dollars per year for 5 hours work, we highly recommend you do it!

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