We recently got the following question:
"Which best improves your affordability and chances for getting a second home loan? Repaying the current home loan you have quicker or putting the extra money into savings for your future deposit?"
Although we're not advice columnists or qualified personal finance advisers who may give financial advice, this question did tickle our fancy. We decided to take a dive into the topic and explore what does this question means for the everyday personal finance hero out there.
And yes, we're still not giving advice. We're just thinking aloud. That's why you will find tons of usually's, posably's, probably's and seemingly's in this article.
Our first thought, what is the outcome or goal of the question?
The outcome of this question is the desire to improve affordability so the person can get a second home loan. Whether to increase their real estate portfolio or to give their parents a new home is mostly irrelevant to achieving that affordability.
Here, we're not looking at what the wisest investment choice is, but rather at what will most seemingly lead to improved affordability for a second home loan.
What does affordability actually mean?
Now, it's probably best to understand what banks or lenders see as affordability if we want to answer that question. Typically, these are the general affordability factors they look at:
- What is your credit record?
- What is your current debt exposure?
- How much of your debt exposure is secured (home loan) versus unsecured (personal loan)?
- How many loan accounts do you currently have?
- What is your net worth?
- What is your annual income?
- What is your disposable income i.e. can you afford a second home loan monthly repayment amount?
- Do you have some kind of deposit?
Ultimately, the question becomes whether you are a risk worth taking or not. Can you actually afford the financial implications of a home loan or second home loan?
Debunk the piggy - your savings account is probably not a good idea
The second part of this question asks whether you should pay off your current home loan (or other forms of debt) quicker or put the extra money into a savings account.
This is relatively easy to answer. Are you paying more interest on your home loan (or other debt) or are you earning more interest in your savings account?
If you're living in South Africa and you earn more interest in your savings account than the average interest on a home loan, please tell us now. We want in on that!
The point is, if you are paying more than you are earning, you need to get rid of what you are paying. To frame all of this, keep in mind you want to increase your NET value or worth.
Which leads us to your actual action plan.
What you should be doing with that extra money (usually)
Remember, at the end of the day you want to improve your affordability. This means you want more available cash flow so you can afford to pay something. You also have some extra money right?
How do you get more available cash flow?
- You earn more money
- You pay less money
Or as most people have coined it: "Spend less than you earn".
If you have achieved a point where you get some extra bucks, your best possible course of action (probably), is to put that money where you will get the most value out of it.
In the context of this question, it will be better spent on your home loan because you are paying more interest there than you will earn in your savings account. Your NET value therefore increases. Now, what about when you have a credit card that is charging even more interest than your home loan? You pay that thing off, ASAP!
Noooo, it doesn't make sense! I need savings! I need emergency funds!
Many people think they still need to put money into savings because... You need to save! No, not if you want to increase your NET worth.
It all comes down to the simple equation: If you are paying more (interest) than you are earning (interest), you will end in a serious negative.
NET worth is calculated. Total Assets - Total liabilities = NET worth.
Now place this in the simple equation. Total Assets (Earning less interest than liabilities) - Total liabilities (charging more interest than assets are earning) = NET worth that becomes less and less and less and...
When you pay off your highest interest charging forms of debt as soon as possible, ALL of that interest you would have paid every single month now forms part of your monthly disposable income. Which means you have more available cash flow and your affordability has just improved. Which can also be purposed towards asset building.
The reality is, there are tons of people who pay thousands of Rands every month just on interest. Yes, R1,000... R2,000... R3,000 and more. Every single month.
When you get to a point where you make all of that money available PLUS adding the extra money you are already earning, you could actually stand a chance of getting on the good side of interest.
How? You aren't spending money on interest any more and you can now easily boost your annual investments with more than R36,000 (assuming you were paying R3,000 a month to loans).
What does that mean for your future self? Check out this article.
Let's apply the above action plan to the general affordability factors and see how it influences those questions:
- What is your credit record? Improved because you reduced debt
- What is your current debt exposure? It's less because you reduced debt
- How much of your debt exposure is secured (home loan) versus unsecured (personal loan)? More is secured home loan debt with less outstanding on the loan because you reduced unsecured forms of debt
- How many loan accounts do you currently have? Less! Yes!
- What is your net worth? It's better (even if the negative is still there, it's better)
- What is your annual income? Stays the same
- What is your disposable income i.e. can you afford a second home loan monthly repayment amount? It's more!
- Do you have some kind of deposit? Yes, extra money or my current mortgage which with less outstanding on the loan
The left fielder a.k.a the "time factor"
In the above conversation, we're assuming a short term of 1-2 years max most of the time. We're also assuming the person is not really going to take the chances of speculating some of that extra income (did someone say cryptocurrency?).
If you have a longer time frame in which you want to put money away it does open up some options. If there is a sweet spot in the market and you can get a well-performing fund over a medium term, then it could mean your money is better spent there.
The catch? If your money is going to be in lockdown when you need it, then it's not an option.
The second catch? Will you be earning more (real-return) interest in that time or will you be paying more interest on your home loan? Over the long run, the fund will usually mean more interest earned and remember, your home is also an asset to a certain extent.
The third catch? The above mostly doesn't count for high-interest short term debts. It will still be better to get rid of those high-interest debts.
If you are paying more than you are earning...
As we already discussed, the outcome of this question is the desire to improve affordability so the person can get a second home loan.
The best way to improve your affordability in life is to get rid of all financial areas where you are paying more (interest) than you are earning (interest).
In the case of the reader's question, it will presumably work in their favour to rather pay the extra money into their home loan to reduce the amount of interest they would have paid over the long run.
By reducing their total debt exposure AND their monthly repayments, they have become a risk worth taking for the bank or lender. Neat. Assuming they had no other higher interest forms of debt. We think you're getting it by now :-)
Einstein or some other wonder thinking genius said "Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn't … pays it."
Which are you?