23 Oct 2023
When you decide to buy a new home, you'll want to pay attention to relevant home ownership news, which typically focuses on the state of the property market and how interest rate changes are impacting it. While interest rates drive the costs of all credit purchases, they have the biggest impact on your home loan and your ability to afford the monthly repayments.
When you take out a home loan, you repay it over a long period of time - typically 20 years - and are charged interest on the loan amount outstanding / owing at the time. Your monthly repayment is typically a combination of the interest charge plus a capital repayment to amortise (pay down) the capital balance outstanding. The rate you are charged has a huge impact on the affordability of the home loan. For example, on a 20 year R2m loan at 8%, your repayment is roughly R16500 pm which means your total interest cost over 20 years is about R2m. However if rates were to increase to 12% your monthly repayment jumps up to R22000 pm. In the first few years, almost all of your monthly repayment goes to paying the interest, and very little to reducing capital. As the loan gets paid down, less interest is charged and hence more capital repaid each month, so in the later years the situation is reversed and your repayment is primarily paying down the loan balance.
In South Africa, base interest rates are determined by the South African Reserve Bank, and these provide the basis or starting point for the rates such as Prime, JIBAR or the Repo rate which banks and credit providers set for their products. The interest rate charged to the client is typically a base rate plus a "risk margin". The additional margin is determined by commercial factors influencing the risk to the lender - the higher the risk, the higher the rate charged. Risk factors include the borrowers credit worthiness, the type of credit product, the size of the loan, and the term and conditions of the repayment period.
The SARB increases or decreases interest rates to influence a country's spending habits, economic activity and inflation levels. When interest rates go up, borrowing becomes more expensive and this reduces spending and inflation — which is bad for anyone repaying a loan but good for someone with savings or investments that earn interest. When interest rates go back down, spending becomes more affordable and loan applications can increase.
When you apply for a home loan, you can consider either a variable or fixed interest rate. What you choose when taking the loan out will apply to it until you repay the loan in full or refinance it through another lender to get a better deal (a "switch"). A variable interest rate is directly linked to the SARB's rate and hence the Prime or JIBAR based mortgage rate. Over a 20-year term, rates will inevitably go both up and down - so you will encounter some periods of high rates and high repayments, and also some periods of lower rates and reduced repayments. As the interest rate fluctuates, so will your monthly repayments. By contrast, a fixed interest rate remains static throughout your loan repayment period.
In countries with low interest rates - such as the USA where rates are around 3-4% - fixed interest rates over longer terms, typically 30 years, are common. At these low rates, the extra interest charges of fixed rates for longer terms are low, and the increased repayment predictability is to the borrowers benefit. However, in SA where our rates are so much higher, the interest costs of fixed rates and/or longer terms can become very uneconomic. A fixed rate will be dependent on the going rate at the time you take out a loan, so a key decision criteria is your view of where we are in the interest rate cycle - are we at a peak or trough? This is difficult to know - even professional economists cannot predict the future. It is easier to predict over shorter periods - so fixed rate agreements are more common and popular for shorter repayment periods - eg 1 to 3 years. However, for a long mortgage period, a fixed interest rate will start much higher than the equivalent variable interest rate, as the fixed rate poses much more of a risk to the lender. The lender will carry the cost if rates increase. In theory they will profit if rates decrease and yours stays high, but in reality they face the likelihood that you will simply switch out to a variable rates if rates go below your fixed rate - hence fixed rates are not an attractive product for long term loans.
If you don't like uncertainty and like to budget for all your purchases, a fixed interest rate provides long-term predictability. You'll know exactly what you need to pay monthly for the foreseeable future and any interest rate changes won't impact you. However, your starting rate and monthly repayment will typically be much higher than if you had chosen a variable rate. Also, if you haven't timed the rate cycle well, and interest rates then fall, you'll be locked into a higher repayment than what you would be paying had you chosen a variable interest rate, or you will need to find a way to switch back to variable, which might entail additional costs.
If you're able to afford more risk for starting with lower repayments, a variable interest rate may better suit your needs.
No matter which option you go with, making additional payments over and above your minimum scheduled repayments will be hugely helpful. Additional payments means that your repayments will be reducing the actual loan balance much sooner, so your interest charged each month falls much more quickly. If you find yourself able to afford higher repayments, you can make them whenever you're able to. If you take out a variable interest rate loan and the interest rate decreases, you can continue to pay the higher amount, so you can settle your loan more quickly. For example, in the scenario above - if rates started at 12% but fell to 8%, but you kept up the higher repayment - you would pay off your entire loan in only 10 years. If rates were at 8%, and you could afford to pay an additional R4000 pm, you would reduce your loan repayment period from 20 years down to 13 years, and save nearly R800 000 in interest charges!
Don't be afraid to ask questions should you need to gain clarity on the situation and never feel pressured to make a decision. SA Home Loans has plenty of experience in helping customers navigate the often complex world of home loan applications. For more advice from our team, contact us today at 0860 2 4 6 8 10