reduce debt to lower TDSR

About Deleveraging

With prevailing interest rates much higher than last year, we certainly see more people contemplating doing a lumpsum paydown whilst refinancing their home loan.  Then there are those purchasing their first property but opting for a much lower LTV (loan to value) than what they are entitled to (maximum 75% for first mortgage) for very much the same motivation – to reduce debt.

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Nobody wants to make the banks richer.  It definitely makes financial sense to deleverage as interest rate rises especially if it goes above 2.50% (CPF Ordinary Account interest), and if one is holding on to surplus funds in cash or fixed deposits. It might be hard to achieve such risk-free returns.  Still, we like to share some thoughts on this topic of paying down debt versus access to liquidity as we think more deliberation may needed.  Some of these considerations are often overlooked.

 

1. Drawing Out Equity Term Loan Later May Be Difficult

To illustrate this point, we use a typical purchase scenario of a first-time home buyer (couple) who could be borrowing a typical loan of $750,000 towards purchase of a unit at a new launch project:

Purchase Price                        = $1,000,000

Downpayment in cash            = $50,000        (5% deposit)

Combined CPF to be used      = $200,000

Bank Loan                               = $750,000      (maximum 75% LTV for 1stmortgage)

Let’s now suppose instead of using $750,000, the couple decides to take a smaller loan of $500,000 as they like to deploy all their cash on hand of $250,000, hence they will be using total of $300,000 cash towards the purchase (ignoring transaction costs and stamp duties etc):

Purchase Price                        = $1,000,000

Downpayment in cash            = $50,000        (5% deposit)

Combined CPF to be used      = $200,000

Cash to be deployed                = $250,000

Bank Loan                               = $5000,000    (LTV only 50%)

Let’s imagine 5 years later and the value of the property has now appreciated by 20% to $1.2m.  The couple now plans to buy a Universal Life plan which requires an upfront payment of $300,000 in premiums and they reckoned it would be good to take out an equity term loan (ETL) from the property.

Property valuation                               = $1,200,000

Outstanding loan                                 = $420,000

CPF used (add accrued interest)         = $370,000 (both initial lumpsum plus servicing over 5 years)

An ETL is a loan taken against the equity portion of the property value, which would have increased over time from both a reducing loan and a rising valuation; it is disbursed directly as cash to the borrower and must of course come from the same lender who has a charge on the property.

Equity Term Loan eligible to be withdrawn = 75% of valuation less outstanding loan less CPF used

= 75% of $1,200,000 – $420,000 – $370,000

= $110,000

To their surprise, the amount they could withdraw is less than half the additional cash portion ($250,000) they have deployed voluntarily at point of purchase.  And they were hoping for more than $250,000 as their property has also increased in value by $200,000.

The same situation will occur when homeowners prepay partially on the loan using cash on hand whilst refinancing; when situations change later on and they decide to go back and ask for a term loan on the mortgaged property, they might be disappointed especially in situations when a lot of CPF funds has been utilized over the years.

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2. Access To Liquidity – Worth Paying?

So, what are some of these situations that may require access to liquidity or cheap source of funds?  The list below is by no means exhaustive:

  • Investment opportunity (eg when stock market crash, distressed sale, etc)
  • Starting a business
  • Buying protection and annuity in lumpsum when it is cheaper (eg Universal Life plan)
  • Childen’s overseas education
  • Family crisis due to accidents, medical costs, etc
  • Tide over challenging times when there is change in employment situation

Here we are referring to financial commitments beyond the usual emergency or rainy day funds which financial advisors generally advise setting aside at least 6 times of one’s salary or income.  Some people might feel more secure with a 12-month’s buffer.

When situations arise that require a sudden lumpsum commitment – the cheapest source of funds one can lay hold of has got to be that from an ETL as it is secured against an asset.

In a report covered by Straites Times just last month, both MAS and IBF (Institute of banking and finance) estimated that 100 out of 121 jobs in the finance sector of Singapore would see tasks being displaced by automation and AI within the next three to five years.  The finance sector is not alone here.  This trend is happening world-wide and all industries will be impacted in the next 10 years.

With such forces shaping labour markets today that is unseen in past decades, our government is certainly worried.  Job security is no longer what it used to be. There is wisdom to ensure one has access to liquidity at all times, rather than paying down to the maximum on a mortgage with no leftover funds to help service the loan duing such unforeseen periods which may last longer than expected.

 

3. Interest-Offset Account May Be A Solution

For those who with substantial funds on hand and unsure of how much of it to pay down on a home loan, an interest-offset account may just be the solution.  For full explanation of how that works, you may refer to a recent article here.

 An interest-offset account has the same effect of prepaying down on a home loan, but without having to actually prepay. In that sense, it is the “most ideal” replacement for ETL as one can effectively withdraw or get back the same amount of cash used to prepay when there is a change of plan, without being subjected to restrictions on ETL limits and unaffected by CPF usage in the property.

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 This is where some people get confused.  We often get feedback that the return from such an interest-offset account is not attractive enough as one can easily beat this rate by investing in bonds or other investment vehicles like REITS, Perps, etc. That is true.  However, we are not talking about comparing yield or returns from investment.  All investments carry risks.  Just look at preference shares of Hyflux.  And it’s easy to put money in, but not always the same when it comes to taking money out.  If bond prices crash all of a sudden, investors might not be able to liquidate without incurring a substantial loss.

Interest-offset account is a place to park liquid funds (where there is no intention to deploy for investments where one may lose access or even the principal sum), and the more appropriate comparison woud be fixed deposit account or high-interest savings account like DBS Multiplier, OCBC 360, UOB One Account, etc.  For the former, one often needs to commit at least 12 months to get a reasonably-good interest rate.  For the latter there is often a cap, with the need to spend a certain amount on credit cards. In situations where one is unable to maximize such risk-free returns from various banks, and finds it hard to keep track of all qualifying criterias that keep changing, the easiest way is perhaps “pay down” a substantial amount in an interest-offset account. Period.  No hassle. No tracking. Withdraw and put back anyime when needed. Or perhaps get an interest-offset account as a standby “risk-free” interest-earning facility, when you move your liquid funds in between the various promotions for fixed deposits and high-interest savings account.

It is also noteworthy to highlight, with an interest-offset account, there is somewhat of a “reverse compounding savings effect” as more of the monthly repayment each month goes into reducing the principal loan, thereby leading to lower interest to be paid in the following month, and so on.  We will illustrate this point in a subsequent article so watch this space.

Speak to us today if you are looking to refinance to a mortgage with an interest-offset feature and enjoy a special $150 Refinancing Valuation Fee Offset from us, subject to min loan of $500,000. Other terms and conditions apply. Speak to our consultants today.

 
 Since 2014, MortgageWise.sg has provided thought leadership in the mortgage planning space in Singapore, taking deep dives into the latest developments in the industry, providing useful mortgage tips, and making sense of rate movements.  We seek to build trust with clients over the longer term instead of doing product-peddling for quick one-time deals.  That’s why we always present “whole-of-market” perspective including home loan packages that some banks do not pay us.  Read our clients’ testimonials.

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About Darren Goh

Darren Goh is the Executive Director of MortgageWise.sg, a thought leader in the Singapore mortgage industry, with frequent interviews and quotes by the press - Business Times, Straits Times, Zaobao and EdgeProperty for his views on the latest mortgage trends. He is an avid property investor with careers in banking & real estate before becoming an entrepreneur.
View all posts by Darren Goh

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