A couple of weeks ago I received an email that directed me to an article on the website of a finance company that specialises in personal loans. The article was about financing a home renovation. It considered the relative merits of financing a $20,000 home renovation using either:

• Equity available from your existing home mortgage loan; or
• A personal loan from the finance company.

If you increase your home loan by $20,000 to pay for the renovation and make repayments over the remaining duration of the loan (assumed to be 20 years in the article) then the additional loan repayments would be $130 per month based on a variable loan rate of 4.7% per annum. I confirmed for myself that the $130 quoted was correct (after a little rounding).

By the way, if you are actually paying 4.7%, or anything close to it, on your home mortgage, you really should read Strategy 28 – Get the best mortgage loan – of my forthcoming book Slow and Steady – 100 wealth building strategies for all ages. You may be able to save yourself tens of thousands of dollars over the duration of your loan.

Next the article calculated that the total additional interest paid over the remaining 20 years based on 20 years of additional $130 monthly repayments, would be $10,900 – again, a correct figure after allowing for some rounding.

Then by way of comparison, the article said that if you took out a personal loan from the finance company at a 10% interest rate with a 5-year loan duration, the monthly repayments would be $438 per month. This was higher than my calculated monthly repayment of $425, but when I looked at their website I realised that the company charged a personal loan establishment fee; if that is amortised over the duration of the loan, that would make up the difference.

The article then calculated the total interest payable over the 5 year personal loan as $6,260 and compared this figure with the $10,900 payable if you financed your renos via the home mortgage – a saving of over $4,600.

So, you should finance your renovation via a personal loan rather than your home mortgage, and save yourself $4,600, right?

Um, actually, no. Negative. Nein. Non. Nyet. Nee.

The calculation of the “savings” of $4,600 ignores the time value of money. Repayments over 5 years are not the same as repayments over 20 years. The present value of a dollar paid in five years’ time is much higher than the present value of a dollar payable in 20 years’ time. A naïve comparison of total repayments may, and in this case does, produce a misleading conclusion as to the preferable strategy.

Let’s make the comparison fair. Let’s say you fund the renovation via your home mortgage, but for five years you make the same additional repayments ($438 per month) as you would have paid the finance company if you had taken out the personal loan, in addition to your normal loan repayments. How would that work out?

Bloody well, that’s how. On my calculations, given additional repayments of $438 per month, after 5 years, not only would you have repaid the $20,000 loan drawdown for your renovations, but you would also have repaid an additional $4,273 off your home loan compared to the situation where you had stuck with your normal home loan repayments and not renovated at all. So a “like-for-like” comparison reveals that, far from being $4,600 worse off, assuming you make repayments to your mortgage loan at the same time and of the same amount as you would make to the personal loan, after 5 years you would be $4,273 better off. And you don’t have the hassle of completing the personal loan application or worrying about what that might do to your credit rating. As long as you have a redraw facility available or can get the funds from your mortgage offset account, the funds will be readily available from your mortgage lender with minimal paperwork. And you get to deal with those nice banks instead of those shonky finance companies.  (Just kidding!!)

But seriously, if you have equity in your home and you need funds for some private purpose, normally it will work out better to borrow against your home because that will almost always be your cheapest source of finance. So why not use it?