Buying a property is probably your single most expensive purchase. As it is unlikely that you will have sufficient cash to cover the full purchase price, you will probably need a home loan. We look at how home loans work and how you can cut the costs attached to borrowing money.
Once you have found the home of your dreams or chosen a plot of land on which to build, it is likely that you will have to apply for a home loan. Banks and other financial institutions provide home loans.
The main cost of a home loan is the interest that you pay over the term of the loan. Interest, which is the price you pay for borrowing money, is expressed as an annual rate. The standard interest rate, or what is known as the base home loan rate, is the rate the average person pays on a loan over a year.
However, banks are prepared to give their good customers discounted rates. The better your risk profile, the bigger the discount you are likely to get from your bank.
The bank will consider various criteria when assessing your risk profile. These criteria include your financial stability, your income level, the type of work you do, the deposit you put down on the property and your credit track record.
Depending on your risk profile, you may qualify for a discount up to 1.5 percentage points on the base rate. The base rate is currently 11 percent a year (as is the prime lending rate). If you get a discount of 1.5 percentage points on the base rate, you will pay interest of 9.5 percent a year for your home loan.
Loan term
The typical loan term is 20 years. You can also repay your loan over 25 or 30 years, although such long terms are not recommended.
The period of the loan determines the amount of money you have to repay each month. The longer the repayment term, the smaller the monthly repayments. But the longer the loan period, the more the loan will ultimately cost you, because you will pay interest for a longer period of time.
You should make every effort to pay off your loan before the loan term expires, because this will save you thousands of rands in interest.
You can reduce the loan term by paying extra money into your home loan account, either each month or in lump sums - for example, when you receive your annual bonus.
You should aim to repay your home loan by the time you retire. It is almost inevitable that your income will decrease after you retire, when you will rely on a pension and perhaps the income generated by other investments.
How interest is calculated
Banks calculate the interest on the outstanding balance on your home loan each day, and capitalise it to your account monthly. Capitalising means adding up the interest accrued each day and adding the total to your balance on a specific day at or near the end of the month.
The way banks calculate and charge interest on a home loan means you are liable for interest on the amount you owe every day. For example, let's say you take out a R100 000 loan at 11 percent over 20 years. You will be liable for interest on your R100 000 balance of R30.14 on each day of the month, assuming the interest rate remains the same.
On the last day of the month, two things happen:
- The interest you are liable for on each day of the month is added to the outstanding balance on your loan. In our example, each R30.14 for each day in the month is added to your account. So, if there were 30 days in the month, your balance will increase by R904.20. This is the interest that has accumulated over the preceding period.
- On the day you pay your monthly instalment of R1 032, your balance will reduce to R99 872 (R100 000 less the instalment of R1 032 plus the interest capitalised of R904).
On the day the interest is added to your capital, daily interest will be calculated on the total amount, until you pay your next instalment.
How to save money on your home loan
In the early stages of paying off your home loan, a significant portion of the monthly instalments go towards settling the interest on the loan. As the loan balance reduces, however, the monthly interest decreases and so a larger portion of your instalments are used to reduce the capital amount you borrowed.
You can adopt various strategies to pay off your home loan before the contracted term ends. You need to choose the strategy that best suits your financial circumstances.
Your strategy options are:
- Increase your repayments. You can save a significant amount in interest by paying a relatively small additional sum of money into your home loan each month. For example, if you have a loan of R100 000 at 11 percent interest, repayable over 20 years, your monthly repayments will be R1 032.19. If you pay an additional 10 percent of your instalment - that is, R103.22 - each month, you will settle your loan in just over 15 years, saving about R42 216 in interest.
- Make lump-sum deposits. You can save a significant amount of money over the long term if you deposit any additional income you receive (in the form of a bonus or income from freelance or overtime work) into your home loan account.
For example, if you pay a lump sum of R10 000 into your R100 000 home loan (taken out over 20 years at 11 percent interest a year) three months after taking out the loan, you would settle your debt in just under 15 years and save almost R54 728 in interest charges.
- Pay earlier each month. Most people pay their home loan instalment on the last day of each month. However, you will pay less interest if you pay your instalments earlier every month.
Using the example of a R100 000 loan over 20 years at an interest rate of 11 percent a year, paying your instalment five days earlier each month will reduce your home loan term by nearly 1.5 months and save you about R1 366.
- Make multiple payments in a month. Your home loan interest charges are calculated on your daily outstanding balance. Therefore, you instantly benefit from any deposits you make into your home loan account, because the daily interest calculation is based on a lower outstanding balance.
For example, on a loan of R100 000 at 11 percent over 20 years, the monthly instalment is R1 032.19. If you split this instalment into two payments of R516.10 made on, say, the 15th and 30th days of each month, instead of a single payment of R1 032.19 on the 30th, you would save almost R2 035 in interest and the loan would be repaid two months earlier.
Splitting the payment into two means your first payment each month is made in advance.
Types of home loans
Most of the major banks offer a range of interest rate options. In many cases, you have to meet certain criteria to qualify for a particular option, so the choice is not entirely yours. Also, the banks do not make all their options available all of the time. You should ask your bank about the options it is offering when you take out a loan.
Some of the options are:
- Variable interest rate loan. The most common loan is a variable interest home loan. In the case of a variable interest rate loan, the rate you pay rises or falls in tandem with the prime lending rate, which is affected by the state of the economy. Any change in the prime lending rate will result in a change in the base home loan rate and, therefore, in the particular rate you pay.
For instance, if the prime lending rate falls by one percentage point, the interest rate you pay on your loan will decrease by one percentage point.
- Fixed interest rate loan. When you choose a fixed interest rate loan, you are locked into a specific interest rate for a specific length of time. The term can be anything from six months to two years, depending on what is on offer from the banks.
At the end of the term, your interest rate will revert to the prevailing home loan base rate less the original discount you enjoyed at the time of taking up the fixed rate option.
Whether or not a fixed rate is a good idea depends on your personal circumstances and the forecast for the prime lending rate.
Bear in mind that if you lock into a fixed rate of, say, 13 percent for two years and then the prime rate decreases, you have to continue paying 13 percent and the bank will score off you.
On the other hand, if interest rates increase to 14 percent, you will be the one who scores, because you will still be paying 13 percent.
One of the big advantages of fixing your interest rate is that you can budget with certainty, because you know exactly what you will be paying in instalments for a specified period of time. Fixed rates may be higher or lower than the variable interest rate you would get, and are set by a bank based on its view of where interest rates are heading.
Currently, fixed rates are about the same as, or one percentage point above, the variable rate.
- Capped interest rate loan. A capped interest rate loan is a combination of a fixed and a variable interest rate loan. Your rate never exceeds the amount at which you cap your rate (similar to a fixed rate loan), but your rate can decrease if the prime rate decreases (similar to a variable rate loan). The ceiling the banks set on the top rate is usually one or two percentage points higher than your current variable rate.
Thus, capped rate loans give you the advantage of benefiting from a fall in interest rates while limiting the interest rate that you will pay should interest rates increase.
You are charged a fee, which can run into a few thousand rands, to cap your rate. The fee depends on the period of the cap and the amount at which you want to cap your rate.
Where to get a home loan
Banks have traditionally been the main lenders in the home loan market, but recently they have experienced some competition from SA Home Loans, a dedicated home loan lending institution.
To obtain a home loan, you can approach a lending institution directly or go to a mortgage originator. Mortgage originators will find a home loan on your behalf without you having to approach each bank individually. (Mortgage originators do not approach SA Home Loans.) You do not pay a mortgage originator directly for its services. The originator earns a commission from the bank from which you decide to take out a loan.
The type and quality of services offered by mortgage originators vary widely. A mortgage originator may be one person in a home office phoning the banks on your behalf, or a company backed by sophisticated loan-sourcing software and online application systems.
To ensure that you are getting a fair deal from a mortgage originator, make sure that the originator obtains quotations from a range of banks, and not only from one or two. Also, check that the originator is not steering you in the direction of a certain bank merely because it is offering the originator the highest commission. Originators may receive commissions for placing bulk business with a bank.
Access facility
Variable loan bonds, which are often referred to as access bonds, offer a facility whereby you can withdraw the capital that you have already repaid on your loan. For instance, if your original loan was R200 000 and, three years later, it is down to R180 000, you may withdraw up to R20 000. This may be useful if, for example, you need money to renovate your home.
There may be restrictions on the number of withdrawals you can make from a variable home loan account each month. Typically, it is two to three withdrawals, and you may be limited to making withdrawals in multiples of R1 000.
Thanks to First National Bank HomeLoans for assisting with the information for this article.
Part 63:
The cost of buying property