Most of us buying a house will have to apply to a financial institution for a mortgage bond to finance its purchase.
Most mortgage bonds are taken out over a period of 20 years, during which regular payments are made until the house is paid off.
It is, however, possible to repay the bond over 30 years, but this is not advisable as the small saving in the monthly repayment is totally outweighed by the total repayment.
Why is this?
The reason is the slow rate at which the outstanding capital value of your mortgage bond declines. In fact, most people are very surprised, if not shocked, at how slowly bond capital is reduced.
Look at what happens to a person with a bond of R50 000 which is repaid at a rate of 21 percent. Repayments are R889 per month.
After five years of repayments, R53 340 in total, your outstanding capital is still R48 553! You have only repaid Rl 447 of the capital.
"What!", you would say. "That is not possible." The sad truth is that it is.
After 10 years you have repaid R106 680, but the outstanding capital you still owe is R43 952.
It is only in the last couple of years of the repayment period that your outstanding capital value reduces rapidly. That is why it is so vitally important to increase your monthly repayments if at all possible.
The repayment of your traditional mortgage bond consists of two elements: interest and capital.
By far the greatest proportion of your bond repayments consist of interest. In recent years, however, an important development has taken place in the field of mortgage finance.
Mortgage payers are offered an option which could, under certain circumstances, not only pay off their bond, but also leave them with a tax-free lump-sum after a certain period of time.
This innovation is certainly worth looking at. But remember, it also carries some form of risk.
The basic principle is that, instead of paying off your interest and capital, you pay only the interest.
The amount that you would have paid off on your "capital" (slightly more, in fact) is invested in either a unit trust or an endowment policy.
The idea behind this scheme is that in the long term the proceeds of either investment (endowment or unit trust) will be sufficient to cover the outstanding capital at the end of the term and, hopefully, leave a handsome tax-free capital gain.
The repayment of a conventional home loan is structured so that the borrower repays capital plus interest with only a small portion of the repayment being applied in the reduction of capital over the initial period of the loan.
This scheme is based on the assumption that the long-term returns of both endowments and unit trusts in the past are recorded again in the future.
As I stated two weeks ago, the average return on unit trusts has beaten the bond rate over a period of 20 years.
While this is possible, again it cannot be guaranteed.
As an example, based on historical returns, it should be possible to repay your mortgage bond over 15 years (as opposed to 25) via the unit trust linked option, or over 18 years via the endowment linked home loan option.
WHAT ARE THE PITFALLS?
With the conventional repayment of your bond you know that your bond is paid off within a certain period.
The other two options, on the other hand, while offering potentially the greatest return, will not guarantee that your bond will be completely paid off within that same period.
The risk here is that the stock market does not behave as expected in the future. In a worst case scenario one could still have a bond of R100 000 to repay at the end of the 25-year period. But that really presupposes a dramatic change in the way equity investments have been performing for more than 25 years.
Which is best? A difficult one to answer and one which is sure to elicit a great debate from the industry. If I did not take the traditional route of paying off my bond and doing so earlier by paying extra, I would consider the unit trust route as opposed to the endowment route. But this route again has risks as one could suffer a dramatic decline in the stock market a month before the end of the repayment period.
While the endowment option is more expensive it does have some guarantees which the unit trust option does not have.
The table shows how the three options compare.
For certainty, in the face of high interest rates, it most probably remains the best option to pay extra capital straight into a conventional bond.
THE DIFFERENT WAYS TO PAY OFF YOUR BOND
CONVENTIONALENDOWMENTUNIT TRUST
Assumed growthn/a15%19%
Total repayment over 25 yearsR497464R527464R527464
Value of investment at end of termNilR324352R697024
Amount owing on loan at end of termNilR100000R100000
Net investment value after repayment of loanNilR224352R597024
Amount paid above the conventional loanNilR30000R30 000
Net gainNilR194352R567024
No of years to pay251815
The above example is based on a bond of R100 000, repayable over 25 years at an interest rate of 19,75%
Assumption: The difference in monthly payments between that of the conventional bond and the unit trust and endowment linked bonds if R100 a month.