As workers mull how to use returns from sacco dividends or company bonuses, early repayment of mortgage is emerging as an investment option.
The benefit of early principal repayment will be lower monthly instalments if a borrower decides to restructure the debt and equally lower interest payment to the lender.
A borrower will save interest running into millions of shillings over the life of the mortgage if one decides to make early repayments.
Financial experts urge mortgage borrowers who get such one-off payments to consider repaying part of their loan as an investment.
Mortgage interest is calculated on a reducing balance, the result being that most of the monthly loan instalments go towards paying off interest rather than reducing the principal amount.
“So it makes a lot of sense, especially in the early years of the mortgage, that if you get money –like a bonus or dividend - you hit the principal,” said Wanjeri Kihara, the director of mortgages at KCB Bank.
Emphasis is on informing the bank that the bulk payment is meant for principal reduction. Failure to alert the bank to direct the lump sum payment to the principal will see the amount distributed across the coming months, which will not lower the cost of the loan.
“The keyword here is to guide your bank to reduce the principal because the bank cannot assume that is what you want,” said Ms Wanjeri
“Remember most of the loan repayments in a bank are automated; so when the system sees a payment, unless somebody intervenes to guide otherwise, the system will operate in the normal way,” she added.
The mortgage calculator shows 85 per cent of the repayment in the first year goes towards interest, with principal reduction being only 15 per cent.
This means that if you took a Sh10 million mortgage repayable in 15 years at a rate of 13 per cent, your monthly instalment would be Sh126,524.
The annual repayment will be Sh1,518,290, of which Sh231,778 will have gone to principal reduction, with Sh1.28 million going towards interest payment.
The total interest of the loan over the 15-year period is Sh12,774,359. If a borrower makes an early payment of Sh500,000 towards principal reduction, they cut their interest payable by Sh1.7 million while reducing the loan repayment period by 18 months.
However, a decision to restructure the loan so as to reduce the monthly instalment while retaining the repayment period will see a borrower save interest of about Sh436,000.
Only 4 per cent of Kenyans have the income to afford a mortgage of Sh10 million amid the rise in home prices.
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Comparatively, if one invested the Sh500,000 in a Treasury bond yielding 13 per cent for a period of 14 years, they would get an interest return of Sh819,000 net of tax over the life of the instrument.
The mortgage is, however, pegged on a house whose value is appreciating, giving it capital gain that is not available on a bond.
Ms Wanjeri notes that a borrower doesn’t have to wait for a bulk payment so as to prepay their mortgage but can chip off the principal so long as the instructions are sent to the bank.
“It doesn’t even have to be a lot of money. If you can get Sh10,000 directly, reducing the principal, it will save you a lot, especially in the early life of the mortgage,” she added.
Some borrowers usually use windfalls to prepay their monthly instalments in order to ensure they are not late in their repayment schedule.
Besides early repayments, one can also consider shortening the life of the mortgage in order to lower its cost.
The mortgage calculator shows that if the same Sh10 million loan at 13 per cent was to be repaid in 12 years, the total interest payment would be Sh9,794,603. This means the three years early settlement would save a borrower interest payment of Sh2,979,756.
Monthly instalments of the loan would increase by Sh10,938.
“If your income allows, take the shortest time possible; you'll pay less interest,” said Ms Wanjeri.
“You can go back to the bank to ask them to restructure your facility and reduce the tenure if your income has improved. It costs you nothing to do that, and it still saves you money,” she added.
Increasing the frequency of the loan repayment cuts the cost of a mortgage. Though most mortgages are paid monthly, a borrower can make additional payments in between periods.
The Central Bank of Kenya last week moved to entrench the abolishment of early repayment penalties by issuing draft regulations forbidding penalising customers for settling their debts early.
“A Financial Service Provider (FSP shall accept any early repayment under a credit contract and apply the repayment to reduce the retail consumer’s financial liability under the credit contract as soon as reasonably practicable,” says the draft consumer regulations.
High mortgage rates slow down mortgage uptake.
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“An FSP shall not charge any fee, charge or penalty to a retail consumer for early repayment of any amount, in full or in part, under a credit contract,” continues the document prepared by financial sector regulators and the Competition Authority of Kenya.
CBK data shows that the average home loan in Kenya is Sh9 million, repayable at an average rate of 14.9 per cent. The average repayment period for mortgages is 11.1 years, with the minimum being 5.3 years and a maximum of 18 years.
The government offers incentives for home purchase through mortgages by offering tax relief to borrowers.
Mortgage interest relief allows a borrower to deduct interest paid on a home loan, with the maximum annual deduction being Sh360,000.
“Mortgage interest relief is a tax benefit that is given to anyone who acquires a mortgage for home ownership. A lot of people don't take advantage of it. It is really a saving for anybody who pays Pay as you Earn (PAYE),” said John Swaga, a payslip tax expert.
Lack of understanding of how the relief works was cited for failure by most mortgage holders following up on the relief with the taxman.
The first step is getting the loan deduction schedule, which gives a breakdown of how each monthly instalment is apportioned to principal repayment and interest, and submitting it to your employer if the mortgage is not under the employer’s scheme.
“For mortgage interest to be an allowable deduction for PAYE purposes, the employee must provide a mortgage interest certificate issued by the lender,” says Mr Swaga
The mortgage interest allowable is capped at Sh360,000 annually or Sh30,000 per month.
Given that the interest portion declines each month, employers usually average the annual interest repayable and make a uniform deduction each month.
The interest relief can be backdated to the beginning of the year if a borrower had not known of the tax incentive offered by the government.
To qualify for the deduction, the mortgage has to be a residential occupied by the beneficiary of the tax relief.
