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Monday Oct 15, 2012

Beware the hidden dangers of a 30-year home loan

You may be tempted to take out a 30-year home loan for the short-term gains - such as smaller repayments or a bigger bond - but before going this route, give some thought to the potential long-term losses.

Stretching out the term of your home loan reduces your monthly repayment but costs you more in the long run. This, however, is not the only downside, which is why First National Bank (FNB) has stopped offering a 30-year home loan and SA Home Loans has elected not to introduce one.

You can still get a 30-year home loan from Absa and Standard Bank, and the maximum home loan term on offer at Nedbank is 25 years.

"With the consumer continuing to experience financial pressure, most customers are opting for 30year mortgages," Arrie Rautenbach, head of retail markets at Absa, says.

Steven Barker, head of home loans at Standard Bank, says the bank has seen a marginal increase in applications for 30-year home loans, but most Standard Bank customers still prefer a 20-year term.

John Loos, household sector and property strategist at FNB Home Loans, says FNB's maximum loan term is 20 years. The bank does not offer a 30-year home loan because, he says, it does not believe it is prudent for its customers.

"We have a very small number of 30-year loans on our book from the past, often where we restructured the debt of a client who was in arrears," Loos says.

In a Property Barometer article published by FNB, Clinton Martle, property strategist at FNB, says consumers seem to realise that the longer the loan term, the more they pay in interest. But there is less awareness about the other potential risks of extending your loan term - such as the impact of inflation, the risks associated with fluctuating interest rates, over-extending yourself, and the impact on your retirement savings plan.

To make his point, Martle compares a R1-million home loan taken over 20 years versus 30 years, based on the following assumptions:

  • The loans are paid according to the payment schedule over the full 20- and 30-year terms, with no additional deposits being made;

  • The interest rate on both loans is the current prime rate of 8.5 percent; and

  • The interest rate remains level for the duration of the loans.

    The total amount paid (capital plus interest) on a bond of R1 million over 20 years would be R2 082 776, at a monthly instalment of R8 678.

    If you were to take the loan over 30 years, the monthly instalment would drop to R7 689 - making it R989 less a month - but you would pay a total of R2 768 089, or an extra R685 312, over the entire term.

    Martle says you could argue that you need to calculate the total cost in real terms - in other words, adjust the amounts for inflation.

    "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 index (CPI) inflation was nearly 20 percent and interest rates were often lower than inflation. These days, however, inflation is significantly lower [five percent], and interest rates are above the CPI rate. This would make delaying the repayment of debt less attractive."

    Assuming a CPI rate of six percent a year over the 20and 30-year loan terms, and an 8.5-percent interest rate on both loans, you would still pay an extra R78 000 in real terms (the difference expressed at today's price levels) over the extra 10 years, he says. "This differential increases as the level of interest rates relative to inflation increases."

    Fluctuating interest rates add an element of risk to a 30-year home loan, Martle says.

    "At the current abnormally low interest rates by South African standards, 30-year loan instalments are significantly less than 20-year instalments. However, this gap will diminish as interest rates rise (and they normally do), with the instalment on a 30-year loan rising faster in value than the 20-year instalment."

    At an interest rate of 8.5 percent, the monthly instalment on a 30-year R1-million home loan is R989 less than on a 20-year loan. Martle says what you don't realise is that if the prime rate shot back up to 15.5 percent (the level of the last peak in 2008), the instalment on the 30-year loan would be only R494 less than the instalment on the 20-year loan.

    "Herein lies the additional risk," he says, "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."

    You are normally most at risk of defaulting during the early stages of a loan, because that is usually when the loan-to-value ratio is at its highest. (Loan-to-value ratio is the amount of the loan as a proportion of the property value, expressed as a percentage.)

    "If your loan is 100 percent of the value of the home, you may battle to sell immediately without incurring a loss should you suddenly experience financial difficulty, remembering that on top of the price of the house you 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-value ratio to above 100 percent - in other words, the value of the home is then insufficient to provide full security for the home loan, a position known as negative equity," Martle says.

    As you pay off your loan over time, your risk is gradually reduced. In addition, there is usually some house price growth over time, further contributing to a decline in the loan-to-value ratio, he says.

    "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-value ratio declines at a far slower rate, all other things being equal, and therein lies the higher risk in the case of the 30-year loan - for both bank and borrower," he says.

    Like Martle, Kevin Penwarden, chief executive officer of SA Home Loans, points out that the risks to the lender are likely to have an impact on you, the borrower.

    "It is wrong to assume that the interest rate on a 30-year loan will be equal to the interest rate on a 20year loan. The 30-year loan should actually carry a higher interest rate - to compensate the loan company for the increased funding costs and the greater amount of capital that needs to be held," he says.

    Another risk associated with a 30-year loan, Martle says, is that of over-extending yourself.

    You may qualify for a bigger loan amount if you take your bond over 30 years instead of 20, but it isn't just the monthly loan repayment that counts, Martle says.

    "It's also about the costs of running a home, and if one buys a more expensive home, it probably means higher municipal rates, higher water and electricity, and perhaps higher maintenance costs, too."

    Penwarden says a 30-year term home loan is essentially a product designed to enable you to afford to borrow more.

    "From our perspective, it is not a consumer-friendly product."

    He says the product goes against a principle that SA Home Loans encourages: to pay off your home loan as fast as possible to reduce your overall interest bill.

    Angelique Arde
    Personal Finance

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