Q17: Does your bank care about you?

Beware of the friendly bank

Some borrowers may have recently been notified by their bank that their loan repayments have been reduced. Customers who have managed to get ahead on their home or personal loan repayments, thus reducing their interest costs and shortening the term of the loan (we wrote about it in this post regarding home loans), have been offered a lower minimum repayment.

In a recent Fairfax media story it was reported that the Commonwealth Bank is allowing some customers to reduce their minimum required payment, effectively lengthening their loan and increasing their interest bill. No doubt many unsuspecting customers (not readers of The Money Question) will jump at the chance to lower their payments without understanding the effect this will have on their total interest and repayments over the now longer term of their loan.

How it works

Say you took out a loan for $20,000 over 5 years at 14.50%. Your required repayments are around $471 per month. Two years into the loan and, because you’re a diligent borrower and have been paying an extra $200 per month, you’re way ahead on your repayments and the loan is due to be paid off in just over a year’s time. Your extra repayments are on track to shave almost two years off your loan and save you over $3,200 in interest.

While this makes you feel great, your bank isn’t likely to feel the same way. Your financial diligence is depriving the bank of that $3,200 and they’re not happy about that. So they do some recalculations and offer you new terms. Your outstanding loan balance is around $8,140. The bank figures out that, if they stretched the repayment of the outstanding balance to the original loan end date, which is three years into the future, your repayments can be lower. Effectively they’re offering you new loan of $8,140 for three years at your original interest rate.

The maths

In your original loan, including your extra payments, once it’s all paid off you’d have made total repayments over 3.2 years as follows:

Total Interest $4,951
Total Repayments $24,951
Time Saved 1.8 Years
Money Saved $3,283

Then, with the bank’s new offer to “save you money” we get

You’ve already paid this on your original loan
Interest Repayments $4,234.42
Principal Repayments $11,860.00
Total Paid After Two Years $16,094.42
Then we add the New Loan
Interest Repayments $1,947
Principal Repayments $8,140
Total $10,086.69
Bringing your total repayments to
Interest Repayments $6,181.11
Principal Repayments $20,000.00
Total paid after accepting bank’s offer $26,181.11

You were paying $671 a month on your old loan but now you have to pay only $280. What a saving!

Home Loan Repayment Paths, or How Your Bank Grabs Back Its Interest

Crazy logic

We now can see the crazy logic in the bank’s offer to save you money. In the original loan with your extra repayments you’d have repaid a total of $24,951 with $4,951 of that being interest. You’d have been debt free in just over 3 years.

With the amazing money saving offer from your friendly bank you’d have repaid a total of $26,181 with $6,181 of that being interest. You’ve paid extra interest (at 14.50%) of $1,230 and taken an additional two years to be debt-free.

So while you were on track to save interest of $3,283 paying extra on your original loan, the bank — through its lower payment offer — has snatched back 37% of its interest charges from you. Right from under your nose. While you thought they were being kind to you.

The effect is even larger when you take up an offer to “consolidate” your credit card debt to your home loan. Credit card debt is relatively short term but a home loan can be 25 years or more. Adding thousands to your home loan over 30 years may give your short-term cashflow a boost but it massively increases your lifetime interest bill.

The bottom line

The bottom line is that, whenever the bank offers you a way to lower your repayments by stretching out the time you have to repay them, their interest bill is ticking up against you. Banks care only for their bottom line.

It may be a good time to consider the response of one bank to the recent Royal Commission into their behaviour when it said that it does not owe customers “an ‘overarching obligation’ to act in their interests.”

So in whose interests are they acting? Beware the friendly bank.

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