It has been reported that more than 320,000 home owners and 170,000 businesses have put loan repayments totalling $6.8 billion on hold since banks first announced support for borrowers as the Covid-19 pandemic unfolded.
Most banks introduced a loan deferral arrangement where loan repayments could be suspended for up to six months. But it’s important to note that this is a payment holiday, not debt forgiveness. Interest will continue to accrue on outstanding loan balances and will be capitalised.
The financial implications of taking up such offers is therefore worth considering.
How much extra will be repaid?
Assume a 25-year principal and interest loan, established five years ago. The current variable interest rate is 3.5%, and the current minimum monthly loan repayment of $2,030 has just been locked in. The outstanding loan balance is $350,000 and loan repayments will be postponed for the next six months.
If at the end of the deferral period, the borrower resumed paying down the loan at the minimum amount of $2,030 per month, then the term of the loan would be extended by a little more than 12 months, and an additional $12,544 would be paid over the term of the loan.
Alternatively, in order to repay the loan in full by the end of the original 25-year term, some $72 per month extra would be required, being an additional $4,765 paid over the loan’s term.
Loan payment deferral is expensive
Deferring loan repayments therefore comes at a significant cost, and the full implications need to be understood prior to undertaking such an approach. Perhaps reduced payments instead of no payments could be discussed with banks, to lessen the blow on the other side. For example, an arrangement whereby interest only is payable for the six months, and no principal.
Then CBA Chief Executive, Matt Comyn, said the following after the Reserve Bank cut interest rates by 0.25%:
“We will also help up to 730,000 customers by reducing repayments to the minimum required under their loan contract from 1 May. On average, this will release up to $400 per month for customers and create up to $3.6 billion in additional cash support for our economy. Customers will be able to opt out after the change is effective should they wish to keep their current repayment”.
When the interest rate on a variable rate property loan reduces, the amount required to pay the loan out over the original term will also reduce. But many CBA customers choose to continue to pay the higher amount, thus reducing the loan term. And if they do want to pay the minimum, they must contact the bank to ask for payments to be reduced. That is, it is an 'opt in' arrangement.
But what CBA proposed is the reverse. An 'opt out' arrangement whereby the loan will automatically revert to the minimum required payment on 1 May, unless the customer actively vetoes the procedure.
This will also have consequences for borrowers. Five years ago, the official cash rate was 2.25%. So let’s assume our 25-year principal and interest example loan established five years ago, commenced at a variable interest rate of 5.5%. The original loan amount was $392,000 with a monthly loan repayment of $2,408. Assume the monthly repayment was left unchanged over the five years. So that now, with the loan balance at $350,000 and the variable interest rate at 3.5%, the minimum monthly payment required to pay the loan out in 20 years as already noted, is $2,030. That is, $378 less per month.
But if the customer opts out of the proposed CBA arrangement, maintaining repayments at $2,408, the loan will be paid out in 15.8 years, cutting 4.2 years off the loan term, and saving about $31,000 in interest.
Most people do not respond to 'opt out' requests. There is little doubt that customers will unwittingly or otherwise not 'opt out'. And if that happens, the financial consequences for the borrower are significant. While the CBA says this approach will 'help up to 730,000 customers' in terms of cash flow, one wonders if it really does help overall.
Tony Dillon is a freelance writer and former actuary. This article is general information and does not consider the circumstances of any investor.