Get the best rate on your home loan
Understand how mortgages work.
For most middle class South Africans, buying a house is almost a right of passage. And, with very few exceptions, buying a house means taking out a mortgage to finance it. Only the very privileged ever get to buy a property for cash.
Yet while most people will agonise for months over finding the right house, very few give much thought to the loan used to buy it. Since they are just happy to get finance at all, they take what they are offered and never look back.
But there is much more to home loans than just taking the money and running. If you're serious about taking control of your finances, you should understand why you are paying what are you and whether you can't get a better deal.
How does a home loan work?
“The underlying principles of pricing a home loan are not complicated,” says Kevin Penwarden, the CEO of SA Home Loans. “There are two major components when it comes to pricing a loan, and those are the cost of funding and the credit risk of the borrower.”
The cost of funding refers to where the bank or a specialist mortgage finance provider making the loan gets the money from in the first place.
“Home loans are long-term assets, typically over 20 years or even 30 years,” Penwarden explains. “So we need to source long term funding for this asset, and we do that through the capital markets.”
In other words, they issue bonds that are bought mainly by asset managers and life assurers. They have to pay back those bonds at a certain interest rate, and that rate guides what they ultimately charge you.
The rates on the capital markets are however determined by market forces, and generally reflect current interest rates and risk appetite. The banks themselves have very little influence over what these rates are.
“For example, before the credit crisis of 2008, the funding that we raised on the capital markets was at least 1% cheaper than we can get now,” Penwarden says. “So if we go back to 2007, people could easily get loans at prime less 2%, but in the current market its difficult to offer even prime less 1%.”
Even more recently, the problems at African Bank have also had an effect on the cost of funding, as it has increased the levels of risk aversion in the market and so pushed interest rates higher. These impacts are passed on to home loan clients who end up paying higher rates.
Credit risk
The second factor in how a home loan rate is calculated is the risk of of the borrower. In other words, how likely you are to have problems keeping up to date with the repayments.
“In simple terms, as risk to the lender increases, so too will the interest rate that a consumer will be offered,” explains Tommy Nel, the head of credit at FNB Home Loans.
Banks use a number of variables to work this out, but there are three that have the most impact: past credit behaviour, loan-to-value and employment type.
Past credit behaviour refers to how the borrower has dealt with all forms of credit, from store cards to car finance in the past. Up to the last five years may be taken into account.
“The bank uses credit scorecards that assess the likelihood of the client to default,” Nel says. “It uses a range of information for this, including information disclosed by the client when applying for the loan, information the bank may hold on the client as a result of a banking relationship the client holds with the bank, and credit bureau information.”
The second key consideration is the loan-to-value. Essentially this means how much of the total cost of the purchase are you asking for as a loan, and how much are you paying upfront in the form of a deposit.
“The greater the deposit from the borrower, the less risky the loan is for the lender,” says SA Home Loan's Penwarden. “This typically has the biggest impact on the pricing.”
Thirdly, banks take into account where and how the borrower is employed. For instance, self-employed people are considered higher risk than those in formal employment and will attract a higher price.
So what can you do about it?
Taking all of this into account, they key question then becomes what do you need to do to get the best rate out of your bank or home loan finance provider? For a start, don't place too much hope in your negotiating skills.
“There's very little room to negotiate once approval has been given at a specific rate because the price that we offer is scientifically calculated,” says Penwarden. “The components might be easy to understand, but there are some complicated mathematical models behind it. Profit margins on home loans are also very small.”
So if you want to get a better rate on your home loan, you really need to put in the work before you apply. Most critically, make sure you have a good credit record in the first place.
“Manage your credit affairs prudently, by always making your required payments on time,” says FNB's Nel. “Never exceed the limits in term of credit facilities made available to you. It is also generally not the best idea to use more than 90% of your credit limits as credit providers may conclude from this that you do not manage your financial affairs that prudently.”
If you know that you have a bad credit profile, rather settle all your debts and wait for two or three years before applying for a home loan. Otherwise, even if your application is approved, you will end up paying a higher rate.
Importantly, you should also build up a deposit before approaching a bank for finance. Also don't be shy to ask issuers what size deposit will secure you the best terms.
On that note, understand that different lenders have different views on the credit risk of individuals. So don't just get a quote from one bank. Shop around and find who offers you the best terms.
Bond originators can do some of this for you, but some lenders don't deal with them and often your own bank will insist that you approach them yourself, not through a third party. So it's really best to do the leg work yourself.
Also, carefully consider how long you want the loan to run for, since this will have an effect on what you pay.
“Home loans financed over 20 years are typically also offered at lower interest rates than 25 and 30 year finance,” Nel says. “So if your bank offers you a 30 year loan, make sure that you also get a quote for a 20 year loan to make sure that you don’t pay more if you don't really need it.”
The reason for this is that the longer the term of the funding the bank needs to secure on the capital markets, the higher the rate they will have to pay. And that gets passed on to you.
Finally, once you have taken a loan, don't think that that is the end of it. You are not obliged to stay with the same finance company forever and you may be able to find a better rate a few years down the line.
This is because the loan-to-value is one of the most critical parts of calculating the rate you pay. And if the value of your property has increased and you have managed to pay down some of the capital on your loan, naturally the loan-to-value ratio on what remains will now be more in your favour.
“If the property market is strong, people should look to switch their loans every three to four years,” advises Penwarden. “Generally you will need to shop around outside of your existing lender, but there is definitely a chance to switch to earn a better rate when you have seen reasonable property price increases.”
Source - moneyweb.co.za