Or: Are the banks really heroes?
Treasurer, Josh Frydenberg, recently praised the ‘big four’ banks for ‘stepping up to the plate and playing their part in Team Australia’.
It’s a confusing turn of phrase. A baseball metaphor for a country more usually identified with football or cricket (or, our Prime Minister’s beloved rugby). Mixed with a reference to the metaphorical ‘team’ our former Prime Minister, ‘Captain Abbot’, was so fond of.
But what moved Frydenberg to wax lyrical about the banks in the first place? Their offer to defer loan repayments for six months for small business impacted by coronavirus.
It’s an offer that has also been extended to home owners. However, as the ABC has pointed out, the ‘pause’ being offered is not exactly a holiday.
Why? Because your interest will be ‘capitalised into the rest of the term’. What does this mean?
In plain language, as the ABC reports, it means that ‘after you’re done with your mortgage ‘holiday’… your balance will be bigger than when you started the process.’
Not might be bigger. Will be bigger.
Essentially, while your loan is on pause, the interest that you’d otherwise be paying as part of your monthly repayments is added to the amount you owe.
We all know compounding interest can be a wonderful thing, when we stick $1,000 in a savings account. Not only does the bank pay us interest, but the following month, it pays us interest on that interest.
But it’s a horrible thing when that equation works in reverse.
Let’s look at why.
Imagine you have an outstanding mortgage of $400,000. That might sound like a lot, but it’s actually pretty typical, with averages higher in places like NSW and the ACT.
Let’s also assume your interest rate is around 3.1%. It’s not a particularly great rate, but not the worst either, according to advertised rates on ratecity.com.au
Now, we’ll compare how your loan would look after 6 months, under three payment conditions:
- Principal and Interest (otherwise known as a ‘P&I’ loan)
- Interest Only, and
- Payment Pause (interest capitalised)
Principal and Interest
Monthly payments on a regular P&I loan of this size would normally be $1,918 per month. (You can test this for yourself by plugging the details into any home loan calculator, such as this one from RateCity)
But it might shock you to know that even with such historically low interest rates (rates hovered between 5-8% back when we were paying off our loan), more than half of this payment goes to interest. (If you hit the ‘interest only’ button on the calculator, you’ll see that $1,033 per month, or close to 54% of your monthly payment at this rate is just paying the interest. A measly $855 actually goes towards reducing the principal.)
Of course, each time you reduce the principal, you also reduce the interest due the following month. While your repayment generally stays the same, it means a bigger part of your next payment is dedicated to reducing your debt, with less going to line the bank’s pocket.
So in month 1, you’ll pay $1,033 in interest, and reduce your balance to $399,116.
The following month, thanks to this smaller balance, you’ll pay just $1,031 in interest.
Yes, it’s a small difference, but it adds up over time.
This is why making extra repayments is so powerful. As little as $10 extra per week will reduce the total term of your loan by nine months, and save you close to $6,000 in interest payments you’ll no longer need to make.
Without making any extra payments, you’ll pay $11,508 over six months. Of this sum, $6,165 will go to the bank in interest. The rest will go towards reducing your amount owing, which, at the end of the six months, will come to $394,659.
What happens when you’re no longer reducing the principal?
Sometimes, it makes sense to switch a loan to ‘interest only’. This doesn’t have to be due to financial hardship. Some people have interest only loans for investment purposes, for example.
So, what would happen if you switched your $400,000 mortgage to interest only payments for 6 months?
Immediately, your repayments would be reduced from $1,918 per month to $1,033.
Since you’re not reducing the principal any longer, you will keep paying the same amount of interest every month for the interest only period.
At the end of the six months, you would owe… $400,000.
Exactly what you owed at the beginning.
Without making any extra payments, you’ll pay $6,198, all of which goes to the bank in interest. You might notice that this is slightly higher than the amount of interest paid in the scenario above ($6,198 vs. $6,165 – a difference of $33). This is because every bit you pay off the principal reduces the interest you owe.
You’re also $5,341 behind where you would have been, had you been able to keep up principal and interest payments for the past six months. This means you’ll either have to extend the time it takes you to pay off your loan by another six months, or you’ll have to increase your payments from now on to ‘catch up’. (The options available to you will depend on your bank’s rules, and what your equity is like).
For many, however, such a delay is a small price to pay in order to be able to essentially halve your payments for a period of time, until you’re in a more financially stable position.
What happens when you’re no longer paying the interest?
If, instead of switching to an interest-only loan, you take one of the big four banks up on their offer to ‘pause’ your loan, and make no payments (towards principal or interest) for the next six months, the situation is quite different.
You begin, just like in the other two scenarios, by owing $400,000.
At the end of the first month, the bank charges you $1,033 in interest, as per usual. But instead of you paying this off in full, as you would in the other two scenarios, it is simply added to your existing debt. So you now owe $401,033.
The following month, you don’t simply owe money on the initial balance, but on the interest you clocked up last month, too. So your interest owing this month has grown, to $1,037.
Now, your total debt has ballooned to $402,071.
And this carries on every month, until at the end of six months, you now owe $406,246.
It’s rewind. Not pause.
When I first heard news reports that banks were offering business and home loan holders a ‘pause’ and a ‘holiday’, I’m afraid I took them at their word. For once, I was in agreement with Frydenberg. Some praise for the big banks, I am ashamed to say, actually passed from my lips.
‘At last,’ I cried, ‘They’re actually doing something decent!’
I thought, like I assume many Australians thought upon hearing this news, that banks really were pausing the amount owed.
When we hear words like ‘pause’ we imagine that the $400,000 we owe will pause at that figure, and that when we ‘un-pause’ six months later, we will still owe $400,000.
Because, I don’t know about you, but when I hit ‘pause’ on a movie I’m watching, or a song I’m listening to, I expect it to restart playing from that point. Not to rewind a substantial way and then start again.
Which is what the banks are really offering.
At least, as of this writing.
For some people, even though the ‘pause’ involves taking on more debt, and having to play catch-up later, it may be a good short-term solution – or at least, the best that’s on offer at the moment.
Things are changing very quickly in this space, and hopefully, more relief will be on its way very soon for mortgage holders – both households and small businesses.
The point of this article is not to tell home owners they should not pause their payments if there are no other options available. But rather, to point out that banks are not the heroes of ‘Team Australia’ they’re being made out to be. This arrangement allows banks to charge homeowners thousands of extra dollars in interest without having to lend them any more money. We need to keep on our feet, and keep lobbying the banks and the government for better action on this issue.
That being said, for some, pausing payments may be something to consider, if:
- you have already tried reducing your other expenses as much as possible (you’ll find resources below), and
- an improvement in income (with additional hours, a new job, or government support – you’ll find contact details below) doesn’t look likely before your next payment is due.
As always, it’s important to know what you are signing up for when you sign any contract.
If you are experiencing financial difficulties, before you lodge any paperwork with the banks, check to make sure you understand what they are really offering.
Look out for words like ‘interest capitalised’ or ‘capitalising interest’.
It’s also always important to seek independent advice.
But that can be difficult to find when you’re already stretched financially.
Fortunately, the government runs a free National Debt Hotline you can make a free call to (1800 007 007). The government also maintains a list of financial counselors who can help you think about ways to improve your financial situation, and liaise with your creditors (which includes banks) about repayments. Financial counselors can also see if you are eligible for any government assistance, and, if necessary, assist you in applying for hardship variations like the payment pause, if that turns out to be the best option for you. You can find more on the Money Smart website.
Many charities and religious groups also offer financial advice – just make sure to find someone who is appropriately qualified to help out.
And try to remember, we’re all in this together. Everyone is having a tough time at the moment. You are not alone. And although times are tough now, I have every faith that we will come out the other side a stronger, more compassionate world than we were going in. With better safety nets. Maybe even a universal basic income.
If you are a long-term reader of Enrichmentality, you’ll know that there is a lot we can do as individuals to improve our finances, even in the face of hardship. Here are some ideas to get you started:
- Work out which debt to pay off first
- Understand refinancing
- Make reducing debt fun
- Deal with your finances, without sticking your head in the sand or becoming obsessed
Groceries and utilities:
- Slash your spending in every category
- Start menu planning
- Shop for groceries less, and spend less
- More shopping strategies
- Work out what is a need vs. a want
- Grow your own food, even if you don’t have a garden
- Save on utilities
And some specifically COVID-19 related articles:
Hang in there, and stay well!
If you need someone to talk to, 24 hours a day, Lifeline Australia (13 11 14) is there to help, throughout the coronavirus crisis.