Are you someone who is always chasing for the “lowest possible rate”? Are you someone who is upset because you’re not getting the sharpest rate ever on market?
Well, there are various reasons on why you may not be eligible for that “sharpest rate”. That’s why today I want to share my thoughts on why there is such discrepancy and the concept of 4 different interest rate quadrants.
Apart from the fact each lender’s funding source is different (so the acquisition cost will be different), broadly speaking, lenders position their products offering based on purpose & repayment type and this can be easily drawn out as 4 different quadrants:
Because of the differences in terms of purpose & repayment type, the interest rate on offer varies differently as well. So let’s have a look at each quadrant:
1. Quadrant #1 – OO & P&I
Quadrant 1 represents the group of people who are telling the bank they are buying their own home and will be paying down the principal as part of their repayment schedule. Because of the purpose – they are buying to live in there for themselves – so lenders cannot (and does not?) want to put too much burden onto the borowers and certainly does not want to put them into financial stress or hardship due to mortgage repayments.
As such this is the quadrant that claims the crown of “lowest rate” out of all 4 quadrants. They are the winner in terms of getting lowest interest rate. However in almost all circumstances borrowers are not able to borrow a lot and their borrowing capacity is purely based on how much income they have in order to service the loan.
Most of the people have only one job and that’s the single source to be able to repay the loan, hence lenders need to be careful not to burden them with interest rate that are too high which could cause mortgage stress or financial hardship.
2. Quadrant #2 – OO & IO
This is the group of people who are telling the bank they are purchasing their own home however they are not going to pay down the loan. Instead, they are just going to pay the interest – hence the repayment type is called “Interest Only”.
Because they are only going to hold the mortgage without paying it down, hence lenders will tend to charge slightly higher interest rate than that in Quadrant #1.
However in the current environment lenders have steered away from these type of lending. They are now classified as “higher risk loans”, due to the fact the borrower is intending to hold onto the loan without chipping it away for the period of time and to them this is increasing the chance of borrower having to pay more in remaining loan term and could substantially put them into hardship. Also borrowers will usually end up paying more interest during the period of IO than those who are paying P&I repayment.
Lenders will also want to understand the reasons behind why the purchaser is seeking an IO loan – is it because of a temporary reduction of income such as wife going on maternity leave or due to some other reason? Either way, lenders don’t approve OO IO loans that easily nowadays so purchaser will need a really good reason to be able to get this.
The interest rate offered in this quadrant is similar to that of INV P&I (Quadrant 3), if not slightly higher (due to the IO nature). Also as a fun fact – the monthly repayment in this quadrant is actually lower than that of OO P&I (Quadrant 1), despite the fact interest rate is higher than OO P&I. But whether you can get it approved or not is another question….
3. Quadrant #3 – INV & P&I
This is the quadrant where applicants tell the bank they are purchasing an investment property and will be paying down the principal as part of the repayment schedule. Due to the P&I repayment nature, lenders do welcome this type of lending and as such they position a fair interest rate in order to attract customers.
Lenders understand as an investment property you have the additional support of rental income and as such will be better off from cashflow perspective than just purchasing for your own living. Because of this reason, INV P&I rate offered is usualy similar to OO IO (Quadrant 2) but would be higher than that of OO P&I (Quadrant 1).
You can think of it like whatever profit you’re making from rental income, lenders will also want to take a “cut” from it – hence despite the repayment type are the same, interest rate offered will still be higher than that of owner occupied purpose.
4. Quadrant #4 – INV & IO
This is the quadrant where it was most popular back before 2015 – where APRA curbed the growth of INV IO lending because it was simply spiralling out of control. Simply put, this is where borrower tells lender that he/she is going to purchase an IP but will simply be holding the debt and not paying down. As you can tell this is the type of finance that suits buy & hold strategy where it allows you to hold an IP with minimum cost. And so it was proving to be very popular….well, up to 2015 that is.
Like INV P&I (Quadrant 3), because the purpose is to purchase IP with rental income and not paying down the debt, this quadrant is classified as most “risky” from lender perspective. As such this is where lenders tend to charge the highest interest rate in order to mitigate their risk and also taking a cut of the profit from purchaser.
The interest rate spread between INV IO & INV P&I used to be quite big since 2015 – somewhere between 0.75% to that of 1.25%. However with recent rate cuts the spread between INV IO & P&I has drastically reduced. Now the gap is somewhere between 0.25% to 0.75%, making IO repayment more promising again for the buy & hold type of strategy and people who wants to keep ongoing holding cost to a minimum.
However there are always risks associated with IO lending, as most of the time you can only get 5 years IO period upfront and then you’ll need to repay the loan back in 25 years time – unless you can extend for IO period again or refinance to a different lender! But to be able to do that you’ll need a good income to be able to service the loan. Some investors who have had big portfolio with high leverage previously may find themselves stuck and unable to extend IO or refinance and will be forced to pay P&I repayment instead. And by that time P&I monthly repayment could be 30% more that what you were paying on IO previously….big ouch!
So hopefully this article gives you some idea on why you’re not always getting the advertised “sharpest rate”. It really comes down to the purpose of the loan and the repayment method which determines which quadrant you’re on, the risk associated with this type of lending and hence determines the actual rate you’ll be getting.
Has the loan purpose changed over the years? Unsure how to decide whether next property should be an IO repayment or P&I? Feel free to reach out to us via the contact form and we’ll be in touch shortly to assist!