Should you dribble money into your bond?

Marc Ashton
2013-07-02 18:18
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Johannesburg - Arguably one of the best sources of personal finance information on the web today is the Bankers Anonymous website, which looks at things from the perspective of the financial services institutions who are structuring the products.

In other words, they show you how you’re being screwed financially. The most recent post on the site concerns the question about whether or not you should pay in additional instalments to your bond and whether you as the consumer are really saving by doing this.

The answer is fascinating: paying off your mortgage principal in small early increments does not make much sense from a pure financial maths perspective, but it can be the correct thing to do for certain psychological reasons. The maths part of it is interesting.

In the US, your mortgage repayment is essentially applied to the last instalment and then worked backward to your current payment. This meant that in fact the “saving” that you thought you were making was significantly less than the saving you were actually achieving.

This article got Finweek thinking about whether the maths worked the same locally and we approached Ewald Kellerman, head of sales at FNB Homeloans, to do the maths for us. He explains it as follows:

A typical homeloan’s interest is calculated daily and capitalised monthly. This means that daily fluctuations in balances changes the amount of interest being added to the loan, and can incentivise the borrower to pay additional funds into the account as early as possible.

This is in contrast to an instalment sale loan where interest is often capitalised up front, and a fixed amount paid off over a term.

Flexibond facilities or their respective counterparts at other banks allow easy access to your homeloan. This mechanism allows easy access to any prepaid (or surplus) funds that have been deposited above the required instalment.

The term of a new homeloan is typically 20 years (although some banks do 30-year loans), the longest out of the most popular household debt instruments. This term can be significantly reduced by additional repayments over and above the normal required instalment.

In certain cases, the term may even be extended to provide the borrower with a facility for a longer period of time.

Given the way that interest is calculated, the transactional capability and the typical rate charged on a homeloan, this debt instrument is ideal for:

1. Interest savings

Any surplus funds deposited into a homeloan will perform better than a separate savings deposit that attracts a lower rate of interest.

Instead of opening a separate savings account and earning interest on the balance, the borrower will pay less net interest (i e interest paid minus interest received) if the money is deposited to reduce the outstanding homeloan balance.

Additionally, earnings on a savings account may be taxed as income tax (certain exclusions apply), whereas a reduction in expenses on your interest repayment does not attract the same income tax.

Building on the earlier example, if the R100 000 is deposited into a separate money market account that attracts 3.4% interest per annum, the income generated from the account excluding any fees is R3 453.

This amount will be included in your income tax calculations and may even attract income tax (depending on any other income generating investments you may possess).

This is in contrast with a R8 839 saving that would be realised in a year if the amount is deposited into the homeloan account.

2. Debt consolidation

Increasing the value of your bond to pay off other debt instruments could significantly reduce the total amount of interest paid on your total debt.

Short-term or revolving credit such as personal loans, credit and store cards attract higher rates in interest in line with the risk faced with these lines of credit. Tapping the equity in your homeloan to repay these debts could significantly reduce the overall rate of interest charged.

3. Using your homeloan to fund vehicle purchases and other lifestyle expenditure

Where there is enough equity in a bond to buy a vehicle with the surplus, the rate of interest charged could significantly be reduced by funding the purchase via the homeloan instead of another line of credit.

Similarly, other lifestyle expenditure such as holidays can be funded from the homeloan account instead of other often more costly short-term debt.

Benefits of repaying a homeloan at a faster rate

As little as a 10% additional payment per month could save approximately four years of repayments and R250 400 in interest on a R1m loan over the life of the loan.

These calculations have been based on the current level of interest rates. The additional repayment is immediately set off against the capital value of the loan, thereby reducing interest paid.

Depositing 10% of the purchase price upfront without reducing the repayment can decrease the time it takes to repay the entire loan by four years and three months, and save approximately R452 000 in interest charges throughout the life of the loan.
 - Finweek

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