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Tuesday 14 August 2018

The Ugly Side Of Home Loans

Home loans - not always fun!
Home loans are sneaky beasts – on the one hand they enable many to reach their dreams of home ownership, but on the other hand you can be sure that the banks aren’t dishing them out for free - there is some good money to be made off of Joe Consumer's home ownership aspirations. The interest bill on a home loan usually ends up being in the millions.

And although my Early Retirement Plan dictates that I will be putting almost all my discretionary savings into equity investments, the numbers in this article have certainly given me some food for thought…

Let’s consider someone who takes out a R1 Million home loan at an interest rate of prime (10%). The resulting monthly instalment is R9,650.22 a month.

Now here’s a question for you…

After a year, this person would have paid in a total of R115,802.64 (9650.22 x 12). Given that they have put in over R115k, how much of the loan's capital do you think has been paid off?

The answer – R16,547.38. In the first year, interest vapourised a whopping R99,255.26!

Or another way of looking at it – despite paying around 11.6% worth of the purchase price in instalments, only 1.65% of the loan has been settled. After R115k of payments, they are the proud owner of er… the front door and a few tiles?

Okay onto year two…

A total of R231,605.28 in instalments would have reduced the loan by a measly R34,827.50. Nasty!
  • Percentage of purchase price paid in instalments – 23.16%.
  • Percentage of loan repaid 3.48%

And we can extend this to see how it plays out for each of the 20 years of the loan - the table below summarises result (click for larger image):

After 5 years, a total of R580k would have been paid in, but only 10% of the loan's capital would have been repaid! A quarter of the way down, and still 90% of the balance outstanding - that seems very inefficient...

The graphic alongside, shows how long it takes to pay off each quarter of the outstanding balance of a 20 year home loan at prime (10%) .

The first quarter takes 10 years, the last quarter just 2!

After 10 years, despite being half way done with repayments, and contributions totalling more than the original purchase price, there would still be around ¾ of the loan amount outstanding! Half way through the loan and its only 25% down!

Only in the 15th year is the half way mark in terms of the outstanding loan amount reached (this despite being ¾ of the way through the loan). A full 15 years to get halfway, and then a mere 5 years to settle the other half!

As you can see, most of the damage is done in the beginning. Since interest is calculated on the outstanding balance, and, at the start of the loan, the outstanding balance is large, almost all of those beginning instalments go towards interest, and very little is used to pay off the principal amount.

At the end you are able to squash the last 25% in a mere 2 years because the outstanding balance is small, and now almost all of the monthly instalment goes towards the outstanding balance and very little towards interest.

Now all of the above assumed a home loan at prime 10%). Of course not everyone is as lucky, and it gets even worse at higher interest rates.

So one last graphic - the table below shows the percentage of the loan paid off at the end of each year, for a 20 year home loan, at various interest rates (click for larger image).

So, what to do?

Despite all of this, many of us want to own a home (myself included) and a home loan is almost always the only option. So, what can you do?

Unfortunately I do not have much to add here other than the usual stuff which you already know (but which very few people implement...):
  • Get together as large a deposit as possible. While this won’t change the percentages in the table above, it will change the absolute rand amount which you will pay in interest. (And your larger deposit will mean lower monthly instalments, which then has the knock on effect of allowing you to...
  • Pay in extra every month – especially in the beginning . Anything extra you are able to put in goes straight toward the capital amount, and will give the loan repaid percentages a nice kick up the ass. (Or even better, buy for less than what you can afford, and then put the difference in as extra payments).
  • Don’t be scared to negotiate with the bank and/or other banks for the best interest rate. Even half a percent can save you tens of thousands.
  • Try avoid buying until you are certain you can commit to the location and the house for many years. Upgrading/moving is not only really expensive in terms of transfer duties, commissions and shark attacks lawyers fees, but every time you take a new bond, you reset the table.

And then, just so it’s not all doom and gloom, I will leave you with a little bit of light at the end of tunnel...

Inflation does go some way to counteract this. While inflation means your salary should increase over time, your bond repayment amount will remain constant (assuming no interest rate changes of course). So as time moves on, your bond repayment will hurt less and less and, if you are smart about this, after every pay raise you will increase the amount of the extra monthly payment you make into your bond. This will enable you to squash the loan a lot faster and save you plenty of your hard earned Rands.

Till next time, Stay Stealthy!
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