Banks set to reap massive rewards from financial inertia

If there is one thing almost guaranteed to cost you lots of money, it is financial inertia.

We all pay for this inertia every time we simply roll over insurance policies, energy suppliers, internet suppliers and by keeping our current arrangements with banks and superannuation companies.

We all know that there are probably much cheaper deals out there if we could be bothered spending the time and effort in hunting them out but expensive financial inertia usually wins.

At the moment Australia’s biggest bank – Commonwealth Bank (ASX: CBA) – is conducting a large-scale experiment that promises to cost its home loan customers huge sums of money unless they ignore inertia and make a decision.

In emails to 748,000 eligible variable principal and interest mortgage customers who are paying more than minimum repayments, Commonwealth Bank has announced that it will automatically changing direct debit mortgage repayments to the minimum amount required.

Commonwealth has also processed around 70,000 requests to defer home loan repayments for up to six months.

The idea is to free up cash for customers so that they have more cash at a time when the COVID-19 pandemic is raising unemployment and leaving many households in financial stress.

Nice sentiment but it could be costly

That is a lovely sentiment but it could also be a very costly one because automatically reducing home loan repayments by up to $400 a month has the effect of greatly increasing the length of the loan and the overall amount of interest that is paid.

In some cases, the loan could be extended by a decade or more.

Given that interest rates have been falling for a long time now and home loan repayments have often been left at their previous level, most home loan customers are making repayments that are much larger than the minimum required.

By automatically reducing repayments to the minimum, the bank is effectively increasing the term of the loan back to the original level – erasing the previous advantage of getting ahead on the loan by making larger repayments.

Minimum repayments undo years of hard work

It undoes what may have been many years of hard work in reducing the term of the loan from the original level by making extra repayments.

From the bank’s point of view, they have effectively expanded their customer base without any real acquisition cost by adding many years of extra interest repayments across their current home loan book.

Thanks to financial inertia – customers leaving their loans alone at the new lower repayment level – the loan book will stay intact for much longer and interest will continue to accrue on loans that would otherwise have been extinguished.

Canstar analysis found that while paying only the minimum repayment from May 1 onwards could add $200 to a borrower’s cash flow each month, such a change could also potentially cost around $40,500 in total interest paid and lengthen a loan by nearly five years.

This calculation was based on the current average variable interest rate for owner-occupier borrowers paying principal and interest on a $400,000, 30-year home loan taken out at the start of 2019, with repayments unchanged until now.

Customers free to set own repayment level

From Commonwealth’s point of view, it is merely helping their customers through a tough time.

However, along with the option of a six-month home loan holiday, this can be the right answer for some customers but is unlikely to be the right answer for everyone.

Commonwealth’s answer is that customers are free to set their own level of repayments after May 6 after the minimum repayments have been introduced across all principal and interest home loans.

They can do that online via Commonwealth’s NetBank app.

The interesting question is, how many customers will actually do that or how many will simply allow financial inertia to take over.

The other interesting question is whether the other banks will copy Commonwealth’s move – something they haven’t done as yet.

If financial inertia pays off for the Commonwealth – and it is highly likely to do that – then it would not be a surprise to see automatic minimum repayments introduced on loans at other institutions.