Should you refinance your home? 

Iona Minton
Thu, 21 Apr 2005

This article is a printout from iafrica.com
Copyright © 2000 iafrica.com*, a division of Metropolis*

Homeowners have seen the value of their homes double or even triple in the past five years, and the good news is, there’s just been another rate cut, this time of 50 basis points. So not only do you benefit from reduced repayments, but the capital value of your home has skyrocketed. Increases in property prices also have a real benefit for financial institutions as risk factors decrease. But by far the biggest windfall is the opportunity to lend their clients even more money. Take care though — this money can come at a huge cost to your long-term wealth.

Equity: the difference between debt and asset value

All of a sudden a R300 000 bond on a home that is worth R900 000 does not seem like a big deal. The difference between the R300 000 you owe and the R900 000 the house is worth is called equity.

Financial institutions are in a very favourable position when property prices increase at this velocity because it means they have huge security margins if the homeowner defaults on their payments. However they also realise that there is an opportunity to lend the homeowner more money. The adverts say that refinancing releases capital in your home and this is true, but if you access the capital you will pay interest, so all you are doing is getting deeper into debt. You are not getting a windfall, you are simply being extended credit.

Refinancing: the US approach

Refinancing is big business in the USA but the way in which the mortgage finance works there means that refinancing often makes sense. The major difference between SA and the US is that in the US you can fix your bond rate for 30 years.

If you apply for a loan and your credit record is not the best it could be, or if you are perceived by the bank to be high risk, you will be charged a higher rate of interest. However a lot can change in thirty years and in all likelihood you will then be a better credit risk, which means you can start negotiating on interest rates.

The wasted costs associated with bond switching are relatively low in the US but the refinancing company can take as much as 10 percent or the amount they save the client. It is still worth it in the long run.

For example, let’s say the client was locked in at a rate of 8 percent on a thirty year bond and in addition to their credit rating improving, rates dropped to 4 percent. A refinancing company could probably get them a loan at 4 percent.

So if the loan amount was R500 000, and the repayments over 30 years were R3644 per month they would drop to R2379 per month. This would translate into an interest saving of a whopping R455 537 over the life of the loan. Even forking out R45 000 plus costs of around another one percent is tolerable when you look at the benefits.

The South African approach

It works differently in South Africa, because the longest we can fix a mortgage for is two years. In addition the wasted costs of switching are much higher. So is there any merit in refinancing?

Three reasons to switch a bond

There are three main reasons for bond switching. One is to get a better rate, as we have discussed, another is to release equity in your home and the final one is to do a debt consolidation exercise.

You don’t always have to switch your bond to a secure a lower interest rate. A simple phone call to your bank manager may be all it takes if you have a clean credit record.

If your bank does not offer a debt consolidation service, it may be worth your while to switch, especially if you have a lot of high-interest debt. A consolidation loan can reduce your interest payments and save you money, but you need to be disciplined. If you roll your car loan into your bond you need to pay in the same amount that you were paying before, otherwise you could end up paying the car off long after it is on the scrap heap. You also need to close all the accounts that you consolidated. Keeping them open could tempt you to run the credit up all over again.

Both of the above have merit but switching to access the equity in your home is a no-no, especially if you have your sights set on a world cruise. If you take out the equity in your home all you are doing is creating more debt. Increasingly people are using the money to finance vacations, school, fees and luxury purchases, and this means that they are robbing their retirement funds of potential contributions. Paying interest on depreciating assets (or intangibles like vacations) is madness. South Africans are spending over 60 percent of their disposable income on debt repayments, and this is why 95 percent of them will be underfunded for retirement.

Refinance for the right reasons

So if you are looking at refinancing your home, do it for the right reasons. Lower monthly payments should be your main objective, and don’t overlook the option of renegotiating with your current bank.

Repay debt faster

And finally one more point to ponder. The same principles apply to interest rate cuts. If you have a bond of R500 000 at a rate of 10.5 percent, the reduction will appear to put an extra R162 per month in your pocket, and if you take the past two years into account your payments may have reduced by almost R2000.

The chances are that you have simply absorbed the extra cash flow into your budget. You may be able to go out for dinner more often, replace that old lounge suite, or go on vacation. And while it’s great to have some extra cash, simply spending that extra money could cost you a small fortune in the long term.

What people fail to understand is that while they have repayments to make on a bond each month they are paying interest. The “windfall” they receive from lower interest rates should mean that they simply pay off the bond quicker thus saving thousands of rands. We need to change our mindset, and not see an interest rate cut as income, but rather as a way to get rid of interest-bearing debt.