Buying your home or investment property can be very exciting particularly if it is the first one. This is something you have planned, saved and sacrificed for. You have applied for a mortgage at the bank to acquire this dream property and have just been notified that your loan has been approved. You are all ready for the next step and you have been told you will need to execute a mortgage loan agreement. This sounds simple enough you think to yourself so you head off to the bank and they hand you this mountain of paperwork in the name of an agreement. With no desire to be overwhelmed by the sheer amount of tiny print, legal and financial jargon you quickly scheme over it in search of the portions where your signature is required. After all, they are professionals and know what they are doing. Yes they do, but do you? You may be reading this and acknowledging this is exactly what you did or exactly what you were about to do. Well this article is about demystifying the mortgage agreement and letting you know why you should pay more attention to the fine print.
What is a mortgage loan agreement? It is an official binding contract between the borrower and a lender that gives the terms and repayment information about the debt. This agreement establishes the contractual terms and obligations of both parties to a mortgage loan. A mortgage lender agrees to finance the buyer’s purchase of a property in exchange for a conditional right of ownership, known as a lien or charge. The new property owner must repay the original loan, plus interest, as stated in the mortgage agreement or risk losing his/her hard earned property.
To understand some of the terms stipulated in the agreement it is very important to remember two basic conditions at all times:
1) The lender has taken a risk on you by advancing you the loan amount to acquire the property. Most property buyers do not have the cash available to immediately cover the cost of purchase. By executing the agreement, they therefore agree to transfer conditional ownership of the property to the lender. This is put in place so that should you stop paying back your lender at any single point in time, they actually have the right to take ownership and sell your property to recover money.
2) That the interest is where the lender derives profit on the loan. The mortgage agreement will have a repayment schedule from 5 up to 30 years. It is in the lenders best interest to make as much profit i.e. collect as much interest on this loan as possible.
Most of the terms in the mortgage agreement are directly or indirectly related to how the above two are going to happen. Being able to understand them enables you to know what you are getting yourself into (as stated above it is a binding contract), how to protect yourself and if need be what terms can be renegotiated. So what basic key things do you need to be aware of that will be put down in this agreement?
Loan Amount: A lot of first time property buyers do not realise that the financial commitment exceeds the sale price of the property. Your mortgage will cater for the amount the bank is willing to lend you towards acquisition of the property. Unless otherwise negotiated with the lender, the loan amount will not include closing costs such as legal fees (both the buyers and lenders), valuation costs, stamp duty, insurance and registration of the charge. To meet these costs you will need to budget for approximately 9% of the full sale price and they will have to be catered for before disbursement of the loan. If these amounts are included in the loan advanced to you, it is important to note that you will pay more in interest charges over the life of the loan. For example to acquire a property of Kes 5,000,000 you would need to budget for approximately Kes 450,000 in other costs. If this is included in the loan amount, assuming a 20 year mortgage at 14%, you will pay an additional Kes 893,000 just in interest costs for the initial borrowing of Kes 450,000. It is therefore always better to have included these “closing costs” in your savings plan towards this property purchase.
Interest Costs: The interest may be a fixed rate i.e. is not subject to change or may be a variable rate which may fluctuate usually in line with market interest rates. With fixed rates you will have the comfort of knowing that your interest rate will not go up, but neither will it go down even if interest rates fall. With variable rates you will not have that same level of comfort but you will benefit if market interest rates drop as your repayment will be lower. It is however important to note that some of the advertised fixed mortgage rates which tend to be very attractive are not applicable for the entire duration of the loan but may only apply for a specified period e.g. 5 years. The interest rate can therefore revert to a much higher rate when the period has lapsed. Ensure you understand what type of interest rate you will be paying and for how long.
Default Conditions: Life is not static and at times circumstances beyond our control may occur. We may lose a job or source of income and therefore may be permanently or temporarily unable to fulfill the obligation to the lender. Where a borrower is in breach of the contractual obligation to repay the loan in the schedule installments, additional interest will automatically be charged on the amounts that are unpaid. If the default continues for a long period the bank may call on the security i.e. sell the property to recover its money. It is important to understand what the financier will consider as default and what action will they take when. Will one late payment mean that auctioneers will be at your house or is it after several months that drastic action on their part will lead to this? Should you default are there any late fees or penalty interest rates that will become payable on your loan? On speaking to several banks when writing this article they did give the impression that it is also in their best interest to come to some form of agreement should this happen. Be very clear with your financier on what default is considered to be and the consequences.
Prepayment Penalty: This is the main contentious issues in mortgage agreements. A prepayment penalty is levied if the borrower pays off the loan balance early. The purpose of a prepayment penalty is to compensate the lender because of the lost opportunity to earn interest and realise profit on the loan. Borrowers should ask up front if a mortgage agreement includes a prepayment penalty and what period that this penalty would apply to. Some financiers would levy penalties for only a certain period e.g. if mortgage is paid off within the first five years. This is because banks make most of their interest in the early years of a mortgage. The table below helps us untangle this further, and shows what the bank looses when you pay your loans early. It illustrates how much money a bank or mortgage lender would make in interest at the various stages of a 20 year mortgage.
Mortgage Amount Kes 5,000,000
Interest Rate 14% p.a.
Years Interest Earned By Bank.
Yrs 1-5 Kes 3,399,339
Yrs 6-10 Kes 3,066,259
Yrs 11-15 Kes 2,398, 229
Yrs 16-20 Kes 1,058, 421
TOTAL INTEREST PAID TO BANK ( excluding initial loan amount/principal) Kes 9,922,248
In summary most of the interest on this 20 year mortgage will be earned in the first ten years. Another way of analyzing it is understanding the components of the scheduled mortgage repayment – Kes 62,000 -using the same example. The table below shows how much of the monthly repayment is being allocated towards principal (the original loan balance) and interest (lenders profit) on various stages of the mortgage.
Years Principal Component Interest Component
Yrs 1 Kes 4,000 Kes 58,000
Yr 6 Kes 8,000 Kes 54,000
Yr 11 Kes 15,000 Kes 47,000
Yrs 16 Kes 31,000 Kes 31,000
Yr 20 Kes 53,000 Kes 8,000
This is therefore why the lender would want to protect their right to earn profit particularly in the early years. It also illustrates why paying even just a portion of your loan balance early or making extra monthly repayments can significantly reduce the amount of interest you will pay over the life of the mortgage. Find out how much of your mortgage can be paid off without incurring penalty fees and in which periods. Best case scenario is that you shop around for a mortgage that does not have these prepayment penalties. The speed at which you pay down your mortgage has a huge effect on the amount of interest you pay over time.
I’m sure you would never agree to drive blindfolded. The same principle applies when signing on the dotted line with the bank. Take time to read this very important contract, and if need be, get advice on what the terms mean. This is an important step towards financial freedom for yourself therefore it deserves every bit of attention.
Waceke Nduati-Omanga
waceke@centonomy.com
Waceke,
Thanks for this piece.
Where does the consumer protection act come in and do prepayment penalties still exist?
very informative.keep up!