Reduce Interest Rate Payments
Many of you reading this headline may think, “I battle to keep up with the monthly payments on my home loan as it is, let alone having a lump sum deposit to make.” Interest rates in South Africa have increased over the past three years to the extent that many people find themselves in a position where they can no longer afford their home loan payments. In December 2008 we had the first cut in interest rates; hopefully this trend will continue and we can all breathe a sigh of relief.
What goes up, must come down
The interest rates may go up again and in your lifetime you will experience this cycle a number of times. Planning ahead is the best defence to protect yourself against future interest rate increases. Your aim should be to always keep your home loan repayments at an affordable level, allowing for possible increases. When you receive a lump sum payment such as an unexpected bonus or inheritance, resist the temptation to spend it on luxury items you don’t really need and pay it into your home loan. The effect on the interest payments of your home loan may astound you!
What happens if I make lump sum deposits?
Firstly, you must understand how banks calculate interest on home loans. Interest is calculated on a daily basis on the outstanding balance and capitalized (or added) to the home loan monthly. The effect of daily interest calculated on an outstanding balance is that any additional capital you pay off the loan will reduce your outstanding balance and therefore the interest that will be added to the loan the next month.
The banks do not penalize you for paying off your home loan earlier than the contracted term, unless you pay off the loan within a very short period, such as a year. Just to be on the safe side confirm with your bank what their policy is in this regard. Also look at your home loan agreement and check for any clause that allows the bank to add penalty interest for additional payments made.
Get ready for a huge surprise!
To get an idea of the monthly interest you will save by paying a lump sum into your home loan you can use a calculator designed specifically for such a scenario. The banks and many home loan originators have these calculators available on the internet web sites. It will show you how much interest you will save in total and also with how many years you will reduce the period of your loan. Once you see the effect of making a lump sum payment on your home loan it will inspire you to do so whenever possible.
It’s tax-free savings at the highest rate
Paying in lump sum deposits in your home loan should be seen as tax-free savings at the highest rate available as home loan rates are always higher than the prevailing investment interest rates. If that was not the case banks will not be in business; they have to charge higher interest on loans than what they pay on investments. The difference between the two rates is called the rate margin. The beauty of paying in lump sums is that you can view this as building up a nest egg or emergency fund. The banks will record all additional payments, over and above your monthly instalment, as money paid in advance. This money can be accessed should you need it.
You will have to apply for this access facility at the bank. Paying off your home loan earlier and saving interest should be your main aim when making lump sum payments, but it does provide you with peace of mind to know that you have the money available for unforeseen circumstances. It also provides you with some flexibility during times of interest rate increases.
Every little bit helps
Just as lump sum payments will reduce your loan faster, making any monthly additional payments will also help. Even if you can afford just a R100 extra payment a month, the savings in interest and length in years shaved off your home loan will come as a huge surprise. One way to do this is when interest rates come down, instead of paying the reduced monthly instalment, you continue paying the same instalment. After all, you have been doing so for some time. Again, you can calculate the savings you will make by using one of the home loan calculators mentioned above.
At the end of the day it all boils down to financial discipline and owning a bond free home must be one of the nicest feelings around.