You probably have heard advice that you should try to pay off debt with the highest interest rate first because this will allow you to save the largest amount on interest. This is true, and it can be a very good strategy if implemented cleverly.
Some people take this one step further; since home loan interest rates are generally lower than car loan interest rates, you hear them proudly proclaiming: “I have paid off my car using my home loan’s access facility. I am going to save so much interest!”
But will they really? And is it a good idea to use your home loan to pay off your car?
It can be, but there is an important aspect which needs to be considered – repayment term.
It is important that the remaining duration of each loan is taken into account if you decide to use your home loan to pay off your car.
Yes, the home loan interest rate is probably lower, but remember that a car is generally financed over 54 months, sometimes 60, whereas a home loan is generally financed over 20 years.
What this means is that if you take money out of your home loan and use it to pay off your car then yes, you have financed your car at a lower interest rate, but you have now extended the car loan’s duration – by effectively setting it to the remaining home loan’s duration.
And because you are now paying the loan over a longer period, you actually end up paying more interest. The effect of this is best shown in the following example:
Say you took out a 20-year home loan with an interest rate of 10% and that it has 11 years remaining until it is paid off. The home loan also has an access facility, which allows you to take out the equity that you have built up.
Now you want to buy a car for R100 000, and you were offered finance at an interest rate of 12% over five years. Instead of taking the car loan at 12% interest, you decide to draw R100 000 out of the home loan’s access facility and in doing so effectively pay only 10% interest on the “car loan”.
The car loan, at 12% interest over five years, would result in:
. A monthly repayment of R2 224
. Total interest paid of R33 467
HOW TO LOSE MONEY
If you took the R100 000 out of your bond instead, you would have:
. An additional monthly payment of R1 252
. Additional interest, over 11 years, of R65 262
So by paying for the car out of the bond, you end up having paid twice as much interest. This is because of the extended duration to pay back the R100 000 loan.
The longer you have remaining on the bond, the more money you’d have to pay back. For example, if you still had 15 years of payments on the bond, you would pay R93 429 in interest. That’s almost three times as much interest compared with the 12% car loan.
HOW TO SAVE MONEY
The trick to saving from the lower home loan interest rate is to take the money out of the bond and then pay back what you would have paid on the car loan for the same duration as the car loan.
So in our example above, for a R100 000 car with 11 years remaining on the home loan, you should put an extra R2 224 into your bond every month for the five-year duration of the car loan you would have taken.
If you do this, you will pay R27 482 in interest instead of R33 467 for the car loan, thereby scoring almost R6 000 saving.
The same principle would apply to any form of debt, for example, taking money out of your home loan to clear your credit card, personal loan or store account.
Make sure you are actually saving by sticking to the repayment amount and duration of the original loan. If you are able to do this, there is definitely some interest to be saved.
- Stealthy Wealth is a personal finance blog on stealthywealth.co.za