In 2019, I sat in an insightful employee financial wellness session. Home loans were a hot topic. The employer had an agreement with their pension administrator and one of the banks to allow pension-backed home loans for their employees. While we were deep in discussions about what could possibly go wrong and some benefits of this arrangement, a gentleman who had a calm demeanour about him casually cleared his throat and asked almost under his breath why he needed a home loan to finance a property? Bewildered by this question but trying to stay calm, the home loans bank consultant said: “Well, it’s the only way.”
“Got you,” responded the gentleman, “but let's say I use a personal loan, chances are I’ll pay off the house in five years max, and if I default on the loan, my home is not in danger,” he added.
As I sat there watching this back and forth between the two of them, I thought long and hard about what he had just said. To say your home wouldn't be in danger if you default on a personal loan isn’t factually correct. It may be a much longer process to attach your house to the debt, and it’s a long and strenuous legal process most financial institutions would much rather avoid. But it's possible. He was, however, correct that you could pay back a personal loan off in five years. But at what cost? Assessing the suitability of credit facilities is one of the building blocks of leveraging credit to build wealth. The tricky thing about credit is that the more convenient way may not always be the most efficient. But before I get into why it’s essential to use a suitable credit facility, let me first break down what the two types of loans are, so that you have a better understanding of them.
A personal loan is like a flexible type of credit. It isn't meant for a specific purpose, meaning the bank won't regulate how you use the money. Most people use this type of credit to assist them in paying off school fees, plan a holiday, or pay for unexpected costs. For banks to approve this loan, they look at your credit history and personal information (for example, are you employed, do you make enough income to pay the loan back, your lifespan etc.). You can get up to R300 000 in South Africa as a personal loan from a reputable credit provider. Personal loans are unsecured lending because they have no asset backing up the borrowing and generally attract high-interest rates.
A home loan is a more fixed type of credit to be used for a property purchase. People looking at buying a house or doing major home renovations will consider this type of credit. For banks to approve this, they will do a credit assessment, yes, but they will also look at the kind of property you are looking at purchasing and its value. You will not be able to go to the bank and ask for R1 million when your property is worth R300 000. Likewise, suppose after the bank looks at your credit history and personal information, they feel you are not fit for a loan worth R1 million. In that case, they may ask you to either downsize your property and find a smaller, cheaper one or improve your financial capacity, especially if you’re looking at taking a 100% loan with no deposit.
Home loans are a type of secured lending because there is an asset attached to the borrowing. In loan default cases, the asset can be repossessed and sold to recoup the borrowed funds.
In most cases, home loans attract relatively reasonable interest rates.
There may be reasons why one would use a personal loan to finance a property purchase, often because many people do not qualify for home loan approvals. This is unfortunate, as it puts one in a challenging position. The high interest rates on personal loans mean that you end up paying much more in interest charges than you would have if a home loan facility was used.
Second, for one to qualify for Flisp, the government-funded homeownership subsidy, a home loan needs to be approved first.
Lastly, it is essential to remember that even though the loan period of a home loan is 20 years, it is merely the maximum years one has to pay off the loan. If you are privileged to pay extra amounts into the home loan, that will reduce the number of years to pay it off and significantly reduce how much interest is paid on the loan overall.
The mathematics of how these loans work is also essential. Interest that you pay on any loan is calculated using the interest rate you are offered against the outstanding balance you owe. Remember, on a personal loan, it’s significantly much higher than the interest rate on home loans. The trick is to try to lower the outstanding balance as much as possible.
At the start of paying back a loan, a significant percentage of the minimum monthly payment you make goes to the interest portion of the loan. Any additional amounts you make will go 100% towards lowering the balance owing. A personal loan will have a higher monthly instalment than a home loan for the same owing balance. This means that on a personal loan, you might not have the luxury of paying extra, while the terms and conditions offered on a home loan allow for additional payments to be made.
For example: on a personal loan of R300k over six years and an interest rate of 15%, you will pay a monthly repayment amount of R6 438. For a home loan of R300k (no deposit) over 20 years and an interest rate of 9%, you will repay a monthly amount of R2 699. That makes a difference of R3 739 between the two loans. But if you had to pay the R6 438 on a home loan and recalculate the instalment period, it is reduced to 4.8 years, which is less than the personal loan period. And you can't argue with the maths!
Note that a personal loan is not being used to accumulate assets that hold substance. Think about the ultimate goal and generational wealth you could be building instead of taking shortcuts to have a higher price in the end.