Cashback or lower rate?

There’s a lot of power to the old saying ‘a bird in the hand is worth two in the bush’. Humans tend to gravitate towards benefits today rather than future gains. That’s become an issue at present as home owners flock to refinance their home loans.

These days, to get the best deal we have to shop around and change lenders, or at a minimum ask our current lender for a better deal. Home owners are doing just that, with data from CoreLogic showing as many as six out of ten property valuations completed in January related to loan refinances.  

Refinancing can deliver big savings especially as lenders offer new customers lower rates than existing borrowers. Many are also throwing in a cashback sweeteners worth thousands of dollars.

But do you choose a loan offering upfront cash or a lower rate? A survey by comparison site Finder shows one in four of us would choose the cashback, while 46% would opt for the lower rate.

So who is right? To demonstrate the impact of a short term deal over a long term loan, let’s use a traditional 25-year mortgage to see the real cost.

We’ll assume two loans – one with the current average variable rate (for new loans) of 2.7%, and another with a rate of 2.8% plus a cashback payment of $3,000. The rate gap is just 0.1% but what a difference it can make over a 25-year loan.

On a $400,000 mortgage the 2.7% loan with zero cashback could see you pay around $150,500 in interest over a 25-year term. The loan with the $3,000 cashback and a rate of 2.8% comes with a total interest cost of $156,650 over the same period. In other words, you get $3,000 cash upfront but pay an extra $6,150 in interest, so in the long run you’re really out of pocket by $3,150.

These numbers are based on the home loan calculator on the MoneySmart website. So, you can play around with the figures to see what works for you. But experience tells me there is no such thing as a free lunch in the world of money, and a lower rate loan will almost certainly put you ahead over time compared to a cashback deal charging a higher rate.

If you’re not sure which is the best option for you, ask your mortgage broker to do the sums. Just don’t let the value of cash in hand today be the main motivator for choosing a long term debt like a home loan.