Some of you are quite aware of the on-going economic crises in Greece that seems set to spread to the rest of the continent. It is a pretty complex situation, but it basically can be summed up as follows:
Someone (Greece) has borrowed too much money and now they are unlikely to pay it back, so instead of defaulting on the loan they are getting a rich uncle (European Central Bank & Germany) to provide the money to pay back some of the loans. The problem is that the rich uncle is running out of patience and money… But that is a topic of another article. (Read ‘How to Get Out of Debt‘).
Buying on Credit
I wanted to discuss something where most people are effected, that is buying on credit. Years back when I was just starting work, the South African economy was booming. A lot of companies were offering good finance deals on anything from furniture to clothing, cars etc.
The availability of credit also helped fuel the housing and construction boom. And pretty much any company that was not into banking was offering you a credit card. This has slowed down recently, especially with the introduction of the National Credit Act.
Buying a Car on Credit
Recently I read an article about a finance deal offered on a product from a French motoring company. The car in question costs R230 000, but the manufacturer was offering a finance deal where you would not have to put down a deposit and you could pay off the car over 72 months at an interest rate of 7.88%.
The repayments would work out to R3200 per month, but the catch was that you would have to pay off a residual of R72 00 (or 30% of the purchase price). Now if you pull out your calculator you would see that after 72 payments you would have paid back a total of R230 400 or paid back the original price of the car.
The problem is: after 72 months the car is still not “yours”, you would then still have to pay off a lump sum of R72 000 to keep the car.
Now if you didn’t have the R72 000, you could “sell” the car back to the dealership. And if the trade-in value of the vehicle (French cars have a reputation for poor resale values) was less then R72 000 you would have to pay in a little extra for the motor dealer to take the car off your hands.
Assuming you can afford the residual value of the car, the total cost to you is R300 000 for a car that cost would have cost you R230 000 six years ago! And if you could sell that car for R72 000 you would have spent all that money buying you an “asset” that earned you a return of -76%.
Definitely not a good deal!
Now I am not saying credit is bad, it actually allows you to buy something that you need now even if you can’t afford the full purchase price. Like that deal for the car, you may not have R230 000 in cash, but you could afford R4 000 monthly repayments.
Now all of this got me thinking about the old advice when it comes to credit; which is: only use credit to buy big-ticket items and beware of the interest rate. Also pay off the loan as soon as possible.
So I decided to find out how big of a difference paying off your bond makes.
Taking a Loan to Buy a House
I then developed this excel spreadsheet (which you can download at the bottom of this article), which anyone can use to determine your monthly repayments. It also includes an amortisation table which you may use to determine how much of your monthly payments is used to pay off the actual principle (the original debt) and how much is being used to pay the interest on that loan.
In the example I have included a normal home loan for a property to the value of R1,5 million. The repayment term is 20 years at an interest rate of 9% (which is the current prime lending rate). The repayments on the bond works out to be R13 500 per month.
At the end of the loan term you will have paid about R3,2 million rand for the R1,5 million property. The total interest that you’ll pay for using the banks money is a whopping R1,74million. Which is more the original cost of that house!
In the amortisation table (in the downloadable spreadsheet) you will notice that even though the payments are R13 500 per month, most of it will go towards paying off the interest on the loan and less on the principle. This will slowly reverse towards the end of loan period.
Now let’s assume you bought this house and transfer took place at the beginning of the year. At the end of each year you are lucky enough to earn a bonus of R10 000 for the year. Instead of spending it on a fancy holiday or new toys for yourself, you put that money into your bond repayments.
We assume for the sake of simplification that the bonus stays at R10 000 and there is no further increases in the interest rate. We have added R10 000 to the repayments in the amortisation table every 12 months. The 17 payments (17 years of putting in the R10 000 bonus) comes to a total of R170,000. You would end up paying a total of R2,97 million instead of R3,2 million (as shown in the previous example). A full saving of R274,000 over the previous repayment period. You would “own” your home after 208 payments or after 17 and a bit years instead of the full 20 years.
So, clearly it’s a great idea to pay extra into your home loan. What’s even better, is to start paying in extra as early as possible.
If you added your lump sum savings of R35 000 into the home loan at the 6th month (instead of waiting until the end of the year), your total savings would be about R390 000 where you would save an extra R117 000 over the repayment term. And you would own your home in just under 16 and a half years.
What if the Interest Rate Changes?
As we know our interest rates have stayed constant for the last few years, especially since the recession, but that could easily change. So let’s say that there two big interest rate shocks over the space of your 20 year home loan.
Assume that the interest rate moved from 9% to 10% in the beginning of the fourth year and from 10% to 12% at the start of the 100 month of payments.
Each time (because your repayment period is still 20 years) there is an increase in the cost of borrowing, your repayments increase. In the end the total cost of your home is now R3,6 million instead of R3,2 million as originally planned. Now since you can’t control the interest rates would the person who paid off his or her home in less than 17 years be protected by the interest rates hike?
Sticking with the same assumptions that you paid in your bonus every 12 months and you still contributed the R35 000 lump sum in month 6. When the interest rate hikes hit you will now be paying off the loan in 225 months and the total cost to you is R3,3 million, still a saving of R288 000 over the person who didn’t put “extra” payments in their home loan.
I have included the calculations in the excel spreadsheet attached here, you can use the calculations for any of your loan calculations and viewing how the repayments would change for extra payments or an increase or decrease in the interest rates.
Start on the “Calculator” sheet tab, put in your figures, then move along to the other sheets in the workbook.
But please note the calculations are there only as a guide, they do not take into account the monthly admin fees and is in no way a substitute for actual financial advice.
In no means am I saying never buy on credit. Credit is quite useful for buying something you need now. But be careful on how you use it, negotiate the lowest interest rate possible (it is the cost of borrowing) and pay off the debt as soon as you can.
And never default on a payment. A good credit rating is something worth protecting. Learn the lessons from Greece and the rest of the P.I.G.S (the economies of Portugal, Italy, Greece and Spain) and never let that happen to you.
I hope you are now better educated about the true costs of buying on credit. With a little education comes a better understanding, and this leads to a better enjoyment of life.
Download EnjoyLife’s Loan Calculator with examples. (Right-click and ‘save link as’)
The above article is the personal opinion of the author and does not represent the opinion of EnjoyLife.co.za or of the companies that he has worked for past and present. The article serves for educational purposes and does not constitute financial advice. Always consult a financial advisor before making any significant financial decision.