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With mortgage interest staying high in 2023, should you pay down your home loan?

We get asked this question on mortgage prepayment ever so often with mortgage interest rates now shooting over the 4% roof here in Singapore.

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The question is especially pertinent for those who have been diligently servicing their monthly repayments using cash, and stashing away their CPF funds to earn compounding interest at 2.50% for retirement.  Now that mortgage rates are way above this 2.50% CPF OA (Ordinary Account) savings rate, does it still make sense to do that?

The natural tendency for homeowners is to prepay and reduce their outstanding mortgages quickly, especially when we face a cost-of-living crisis with raging inflation.  However, you might want to take a step back and ask yourself how long is interests going to stay up?

The best way to explain this is to tell you a chicken-and-egg story:

A farmer has 50 hens which lay 50 eggs daily. To make more money, he decides to buy a second farm that comes with 100 hens but he needs to borrow from the bank who asks for 25 eggs per day as “interest”.  He pays them off with the 25 eggs leaving him with 75 + 50 = 125 eggs each day to sell for a profit. Everyone is happy.

Next year, global inflation results in eggs selling for more which means more profit for the farmer.  But the bank says they also require more eggs now as interest and ask for double or 50 eggs per day! Or give them 50 hens instead to “repay the loan” after which he can then have the whole farm to himself. Angered by the greed, the farmer decides to give his own 50 hens to redeem this loan

How many eggs does he end up with per day now?

Whether he repays the loan or not, he has the same 100 eggs per day. The difference is – had he kept his own 50 hens, he would have maximum output from a larger pool of 150 hens. The following year the bank could drop the interest back to 25 eggs or he could also hatch some of the eggs and grow them into hens to repay the loan later.  By redeeming his loan now, his return or production capacity is now capped at only 100 eggs per day.

Of course, living within your means or staying relatively debt-free is espoused as a virtue especially in Asia.  It’s also a subjective matter where the preference to take on more or less debt varies with age so there’s really no right answer here.  However, prepaying down on your mortgage does come with opportunity costs or “reduced capacity” like in the case of the farmer.

There are three possible scenarios to consider before doing a prepayment, partial or full:

Scenario 1: Make money using Other People’s Money

In short, leverage.  And if you think about it, secured lending on a property is the best form of leverage you could ever get as it comes with the lowest interest and, as long as you keep up with the monthly repayments, your collateral will be “safe”.  In other words, the bank is unlikely to do a margin call on your facility.  And unlike unsecured lending on personal loans and revolving lines where the accruing interests is not just ridiculously high, it snowballs on you like a thief.

It’s debatable though the part on investing as it may not be everyone.  There’s a lot more emotional roller coaster rides and challenges that most people underestimated.  Still, if mortgage interests will drop back soon and settle at a much-sustainable longer run rate of 2-2.5 per cent, even relatively safe high-grade bonds, treasuries, and investments such as real estate investment trusts can beat that cost of funds rate. 

The bottomline is, those using cash to prepay down on an outstanding mortgage have got to ask themselves if they might have got better use of their funds elsewhere.

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Scenario 2: Your CPF stops growing & you become liable

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It becomes a little trickier if you are thinking of using your CPF money to prepay in order to save on mortgage interest costs.

Mortgage rates may be much higher than CPF’s savings rate of 2.50% to earn compounding interest, however both are transient.  Mortgage rates can’t stay high forever as it causes economic pain and hardship.  CFP savings rate is more likely to stay at 2.50% longer as it’s pegged to the three local banks’ board rate for fixed deposits and savings account which continues to stay meagre.

When you take $200,000 from your CPF OA to repay your mortgage, most do not realize you are still “borrowing”.  The difference is you are borrowing from yourself in the future rather than the bank.  This is because when you sell the property one day, you will have to return this $200,000 plus the accrued interest that would’ve been earned had you not make the withdrawal.

This means, instead of GIC taking on all the investment risks to pay you that risk-free 2.50% compounded interest, you are paying it yourself, from your sales proceeds.

So remember, when mortgage interest rises, you are really just paying the excess above 2.50% because the Singapore government will be paying you that 2.50% back.  How long it stays above 2.50% then becomes the question, which leads us to our final point.

Scenario 3: It might be harder to increase your loan later

Remember, interest rate goes through cycles of peaks and troughs.  Whether you use cash or CPF to prepay on your mortgage, you might find it hard to “take back” that same leverage when it eventually comes down below 2.50% or the prevailing CPF savings rate.

For HDB home loans, what’s repaid is repaid as you can’t quite “gear up” or borrow against the equity portion of an HDB valuation even though it has risen (Unless, they change the laws.)

For private property owners, you can do a mortgage equity withdrawal loan but you might encounter road blocks with reduced limits and ever more stringent rules in place, as such loans pose higher risks to the banks.  Your income situation might also change, which renders it hard for you to get that additional loan needed.     

As periods of relatively low interest rates tend to be much longer than periods of interest rate escalations, as borne out by the interest rate cycle over the last 20 years, you might find that your ability to generate returns gets crimped in your most productive years.  In the case of HDB owners, you’ll end up paying yourself that risk-free return if interest should fall back substantially below 2.50% for long periods like in the last decade.

This means, instead of GIC taking on all the investment risks to pay you that risk-free 2.50% compounded interest, you are paying it yourself, from your sales proceeds.

Need more advice?  We don’t just throw you a set of rates, or get different bankers to sell to you.  Not only do we help clients navigate through Singapore mortgage rates quick and fuss-free, we show you how best to position and profit from the interest rate cycle, be it for residential or commercial property loan. Work with us today and you’ll also be helping to support our social cause!

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This article first appeared in The Business Times on 30 Jan 2023.

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