Home loans: 20 versus 30 year term?

07 Sep 2012

Homeowners are urged to make sure they understand the pros and cons of the 20 year home loan versus the 30 year option, says a property strategist.

Martle says whereas at 8.5 percent interest rate, the monthly instalment on a 30 year loan is R989 less than on the 20 year loan, what home loan customers are probably not being told is that should prime rate head back up to 15.5 percent for example (the level of the last peak in 2008), the 30 year instalment value would only be R494 less than the 20 year loan instalment.

Clinton Martle, FNB property leader strategist says while there is no right or wrong with regard the choice of the term of a loan, homeowners should be under no illusions that there are significant longer term costs and risks involved, in return for a very limited short-term benefit in the form of a mildly lower instalment repayment value while interest rates remain low.

Martle explains that a 30-year loan can make a loan immediately more affordable, with the monthly instalment on a 30 year loan being less than the monthly instalment on a 20 year loan granted at the same interest rate - at least in the current low interest rate environment.

However, he notes that one will pay the price for this benefit in the longer term.

“I am under the impression that there exists a strong awareness of the “additional” interest charge that one will pay in total over the full 30 years compared to the full 20 years on a shorter term home loan,” he says.

Martle points out that there are some assumptions made, one of which is the loan term is paid according to the required payment schedule.

For example, over the full 30 years and assuming that no additional deposits are made, bearing in mind that additional deposits will reduce capital and interest charges ahead of schedule.

The same applies to the 20 year loan term in the example.

Martle assumes that both loans are made at 8.5 percent interest rate (current prime rate) and for the purposes of this example it is assumed that the rate remains at this level for the duration of the loans.

Comparing the total cost of a 30 year versus a 20 year home loan, 30 year loans ultimately cost more.

The total amount paid (capital plus interest) on a bond of R1 million over 20 years, in this example, would be a total of R2 082 776 at a monthly required instalment of R8 678.

If one were to extend that same R1 million loan to 30 years, with the same interest rate, the required monthly instalment would be a lesser R7 689.

This would imply R989 per month less than in the case of the 20 year loan, but a total of R2 768 089 would be paid over the entire 30 years, translating to an extra R685 312.

He notes that some may argue that we need to do the calculation in real terms, for example, adjusting the amounts paid for inflation over time.

Inflation, depending on its level, can sometimes make it attractive to repay debt as slowly as possible.

That was the case in the 1980s, when consumer price inflation was nearer to 20 percent and interest rates were often lower than inflation, he says.  

The interest rate afforded to the loan could carry an added premium because of higher risk on a 30 year loan compared to 20 year one.

Martle says inflation is significantly lower and interest rates are normally above the consumer price inflation rate and this would make delaying repayment of debt for as long as possible less attractive.

As an example, he says if we were to factor in a CPI inflation rate average of 6 percent per annum over the 20 and 30 year loan terms, still assuming an 8.5 percent interest rate on both loans, one would still pay an extra R78 000 in real terms (i.e. total repayment over the term expressed at today’s price levels) over the extra 10 years.

This differential increases as the level of interest rates relative to inflation increases.

Martle says a 30 year home loan is a higher risk loan for three reasons.

Firstly, this is due to the far slower pace at which the 30 year loan is paid down, compared to a 20 year loan, assuming the borrower sticks to the required repayment schedule.

The borrower is normally most at risk during the early stages of a loan, because that is normally where the “loan-to-home value” ratio is at its highest.

If the loan granted is equal to 100 percent of the value of the home that is used as security for the loan, the homeowner may battle to sell immediately without incurring a loss should he/she suddenly experience financial difficulty (due to, perhaps, a sudden loss of employment/income), remembering that on top of the price of the house she also incurred transfer and relocation costs.

In a weak market, this risk is increased because house prices can decline, pushing the loan-to-home value ratio to above 100 percent, for example, the value of the home is then insufficient to provide full security for the home loan, a position known as “negative equity”.

With time, the homeowner’s risk is gradually reduced as he/she pays down the loan amount outstanding.

He says there is usually some rate of house price growth over time, further contributing to a decline in the loan-to-value ratio.

In the case of a 30 year home loan, the capital amount outstanding is paid down at a far slower pace than in the case of the 20 year loan.

In a weak market, this risk is increased because house prices can decline, pushing the loan-to-home value ratio to above 100 percent, for example, the value of the home is then insufficient to provide full security for the home loan, a position known as “negative equity”.

This means that the loan-to-home value ratio declines at a far slower rate than in the case of a 20 year loan, all other things equal, and therein lies the higher risk in the case of the 30 year loan for both bank and borrower, explains Martle.

Martle points out that while its tempting to take the 30 year loan option with its lower monthly repayment value, we may well regret the decision after 20 years when we realise that we haven’t even paid off half the loan amount yet.

But that isn’t where it ends. There is a second cause of higher risk in the case of a 30 year home loan.

This lies in the fact that in real life interest rates fluctuate.

Now if one does the monthly instalment calculations, you will find that the lower the interest rate the less the monthly instalment value required on a 30 year loan is compared to that of a 20 year loan.

So, at the currently abnormally low interest rates by SA standards, 30 year loan instalments are significantly less than the 20 year instalments, he says.

He notes that this gap will diminish as interest rates rise with the instalment on a 30 year loan rising faster in value than the 20 year instalment as interest rates rise.

Martle says whereas at 8.5 percent interest rate, the monthly instalment on a 30 year loan is R989 less than on the 20 year loan, what home loan customers are probably not being told is that should prime rate head back up to 15.5 percent for example (the level of the last peak in 2008), the 30 year instalment value would only be R494 less than the 20 year loan instalment.

This is an additional risk because when interest rates rise, households with the 30 year loan have a greater adjustment to make than households with the 20 year loan.

Martle says in real life the lender may charge a slightly higher interest rate on a 30 year loan than what it would have for the same applicant applying for a 20 year loan, further limiting any advantage gained from a 30 year loan.

On interest rates in South Africa, he says over the last 20 years the average rate has been 15.97 percent.

If we were to shorten this view and consider 10 year, 5 year and 2 year averages, we would see averages of 12.76 percent, 12.38 percent and 9.25 percent respectively - the result would still be well above the current 40 year low of 8.5 percent.

“We know that prime will fluctuate over the life of the loan, and over time it is quite plausible that the average could increase again, reducing the advantage of the 30 year loan.”

He says the third risk is that a 30 year loan can raise the possibility of the borrower “over-extending” herself, because by extending the term to 30 years, you could qualify for even more.

If you could hypothetically get the same interest rate on the loan as you would qualify for on a 20 year loan, you may qualify for a higher value of 30 year loan than in the case of a 20 year loan, based on the affordability of the loan (a lower monthly instalment than a 20 year loan).

But it isn’t just about the monthly loan instalment value – it is about the costs of running the home and if one buys a more expensive home it probably means higher municipal rates, possibly higher water and electricity if it is a bigger house, and perhaps higher maintenance costs too if the home is more luxurious, he says.

He says finally, 30 year loans may well further hamper the household’s retirement saving drive.

Martle says while it can be appealing to have that bigger, better home and extending the loan term on a low interest rate cycle could conceivably get you there, one needs to be careful of “over-committing” in a low interest rate environment.

Lastly, a risk to the borrower, perhaps not the lending institution, comes in the form of a potential negative impact on saving.

If one takes on a 30 year home loan at the age of 30, one may well only finish paying it off at the age of 60, thus taking the biggest chunk of one’s productive working life.

Having debt until near to retirement age can delay one’s saving for retirement and already SA’s household sector is notorious for its extremely poor savings rate.

What many households need, rather, is to get out of debt at an earlier stage of their lives and begin to accumulate savings and investments at a more rapid rate.

“I’m not sure 30 year loans are conducive to this.”

Martle says while it can be appealing to have that bigger, better home and extending the loan term on a low interest rate cycle could conceivably get you there, one needs to be careful of “over-committing” in a low interest rate environment.

As sure as the proverbial death and taxes, lending rates will rise. Before accepting the short-term gains, we should consider: 

1. The short-term benefit of a reduced repayment over a longer period seems attractive, but the capital reduction is slower, meaning your loan balance reduces at a slower rate if your term is longer.

2. The interest rate afforded to the loan could carry an added premium because of higher risk on a 30 year loan compared to 20 year one.

3. As the interest rate increases, the required instalment on a 30 year loan increases faster than that on a 20 year loan, eroding the relative benefit of a 30 year loan.

4. Larger, more expensive homes can attract higher costs, for example, maintenance, utility costs and insurance costs.

5. The rate of capital reduction on a loan over 360 months, from month one, is far slower than in the case of 240 months.

So, on a bond of R1 million, the balance after 20 years on a 30 year loan would still be around R620 000 with only around R380 000 having been repaid.

Compare this to a 20 year loan where repayment would be complete at this stage.

And finally, the longer a household stays indebted, the greater the potential for its savings rate to be inadequate come retirement age, he adds.

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