Interest that packs a punch / An Opinion on your value / by Adam Howard

The past few Updates have delved deeply into corporate and commercial banking, how to raise capital and emerging technologies and what they might mean for some industries.  

Some have accused me of getting too heavy...going too deep.  Thought I would get back to basics this week and look at how debt and banking works on a shop front level.

I actually got into the banking industry at first at the grand ol' age of 34 in order to learn about money.

Had no idea about it.  Had credit card debt I couldn't pay off, and frankly, didn't want to think about.

Couldn't manage my cashflow.  Didn't know about interest; how much it was and how it was calculated.  Didn't think I could borrow to buy a house, and if I could, didn't know how I could pay it off.

I was a total nube (as my 10 yr old son would say)....

"Shop front" refers to the parts of debt and banking we all kind of think about:  interest on different types of debt and how it is calculated; what effects how much that debt costs us; equity, and what it means and how to work out how much you have.

Stuff like that.  It might make it easier for you when you speak to your bank about a home loan, or a new credit card.

So, first, the big one:  Interest.

INTEREST

Much like any other industry, there are wholesalers of money and then there are retailers of money.

The banks are the retailers.  I like to tell people that the Big Four are the Coles and Woolies of the finance world, and like shopping for food, there are lots of places you can shop for money.  It just depends on what you are looking for, how much you are prepared to pay and how hard you are willing to look.

From the top down there are:

- the Big Four;

- the regional banks (Bankwest, St George, Bendigo, Bank of Queensland);

- credit unions and building societies;

- other public lenders (LaTrobe Finance, Liberty Finance); and

- private lenders.

The price of your debt will probably be around the same if you choose any of the top 3 options, with prices beginning to move upwards considerably once you choose what are cutely called "non-traditional lenders".

Only the Big Four and the regionals qualify as "Full Service Financial Institutions", meaning you can get home loans, personal loans, credit cards, transaction and savings accounts, business loans, property finance, asset finance, foreign exchange services, and more....

That's the summary.

Most of you will already know what a reasonable rate of interest is on a home loan.  Probably about 4.5% or less, right?

Interest on your home loan, business loan, commercial bill, personal loan, asset finance and/or overdraft is all calculated the same way.  Calculated daily on the balance and charged monthly.

For example:  If you had a home loan of $500k, and a rate of 4.4% it would be as follows:

$500 x 0.044 = $22,000 / 365 = $60.27 per day.

The interest charged monthly will differ based on the following:

- how many days are in the month; and

- if the day the interest is to be charged falls on a weekend.

I think we are all currently suffering from a disease I like to call interest ratitis.  We are obsessed with interest rates; making sure we know what it is, who is offering the lowest, how much that will cost, what the Reserve Bank is doing with rates.

It needs to be pointed out that, within reason, your interest rate actually makes very little difference to your repayments.  If you are paying 4.5% on your home loan of $500k and you are on Interest Only terms for the next 2 years, then you are paying interest of $61.64 a day.

But you think you could get a rate of 4.2% at the bank next door.  At that rate, using the calculation above, your daily interest bill drops to $57.53.

A cup of coffee a day.  Not a bad saving, and probably worth investigating.

BUT, what I was talking about was the features that really impact your repayments.  The other two are the amount you owe, and the term over which you borrow it.

If you owed $550k instead of $500k, then using a rate of 4.5% your daily interest bill jumps up by $6 to $67.81!!!

Just for an extra $50k.

And the loan term has an even larger impact.

If you are repaying $500k at 4.5% over 30 years (a normal home loan term these days), then your monthly bill will be $2,533, or $81.70 per day.  Now, remember,  I am now calculating on a Principal and Interest basis.

But if you shortened that term to 20 years, either out of choice or because of the type of debt it is, then your repayments shoot up to $3,163 a month, or $102.05 a day.

So, the big factors to consider with what we call term debt (home loans and business loans) are actually how much you need, and over what term you can borrow.

In many respects, the interest rate is a bit of a smoke screen.  A red flag being waved to distract you from the two bigger issues.

An interesting point to note here is that the banking industry is currently discussing whether 40 year home loan terms are a good idea, with the rationale being the asset that underpins a home loan; your home; has a longer life than 30 years, so why not match the term to the use.

Interesting....

One place where interest is a MASSIVE issue is on your credit card.  

Credit cards are great, aren't they?  You can just pay pass and BANG! You are gone, walking away with your new toy, that maybe you couldn't afford....

Now, all you need to do is remember to pay the card balance off in full before the end of the month.

It's a bit like the old warning with Gremlins.  Remember??  "Whatever you do, never, ever feed them after midnight!"

Credit cards should carry a similar warning.  "Whatever you do, never, ever forget to leave the balance unpaid."

Interest on cards is confusing because there are so many offers out there ranging from 12 months interest free on balance transfers, to interest rates of about 30%.

Now, how interest on credit cards is calculated is even a bit of mystery to me, so here is a rule of thumb I use.

Your interest bill on your credit card will be 3% of the month end card balance.

So, if your card has a limit of $10k, and you owed $8k at the end of the month the interest would be:

$8,000 x 3% = $240

If you annualise that it is $2,880 per year.

Now I will provide some comparisons that are designed to scare you.

That cost of $2,880 is the same as interest on $64k in extra home loan debt.  For $64k you could get a new underground pool and renovate your kitchen.

That cost of $2,880 is the same as the repayments on a $15k car loan over 5 years.

So, the "take home message" here is, make sure you manage your cashflow and pay off your credit card debt at the end of the week or month.

If you can't as it is too large and has gotten out of hand, see if you can roll it into your home loan, or some other type of lower interest facility.

Credit cards = natural born killers.

Finally, a discussion on interest wouldn't be complete without talking about fixed interest rates.  I think taking out a fixed rate loan can be a bit like reading a literary masterpiece; you do it because you want to seem smart, but you don't really enjoy it....

 Fixed rates are good if you want to know EXACTLY how much your loan is going to cost you...and that might be really important for some people, but not most.

Another good reason for taking out a fixed rate loan is if you are in the middle of strange economic times and at that point in time fixed rates are actually lower than variable rates.

Because they very rarely are.

Fixing your interest rate is like taking out an insurance policy.  You do it to insure against the risk of interest rates rising in the future.

If you are in an economy like ours, where the talk is about the Reserve Bank cutting rates further, then it seems clear rates are more likely to go down rather than up, so why fix?

Sometimes you don't have any choice though.  If you are taking out a car loan, or any other type of asset finance, the facility will almost always involve a fixed rate for the entire term (anywhere from 1 to 7 years).

Now, a warning regarding fixed interest rates.  One of the things that I get asked a lot is "Are there any penalties for early repayment?"  and the answer is no...unless you took out a fixed rate and you try to pay out the loan either in full, or just faster than agreed, during the fixed rate term.

Then there will be "break costs"; not penalties, but break costs.

The reason is an economic one.  The credit provider has projected how much revenue will be generated by that fixed rate loan over the full term, and not so much already spent it, but certainly already booked it as revenue.

If you break that fixed rate contract by repaying early, then the credit provider is allowed to claw back the lost revenue.

So, if you sold you house, refinanced the loan to another bank, crashed your car and wrote it off, sold the car and paid the loan out, there would be break costs.

Quick interlude for a story.  I had a customer once; for our purposes we will call him The Idiot.  You may be able to tell from my tone here that The Idiot and I didn't get along that well.

The Idiot took out an asset finance facility over 5 years and bought a nice, shiny new prime mover (that's a truck).  A prime mover costs a lot.  Maybe about $500k for a new one like a Western Star or Mack.  He duly insured it.

A few months in, the truck caught fire while on the road and burned out.  A complete write off.

Now, the truck was insured so it was replaced, but as it was purchased with a fixed rate asset finance facility of $500k over 5 years, there were big break costs; about $30k of break costs.

Before you say "That's just bad luck!!  Why is he an idiot??"  

This guy owned a long haul trucking company, and in that game incidents involving trucks are common.  Funding truck purchases with fixed rate asset finance loans is also common.  

So, there are insurance companies who you can use to insure against the "gap" created when the break costs on your asset finance facility aren't covered by the insurance policy that covers the truck itself.

The Idiot knew this but didn't insure against the gap.

The Idiot and I had some heated discussions about him needing to pay that gap...but he didn't pay.  

Sometimes I wonder what happened to The Idiot...but only sometimes.

 Now, EQUITY.

Equity is how much of your place you own.  Take the last valuation of your house, subtract your home loan limit, and you have your equity.  That's total equity, but what about asking "How much of that equity can be used?"

It's a very simple equation.  All banks will have a list of different property types they view as "acceptable first mortgage security."  And there will be a ratio for each of these property types which banks will be willing to lend.  This ratio is called an "extension ratio."

The easiest and most obvious is standard residential property, where banks will lend 80% of the value.  Some other common property types and their extension ratios are as follows:

- luxury residential > $3m:  70%

- small living area apartments < 40sqm:  60%

- standard commercial:  65%

- non standard commercial:  50% - 65% (this can include properties such as motels, car washes and service stations)

Now, it's not always clear how to classify a property.  I have had success showing the bank that a property zoned commercial was actually residential, and that a rural property was actually standard residential.  It all depends on what data you can gather to create a picture.

Banks use licensed valuers, external and independent third party businesses, to value all properties offered as security. 

Quick note here.  Real estate agents are not valuers and an appraisal offered by an real estate agent is not valuation.  The agent will look forward, at what the market might pay...while the valuer looks backwards at what the market has paid. 

There is almost always tension between the two, as there is almost always a gap between the two numbers.  But one thing needs to be made clear.  A bank relies on a valuation, making the valuer liable for the value put on a property.

An agent's appraisal is really just an opinion; a professional one, but still an opinion...and you know what they say about opinions, and everyone having one along with a certain part of your anatomy?

Back to using your equity.  Let's get hypothetical.  You want to put in a pool, and the whole kit and caboodle is going to cost you $50k and you decide to borrow against the house to pay for it.

You give the bank a call and ask them for the cash and they arrange a valuation.  You owe $500k against your place, so for the extra funds to be made available without too much hard work you need the valuer to say your place is worth at least $688k.

Whoa...how did I perform that little piece of mathematical chicanery??

Well, you need $550k to be equal to or less than 80% of the Fair Market Value (FMV) of your property.  If $550k is 80% of something, the equation looks like this:

$550k = $Y x 0.8

Remembering a little bit of year 11 algebra, you then divide each side by 0.80 to cancel out the multiplication, and get the answer.

$550 / 0.80 = $688k.

If the value comes in higher than $688k you are sweet.  Enjoy the summer in your new pool.  BUT, if it comes in less than that, and you still want to put in a pool, then you will have to pay for Lenders Mortgage Insurance (LMI).

Please, stay with me.  I am winding it up.

LMI is provided by specific insurance companies (QBE, Genworth), and is paid for by the borrower to protect the lender against the higher risk of loss associated with a loan that is above 80% of the FMV of a property.

Simple, huh?

The insurance and banking industries are actually pretty similar in how they work and what they measure:  risk.

Insurance companies charge a fee to insure AGAINST a future event occurring.  So, insurance companies help you protect yourself against the potential bad stuff tomorrow could bring.

Banks lend against your future earnings to allow you to enjoy the fruits of tomorrow's wages today.  Banks lend to allow you to enjoy today the potential good stuff tomorrow could bring.

My final point today.  There is some confusion out there about mortgages and home loans.  Here comes a warning.  Please be aware they are two separate things.  No, you can't have a home loan without a mortgage, but they are two separate things, and here is why.

When you borrow, a bank looks at your request from two perspectives, euphemistically called the first way out, and the second way out.

The first way out is your income.  You have strong enough income to comfortably repay the debt over the term of 30 years.

This is obviously the preferred way out for both parties

Summary; when you borrow to buy a house, you are actually mortgaging the next 30 years of income, as well as your house.

The second way out is the sale of your house, with net proceeds repaying the debt.  Something happens.  Things turn sour.  A divorce.  An illness.  A loss of employment.  Poor financial management.  You go into what is known as "Regulatory Default".  90 days without a payment being made on your loan.

It takes a while to go from there to "Oh my God, the bank is selling my house!" but it happens all the time.

The bank exercises it's mortgage, and you are evicted.  The Bailiff comes and changes the locks.  The house is cleaned and made ready for sale, and then sold as fast as possible.

Not the way either party wants the relationship to end.

Here is another hypothetical.

What if you have a house worth $1m (nice house, huh?).  You owe $500k, but something bad happens and the bank moves in and sells the place for $800k (this is called a Mortgagee's sale in possession).

So, after the bank sells for that much and meets all it's costs, lets say they come to $100k, the balance of $200k goes back to you, right?

Wrong!  The bank keeps it.

Here is a definition of a mortgage:

a legal agreement by which a bank, building society, etc. lends money at interest in exchange for taking title of the debtor's property, with the condition that the conveyance of title becomes void upon the payment of the debt

"Taking title..."  That's right.  When the bank exercises it's mortgage, it then owns that property.

Summary; if you default on your home loan you lose the lot.

And that's why Australians historically will allow all their other bills to run late, and keep their home loan in order.  It's also why the Australian banking system is a lot stronger than the US system.

I guess, to summarise, when a bank decides to lend money it is doing so as an investment in an almost risk free asset, as after it pays for it's money the net margin is only about 2%.

So, the question to ask yourself is "Am I a safe bet?"

Food for thought....