When we apply for a loan, the following questions arise;
(i) Amount can we borrow
(ii) Repayment amount, frequency and number of repayments
(iii) The interest rate, and may be
(iv) the total amount that will be repaid (multiplying repayment amount with number of instalments, it is very easy!).
Normally shop for interest rate. Item (i) and (ii) are determined by lenders using their rules and regulations. The borrower must provide (a) income details (payslip or Tax Returns and Profit and loss statements etc) and (b) details as to stability of the income, like length of employment/business etc.
For e.g. Jack wants 'ABC bank Ltd' to give loan of $ 370,000 for him to buy a house. He has selected 2 houses, one for $370,000 another $300,000.
He is an employee. His family's total income is $ 160,000. Market interest rate 8.5% p.a. compounding monthly, for 30 year. His family living expenses is $ 55,000 p.a.
Jack's 'ability to repay' is assessed on his income $ 160,000 less his living expenses. Living expenses lenders use in this calculation is the greater of $ 55,000 or amount as per lenders own rules. His disposable income is $160,000 - $55,000 = $ 105,000. Approximately 3 times of this amount is what the lender would lend (instalment amount is $ 2422.08 per month). Unless Jack proves he earns more, they cannot lend more than $ 315,000. Even if Jack promises to cut his expenses (and repay $ 2844.98 per calendar month, i.e. $ 422.90 per month more (bank denies his ability to repay this based on their own rules) for a loan of $ 370,000.
The bank would say, 'don't kill yourselves to pay us', 'sorry only $ 315,000'. If the loan is higher, repayment will be more. As per Jack's income he cannot pay the increased repayment.
Let us say that Jack took $ 315,000 loan and buy the house for $ 300,000 + additional refurbishment costs $ 15,000. He repays $ 2422.08 per calendar month. If market interest rate goes up by 0.8% p.a. (at any point in time, say in first 5 years), the bank would adjust his repayment to $ 2602.85 per calendar month.
But in the bank's own words and as per their rules, he cannot pay more than $ 2422.08, "UNLESS HIS INCOME INCREASES". But now market interest rate is increased and NOT Jack’s INCOME and not Bank’s cost of lending (as they already lent the money)!
Since he cannot pay the increased amount and wants continues to pay only $ 2422.08, he will owe $ 328,235.57 after paying $ 874,369.97, in 30 years.
When Rate rises:
Either: after 30 years, owe more than borrowed amount!!
(i) If Jack continues to pay $ 2422.08, not the increased repayment:
He would repay $ 874,369.97 over 30 years, and have his balance owing is $ 328,235.57!!, after 30 years! So his repayments was given NEGATIVE VALUE. He repaid $ 874,369.97, but he only borrowed $ 315,000 and after 30 years he owes $ 328,235.57!!). (Does his money stink? and bank’s money has fragrance!!!).
OR default and lose the property
(ii) If he is forced to pay the increased repayment: $ 2602.85 per month: (as in most loan contracts repayment is automatically readjusted based on market interest rate)
Jack would eventually default as his income has NOT increased. He will loose the property as Bank goes bank on their rules about his 'ability to repay'.
So out of 4 questions above when we went to bank for a loan;
(i) Amount borrowed, calculated by the lenders is MEANINGLESS.
(ii) Repayment instalment amount, number of repayments are both subject to adjustment as per market interest rate. So these are NOT certain and subject of UNILATERAL change by the banks.
Borrower can only change the frequency of repayment, which doesn't mean any big difference in total repayment over the entire term of loan, not even a $ 1000 for the entire period. This is the only right borrower has.
(iii) interest rate quoted, is subject to change from time to time unilaterally by the bank (though can fix it for some time, but cannot be fixed for entire period).
Due to the above paragraph in blue; so it is needless to say here that the (iv) information of 'total amount repayable/paid over the entire term of loan' is HOPELESS!!!
Please note my case against National Australia Bank is dismissed by due to the ONLY defence raised by Mr Chris Archibald represented NAB in VCAT saying that the contract shows ‘total amount repayable’. He didn't raise this question to me when he allowed me to explain all the issues surrounding the 'hidden' compounding method of calculating interest.