As Australian home owners continue to pull their purse strings tighter as a result of Covid-19-related financial pressures, some may be considering a ‘mortgage holiday’, taking up an offer by most Aussie banks to pause repayments on mortgages for up to six months in order to temporarily lower outgoings.

A mortgage holiday doesn’t come without costs, however, which has prompted finance experts to warn mortgagees to take advantage of the banks’ offer only as a last resort. Here’s why.

Mortgage holidays on offer

Commonwealth Bank of Australia (CBA), ANZ, Westpac and National Australia Bank (NAB) have each launched Covid-19 support packages to help customers make it through what will be a lean time for many, chief among which is a repayment pause on home loans for customers unable to service their loans on a suddenly reduced income. Other banks have made similar offers to permit mortgage holidays for cash-strapped customers.

But each bank is operating a slightly different version of the mortgage holiday, as can be seen from the Big Four banks’ fine-print.

For CBA mortgagees, mortgage holidays are permitted on a case-by-case basis and will granted for up to six months. Once the holiday period is over, repayments will stay the same as they were prior, but the term (i.e. length of mortgage repayment period) of the customer’s loan will be extended.

ANZ will permit a mortgage holiday of up to six months, with a review at the three-month mark, and will give customers the option of keeping their original loan term or extending it by six months, both of which are likely to require the mortgagee to make higher repayments after the holiday.

NAB, meanwhile, is offering repayment relief for up to six months on a case-by-case basis and will keep the loan term the same but will require higher repayments after the holiday. Westpac is offering a three-month pause with the option for a further three months after a review, and will keep the loan term the same, with repayments increased.

The real impact of a mortgage holiday

The most obvious pitfall to consider is whether a personal financial recovery after the six-month holiday is actually feasible, because increased mortgage repayments after the holiday ends could create further hardship for any borrower whose financial situation hasn’t improved.

There is, however, a more subtle issue worth considering, which is the real cost of an increased loan term without higher post-holiday repayments.

This is due to what’s known as interest capitalisation. Even while repayments are paused, the loan continues accruing interest, which is added to the balance of the loan. Interest is then charged every month on the increased loan balance – in effect, the borrower is paying interest on interest, so the effect snowballs, as compounding interest famously does.

CBA is the only bank so far to have said that it will make a one-off payment to customers who chose a mortgage holiday to cover this interest-on-interest cost.

A borrower can catch up post-mortgage holiday by making bigger repayments to ‘pay off’ that accrued interest. But if they choose to keep their repayments at the same level and extend their loan term instead, they can end up paying many thousands of dollars more over the life of the loan because they’re effectively repaying a larger sum (and interest on that sum) than they originally borrowed.

RateCity.com.au looked at the potential cost of a longer loan term, as well as by how much borrowers may have to increase their post-holiday repayments in to retain their original term. The comparison site worked out the sums for various loan balances, based on an owner-occupier who is paying principal and interest on their loan at an interest rate of 3.54 per cent.

Its calculations are set out below but, for example, a borrower with a $250,000 mortgage balance remaining with 10 years of its 30-year term to go would need to increase their monthly repayments by $154.83 post-holiday to ensure their mortgage was paid off within the original term.

If the same borrower chose to extend their loan term rather than make higher post-pause repayments, they would have an additional nine months added to their term, but would end up paying $6,382.32 more than they would have under their original loan agreement.

The effect is even more extreme on a larger loan balance – a $400,000 outstanding balance with 10 years of repayments remaining would incur more tan $10,000 in additional costs. And it is less extreme on lower balances with shorter terms remaining.

Source: RateCity.com.au

How to avoid a mortgage holiday

Although a mortgage holiday is a good short-term fix for borrowers in immediate financial distress, it may not be the best option for those who expect that their financial situation will not recover after the holiday, nor for those who wish to keep their mortgage repayments to a minimum over the longer term.

Sally Tindall, the research director at RateCity, emphasises that while a pause on repayments is a welcome move by the banks to help struggling homeowners, a mortgage holiday should only be used after all other options have been exhausted. “Talk to your bank about what other options you might have,” she advises.

According to Tindall, these options could include:

• Switching to minimum repayments: Customers making higher repayments on their loan can ask their bank to adjust their repayments to the minimum to free-up cash.
• Using a redraw facility: Customers ahead on repayments can access them via redraw, although fees may be charged to do so
• Requesting a rate cut: Variable-rate customers can ask for a lower interest rate. While banks typically don’t allow rate changes for fixed-rate customers, in situations of financial stress, it’s worth asking.
• Switching to interest-only repayments: Many lenders will let borrowers pay only the interest on their loan for a period of time. While this will reduce monthly repayments in the short term, the interest rate on the loan is likely to increase and by not paying down the debt, more interest charges will be paid over the longer term.
• Reducing repayments temporarily: Instead of going on a full repayment pause, borrower can ask their bank to temporarily reduce repayments. As with interest-only repayments, this could add thousands of dollars to the mortgage but is likely to be less costly than a full repayment holiday.