The latest slew of economic data suggests we might see a further rate hike. Some economists predict further interest rate hike of 100 basis points before we see the peak, bringing the prime lending rate to 16%.
To add salt to our wounds, the high interest rates are likely to be around for a considerable length of time. During these tight times banks and mortgage lenders often encourage clients to consolidate their debts. Although in theory an excellent concept, the way we react in reality could render this move a financial mistake.
Consolidation means taking more expensive short-term debts, such as credit cards and car finance, and settling these with your mortgage bond. Effectively, this means consolidating these into the home loan at a lower interest rate — usually about 1,5% to 2% below prime. If you continued to pay off the shorter-term debt in the same period as you would have before consolidating, this option would make sense. But, let’s be honest: the reality is different.
If you purchase a vehicle through separate vehicle financing, when the interest rate goes up you pay an additional amount every month, but the vehicle is still paid off in the usual five-year period. Most people who use their mortgage to buy a car might initially stick to good practice and increase their mortgage repayments to ensure the car is still paid off in five years. But when the first rate hike kicks in the mortgage increases.
And instead of increasing the monthly payment they continue to pay the same amount as they did in the previous month because, technically, they have been making extra payments every month. All this because the bank allows the vehicle amount, for example R150 000, to be paid off over 20 years as it forms part of the home loan.
If R150 000 of the bond is paid off over five years, the monthly repayment is about R3 450 for that portion. If it is paid over 20 years the repayment falls to R1 843 a month, which is all the bank requires. So the bank does not automatically increase the repayment — it is up to the client to instruct it to do so. But then there is another rate hike and then another and another and eventually that R1 600 gap is closed and, rather than taking the pain and cutting back on other expenses, the client starts to pay the car off over 20 years.
A car repayment of R150 000 at 14% has now gone from a total cost of R207 000 over five years to R442 320 over 20 years. By consolidating and not increasing repayments when the rate is hiked the borrower has more than doubled the car debt.
The same applies to credit card and other short-term debt. You buy time but at way too high a price. If debts are kept in separate “pots” slightly more interest is paid today, but in the longer term you are forced to keep to the shorter-term payment plan.
Another catch is using the mortgage bond as a savings vehicle. This also has its pitfalls if discipline does not prevail. All the financial advisers will recommend paying extra into the bond each month. To do so reduces the bond tremendously — for example, paying just R300 extra a month into a bond of R700 000 reduces the repayment to 17 years and saves R250 000.
When bonuses are paid a good savings plan is to put some away into the bond for a tax-free investment.
Effectively you can save about 14% tax free. But this requires discipline. The reality — and I speak from my own and others’ experience — is that what usually happens is a new couch for the house or a great holiday with the family become options — and this is possible because there is that extra cash in the bond.
Suddenly the idea of reducing bond repayments has turned into a convenient parking spot for short-term savings. That is unfortunately the reality of our tendency to spend rather than save.
Having a dedicated retirement plan or even a separate money market fund for shorter-term savings helps to keep investment plans simple and clear and reduces the temptation to dip into them.
But while these are warning flags about what not to do with the mortgage, if you are really in a tight spot, consolidation might be the way to get through the crisis. But all other expenses should be cut before taking this route — it should not be the first port of call.