How is interest on your home loan calculated?
Interest on your home loan is calculated daily on the outstanding balance. If you were to deposit a lump sum of money into your home loan account; it decreases your outstanding home loan amount, which in turn decreases the amount of interest that you will pay on your home loan. For example, by depositing your 13th cheque bonus into your home loan account on the 20th of December, you will decrease the interest amount payable as from the 20th of December. Normally the bank adds this interest to your outstanding balance at the end of the month, which is payable at the beginning of the next month.
Be aware of an upward move in the Interest Rate, having an impact on your cash-flow
If the interest rate rises as little as 1%, it increases your home loan rate (the interest rate paid on your home loan), which increases your monthly home loan repayments and this could put financial pressure on you. Before you buy, you need to take into account that the interest rate could rise significantly over time.
To give you an idea of how volatile the interest rate can be; in March 1998 the interest rate was at 18%, and within five months it moved up, by 6% in August 1998 to 24%.
If you had a home loan of R 700 000.00 in 1998 (using recent average home prices), your monthly instalments would have jumped from around R 10 800.00 to approximately R 14 100.00. That would have been an increase of R 3 300.00 per month on your bond repayment.
What you can do if the increase in your monthly home loan instalment is affecting your cash-flow?
If you are utilising a number of different credit products, then any increase in the interest rate will affect all of them, from your home loan to your car finance to your credit card, and so on. There are a few options that you could consider to provide you with some cash flow relief:
1) If you have enough equity in your property (the value of your property has risen and you have paid off a significant amount of your bond already) you could finance your short term debt over a longer period, by consolidating your short term debt into your home loan. This means that your monthly commitments would be reduced (in Rand value), because you will now be paying off the short term debt over a longer period (the term of your loan repayment – usually 20 years). By doing this you will take longer to pay off debt which was meant to be short term, but it also means that you will be paying more in interest on this short term debt in the long run.
2) You could increase the length of your home loan term, for example from 20 years to 30 years, which will reduce your monthly repayment because your debt repayment will be stretched over an additional 10 years. Again, you must bear in mind that you would have now added another 10 years of paying interest on the loan, which means you will end up having paid more interest on the total mortgage loan in the long run.
3) You could increase the amount of your home loan if there is equity in the property, take out that amount you have increased it by and store it into your current account to help you finance your bond repayment shortfall. Bear in mind that this will increase your monthly repayment, but you will have the lump-sum extra in your current account to finance your initial shortfall as well as the increase in your repayment. BUT… you need to be disciplined and only use this money for this specific purpose. This will buy you some time to try and improve your financial situation. Once you are in a better financial position you need put the remainder of that lump-sum back into your bond, and focus on paying in extra into your home loan to work this debt off again.
4) Financial institutions also offer you an opportunity to fix your interest rate for a period of time which will assist you in budgeting better by fixing your monthly repayment for a period of time.
Options 1, 2 and 3 above can be quite risky if you abuse these “Quick-Fix-Reliefs”.
You have got to be very disciplined and not see this as a way of getting out of a tight spot every time you run into financial difficulty.
It is better to curb your spending and not live beyond your means, and to plan properly in the event of interest rate hikes. Each of these options will bring you short term relief, but will cost you more in interest at the end of the day. There can be few things worse than paying off a credit card or car finance over 20 or 30 years.
Before doing anything mentioned above please consult your financial advisers and get the best advice for your unique circumstance.
Plan properly when interest rates are low in order to survive interest rate hikes
When interest rates are at a level where you can manage your home loan repayments with ease, then you need to discipline yourself by increasing your minimum instalment each month. In doing so, you reduce the outstanding balance on your home loan faster and you save on the total amount of interest paid over the entire term. By the time interest rates go up, you will already be used to paying a “higher bond repayment” so you will not "feel" an increase in the interest rate as much.
When the rates go up, and you keep your instalment at this “higher” level (assuming that you don’t increase your payment again, but that you are still covering the minimum instalment required by the bank) your capital repayment will obviously slow down in order to finance the higher monthly interest payable. So, to keep your objective of paying off your bond faster, you need to try to increase your minimum repayment once again, accordingly.
Invest your spare cash in your home loan
If you have been paying additional money (bonuses, extra commission, etc.) into your home loan you would have built up an advance on your repayments, which could assist you in times that you are unable to pay the increase in your instalment when rates go up. This will bridge the shortfall until the advance is depleted which means you will then be back to paying your loan off over the agreed period (i.e. 20 years) and not earlier. When rates decrease or your financial position changes you can always catch up again.
General Home Loan Tips:
By paying extra (more than your monthly instalment) each month into your bond, you reduce your outstanding balance faster, as well as reduce the number of years over which you will pay your home loan.
The larger the cash deposit that you put down, the smaller the loan amount will be, and the less interest you will pay on the home loan.
Always ask your banker/financial adviser to try to get you the best possible home loan rate.
Check whether the company you work for has a corporate scheme with your bank. You might enjoy the benefit of a reduced home loan rate, as well as reduced banking costs.
A home loan can be an investment. Not only does your property increase in value, but by putting extra cash into your home loan account you are effectively investing money at a higher rate of return than that which you would normally receive from other investments, and it is tax-free.
Aim to retire bond-free.
This article originally appeared in Property Power 11th Edition Magazine. To order your copy at the discounted price of R120 click here