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Avoid the debt spiral

Regularly upgrading houses does not create wealth.

A home is probably one of the biggest assets that anyone will ever possess.

However, not everyone can afford to pay cash for their home; the alternative is to finance the transaction with a mortgage loan. The size of the mortgage loan is determined by the buyer’s monthly income.

As a rule of thumb, commercial banks’ loan criteria for mortgage loans are normally twice the buyer’s gross annual salary.

Consider the following scenario:

Kobus earns R50 000 per month (R600 000 per annum). He applies for a mortgage loan and is informed that he qualifies for R1.2 million. His after-tax income is approximately R37 929 per month. It is enough to meet all his monthly expenses and his budget allows for an additional monthly investment of R5 000 in a unit trust portfolio.

Consider, furthermore, the following terms of the agreement:

Loan amount R1 200 000*
Term 20 years (240 months)
Interest rate 10.25% per year.
Instalment R11 779

*No transfer duty and cost of transfer brought into account

An amortisation table sets out the monthly interest payments and capital redemption that apply to the repayment of the loan. Kobus’s mortgage loan encompasses a period of 240 months, and the amortisation table likewise covers 240 months. For this illustration, the prime lending rate is calculated at 10.25% and it is assumed that the rate will not change over the period of the loan.

The following is an extract from the relevant amortisation table for months 1, 10, 20, 30, 40, 50, 100, 200 and 240.

Month Instalment Interest payable Capital redemption Balance
1 R11 779 R10 250 R1 529 R1 198 470
10 R11 779 R10 128 R1 651 R1 184 101
20 R11 779 R9 981 R1 798 R1 166 791
30 R11 779 R9 822 R1 957 R1 147 944
40 R11 779 R9 648 R2 131 R1 127 423
50 R11 779 R9 459 R2 320 R1 105 082
100 R11 779 R8 229 R3 550 R959 857
200 R11 779 R3 468 R8 311 R397 706
240 R11 779 R 0 R11 779 R0

It is important to note that one mainly pays interest at the beginning of the term and that very little capital redemption takes place. As time goes by, the payments on interest decrease and capital redemption increases until the final payment in month 240 goes to capital only and none to interest.

Over the period of the bond, the following applies:

Total interest paid over 240 months R1 627 132
Total repayment to the bank over 240 months R2 827 132

If Kobus pays off an additional monthly amount of only R2 000 on his bond, three significant variables emerge:

Saving in interest over 240 months R620 568
Interest payable over 240 months R1 006 564
Shortening of the payment period 79 months
Total repaid to the bank R2 206 564

It is therefore clear that the additional monthly payment of R2 000 brings about a significant saving in interest. The period accordingly also shrinks from 20 years (240 months) to just over 13 years (161 months). In little more than 13 years, Kobus could be debt-free. Given a real return of 4% above inflation of 6% (thus 10% p.a.) the value of his unit trust portfolio could amount to about R1 589 750 after 13 years.

Kobus grabs the opportunity and pays off an extra R2 000 a month on his mortgage loan because he is eager to save on interest and reduce the term to about 13 years.

The attraction of a more luxurious and more expensive home

Five years on, a property in a high-end golf estate catches Kobus’s eye. The property is priced at R2.3 million.

Meanwhile, his salary has gone up to R56 000 per month. He decides to approach the bank to determine what mortgage loan amount he might qualify for. The bank informs him that he would qualify for about R1 350 000.

The amortisation table of month 60 (year five) presents the following:

Month Payment Interest payment Capital redemption Balance
60 R11 779 R9 274 R2 505 R1 080 757

Kobus also notes the following:

The outstanding balance on the loan in month 60 R1 080 757
Total instalments paid in 60 months R706 740
Total interest paid in 60 months R587 497
Total capital redemption in 60 months R119 243

Over the 60-month period, he only paid interest and very little went toward the capital. He realised that about 83% of the 60 instalments he paid went toward interest and only about 17% went to capital.

Kobus nevertheless pursued the matter further to determine if he would be able to afford the property on the golf estate. He found out that he would be able to sell his current home for R1 350 000. This would enable him to pay off the loan of R1 080 757 on his property, leaving a surplus of R269 243. If he put down the R269 243 as a deposit on the new property, the outstanding amount to be covered by a mortgage loan would be approximately R2 030 000. As he only qualified for a bond of R1 350 000, he decided to liquidate his unit trust portfolio, then worth R464 000, and use it as a deposit. Given the size of the deposit, the bank decided to accommodate Kobus and finance the difference of R1 566 000.

The terms of the new transaction were as follows:

Purchase price R2 300 000*
Minus cash deposit paid R733 243
Mortgage loan R1 566 000

*No transfer duty and cost of transfer brought into account

Furthermore, consider the following as regards the repayment and interest on the new home:

Mortgage loan R1 566 000
Term 20 years (240 months)
Interest rate 10.25% per year
Payment R15 372
Total interest paid over 240 months R2 123 409
Total repayment to bank over 240 months R3 689 409

Conclusion

People sometimes have the mistaken notion that upgrading to a larger and more expensive property will give them a bigger asset. Although one’s home is classified as an asset on one’s balance sheet, it is not the same as an asset that generates a cash flow.

A home in which one lives does not generate income and is actually an expense item that eats into a large part of one’s monthly cash flow. When someone regularly upgrades to another home, they use more and more of their cash flow for bond repayments and are not creating wealth. To make matters worse, investments are also liquidated sometimes to make up a bigger deposit in order to acquire a larger and better property.

If Kobus had continued to pay off his original property, he would have had the benefit that the monthly instalment would pay off more capital during the latter phase of the bond period. Together with the additional monthly capital redemption of R2 000, he would have been debt-free in just over 13 years. The value of his unit trust portfolio would also have continued to grow to about R1 589 750. More importantly, he would no longer have needed to make monthly bond repayments, increasing his cash flow. The cash flow that became available could then have been utilised much more beneficially to acquire an asset that could generate cash flow, rather than being poured into the interest on a bigger and more expensive property.

ADVISOR PROFILE

Tian Ebersohn

PSG Wealth Pretoria-East

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COMMENTS   2

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Nice – R2.3 million in a HIGH-END golf estate.

Nice unit trust Kobus latched onto there. Care to provide some real-world equivalents?

End of comments.

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