Is it the right thing to do?
Dear reader,
Given the tight economic
conditions and post recession hangover, creative thinking is required to get
ahead in the game. I have seen some interesting alternatives to the standard
home loan being offered, one of which is the 30 year loan term. This alternative
is marketed as an added benefit and is sold on the premise that it’s a good
thing. is it? Well, perhaps, in the sense that a 30-year loan can make a loan
immediately more affordable, with the monthly installment on a 30 year loan being
less than the monthly installment on a 20-year loan granted at the same
interest rate, at least in the current low interest rate environment. However,
one will pay the price for this benefit in the longer term.
I am under the impression
that there exists a strong awareness of the “additional” interest charge that
one will pay in total over the full 30 years, compared to the full 20 years on
a shorter term home loan. However, very little seems to be mentioned about the
“other” potential risks of extending one’s credit term.
Besides the obvious impact
of paying more interest over a longer period, let’s look at a practical example
and compare apples with apples. There are some assumptions made, one of which
is the loan term is paid according to the required payment schedule, i.e. over
the full thirty years, and that no additional deposits are made, bearing in
mind that additional deposits will reduce capital and interest charges ahead of
schedule. The same applies to the 20 year loan term in the example. In
addition, I assume that both loans are made at 8.5% interest rate (current
prime rate), and for the purposes of this example I assume that the rate
remains at this level for the duration of the loans.
The total cost of a 30 year vs a 20-year home loan – 30 year loans
ultimately cost more
The total amount paid (capital
plus interest) on a bond of R1 million over 20 years, in this example, would be
a total of R2, 082,776, at a monthly required installment of R8, 678.
If one were to extend that same
R1 million loan to 30 years, with the same interest rate, the required monthly installment
would be a lesser R7,689. This would imply R989/month less than in the case of the 20-year loan, but
a total of R2,
768,089 would be paid over the entire 30
years, an extra R685,
312.
However, some may correctly
argue that we need to do the calculation in real terms, i.e. adjusting the
amounts paid for inflation over time. Inflation, depending on its level, can
sometimes make it attractive to repay debt as slowly as possible. That was the
case in the 1980s, when consumer price inflation was nearer to 20%, and
interest rates were often lower than inflation. These days, however, inflation
is significantly lower, and interest rates are normally above the consumer
price inflation rate. This would make delaying repayment of debt for as long as
possible less attractive.
Let’s take an example. If
we were to factor in a CPI inflation rate average of 6% per annum over the 20
and 30 year loan terms, still assuming an 8.5% interest rate on both loans, one
would still pay an extra R78000 in real terms (I.e. total repayment over the
term expressed at today’s price levels) over the extra 10 years. This differential
increases as the level of interest rates relative to inflation increases
The risk – 30 year loans are a higher risk to both bank and client.
However, the abovementioned
comparison may have been a bit simplistic. The reality is that, all other
things equal, a 30-year home loan is a higher risk loan for 3 reasons.
Firstly, this is due to the
far slower pace at which the 30-year loan is paid down, compared to a 20 year
loan, assuming the borrower sticks to the required repayment schedule. The
borrower is normally most at risk during the early stages of a loan, because
that is normally where the “loan-to-home value” ratio is at its highest. If the
loan granted is equal to 100% of the value of the home that is used as security
for the loan, the home owner may battle to sell immediately without incurring a
loss, should he/she suddenly experience financial difficulty (due to, perhaps,
a sudden loss of employment/income), remembering that on top of the price of
the house she also incurred transfer and relocation costs. In times of a weak
market, this risk is increased because house prices can decline, pushing the
loan-to-home value ratio to above 100%, i.e. the value of the home is then insufficient
to provide full security for the home loan, a position known as “negative
equity”.
But as time goes by, the home
owner’s risk is gradually reduced as he pays down the loan amount outstanding.
In addition, there is usually some rate of house price growth over time,
further contributing to a decline in the loan-to-value ratio.
In the case of a 30 year
home loan, the capital amount outstanding is paid down at a far slower pace
than in the case of the 20 year loan. This means that the loan-to-home value
ratio declines at a far slower rate than in the case of a 20 year loan, all
other things equal, and therein lies the higher risk in the case of the 30 year
loan for both bank and borrower.
The accompanying graph,
portraying what is known as the “amortization curve” illustrates the path of
decline in value of the outstanding capital amounts on the 30 and 20 year R1m
loans at 8.5% interest rate. One can see that after 20 years, when the 20 year
loan amount outstanding reaches zero, there is still over R600,000 outstanding
on the 30 year loan.
Let’s face it, while many
of us would be tempted to take the 30 year loan option with its lower monthly
repayment value, we may well regret the decision after 20 years when we realize
that we haven’t even paid off half the loan amount yet.
But that isn’t where it ends.
There is a second cause of higher risk in the case of a 30 year home loan. This
lies in the fact that in real life interest rates fluctuate. Now if one does
the monthly installment calculations, you will find that the lower the interest
rate the less the monthly installment value required on a 30 year loan is compared
to that of a 20 year loan. So, at the currently abnormally low interest rates
by SA standards, 30 year loan installments are significantly less than the 20
year installments. However, this gap will diminish as interest rates rise (and
ultimately they normally do), with the installment on a 30 year loan rising
faster in value than the 20 year installment as interest rates rise.
So, whereas at 8.5%
interest rate, the monthly installment on a 30 year loan is R989 less than on
the 20 year loan, what home loan clients are probably not being told is that
should prime rate head back up to 15.5% for instance (the level of the last
peak in 2008), the 30 year installment value would only be R494 less than the
20 year loan installment. Herein lies the additional risk, because when
interest rates rise the household with the 30 year loan has a greater
adjustment to make than the household with the 20 year loan.
The
above-mentioned 2 reasons as to why 30 year loans pose a greater risk to bank
and borrower than the 20 year loan, means that in real life the lender may
charge a slightly higher interest rate on a 30 year loan than what it would
have for the same applicant applying for a 20 year loan, further limiting any
advantage gained from a 30 year loan.
Now let’s look at the
history of interest rates in SA. Over the
last 20 years the average rate has been 15,97%. If we were to shorten this view
and consider 10 year, 5 year and 2 year averages, we would see averages of 12.76%,
12.38% and 9.25% respectively; the result would still be well above our current
40 year low of 8.5%. We know that prime will fluctuate over the life of the
loan, and over time it is quite plausible that the average could increase again,
reducing the advantage of the 30 year loan.
The 3rd risk is
that a 30 year loan can raise the possibility of the borrower “over-extending”
herself, because by extending the term to 30 years; you could qualify for even
more. If you could hypothetically get the same interest rate on the loan as
what you would qualify for on a 20 year loan, you may qualify for a higher
value of 30 year loan than in the case of a 20 year loan, based on the
affordability of the loan (a lower monthly installment than a 20 year loan).
But it isn’t just about the monthly loan installment value. It is about the
costs of running the home, and if one buys a more expensive home it probably
means higher municipal rates, possibly higher water and electricity if it is a
bigger house, and perhaps higher maintenance costs too if the home is more
luxurious
And finally, 30 year loans may well further hamper the household’s
retirement saving drive
Lastly, a risk to the
borrower, perhaps not the lending institution, comes in the form of a potential
negative impact on saving. If one takes on a 30 year home loan at the age of
30, one may well only finish paying it off at the age of 60, thus taking the biggest
chunk of one’s productive working life. Having debt until near to retirement
age can delay one’s saving for retirement, and already SA’s household sector is
notorious for its extremely poor savings rate. What many households need,
rather, is to get out of debt at an earlier stage of their lives and begin to
accumulate savings and investments at a more rapid rate. I’m not sure 30 year
loans are conducive to this.
CONCLUDING
Therefore, whilst it can be
appealing to have that bigger, better home and extending the loan term on a low
interest rate cycle could conceivably get you there, one needs to be careful of
“over-committing” in a low interest rate environment. As sure as the proverbial
death and taxes, lending rates will rise. Before accepting the short term
gains, we should consider:
·
The short term benefit of a
reduced repayment over a longer period seems attractive, but the capital
reduction is slower, meaning your loan balance reduces at slower rate if your
term is longer.
·
The interest rate afforded
to the loan could carry an added premium because of higher risk on a 30 year
loan compared to 20 year one.
·
As the interest rate increases, the required
installment on a 30 year loan increases faster than that on a 20 year loan,
eroding the relative benefit of a 30 year loan.
·
Larger more expensive homes
can attract larger costs, eg. Maintenance, utility costs and insurance costs.
·
The rate of capital
reduction on a loan over 360 months, from month one, is far slower than in the
case of a 240 months. So, on a bond of R1 million, the balance after 20 years
on a 30 year loan would still be around R620 000, with only around R380,000 having been repaid. Compare this to a 20
year loan whose repayment would be complete at this stage.
And finally, the longer a household stays indebted, the greater the potential for its savings rate to be inadequate come retirement age. All-in-all, therefore, while there is not right or wrong with regard the choice of the term of a loan, clients should be under NO illusions that there are significant longer term costs and risks involved, in return for a very limited short term benefit in the form of a mildly lower installment repayment value while interest rates remain low.
CLINTON MARTLE:
PROPERTY LEADER SALES STRATEGIST
021-480 8117
Twitter: @clinton_martle
Blog: clintonmartle@blogspot.com
First National Bank – a division of FirstRand Bank Limited. An
Authorised Financial Services provider.
Reg No. 1929/001225/06
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