Wednesday, June 15, 2016

Should We Pay Down Our Mortgage As Soon As Possible?

Most of us will dislike debt. It takes money from us every single month. For our home mortgage, it can be thousands of dollars a month which can be quite a significant sum of money. If mortgage is such a pain, should we use the extra savings we have to pay it down faster? Let's explore it in this article.

In Singapore, we can use either cash or CPF in our OA to pay for mortgage. The cost on a mortgage is on the interest. Like credit card which charges an interest if we didn't pay on time, likewise mortgage loans charges an interest because it is a loan in nature.

Credit: https://pixabay.com/en/photos/debt/

Interest payment can be in 6 figures

Most mortgages will start with around $250,000-$300,000 if you buy a 4 room HDB flat. The interest rate if you take up a HDB loan is 2.6% for 25 years. Did you know for a $300,000 loan at 2.6%, the total interest you would have paid is $108,181.66? If we can shorten the loan to 15 years, the total interest paid would have decreased to $62,594.59. This would immediately save us more than $40,000.


Should we use our cash to pay down our mortgage?

Using cash to pay down our mortgage may be a good choice. Right now, the money in most of our savings account do not earn more than 2.6% interest which is the interest of the HDB loan. Paying it down and reducing the loan tenure will save us more money. As mentioned earlier, it can be as much as $40,000 savings just by reducing the loan tenure by 10 years on a $300,000 mortgage. However, paying down cash means we have lesser cash flow for emergency or anything which you need the money for. It is always important to plan in advance before using cash to pay down our mortgage especially when its a huge sum of money. 

There are various ways to save on the interest we pay on our mortgage. We can reduce the loan tenure which means paying more per month for our mortgage or we can pay lump sum every year to reduce our mortgage amount. We can also refinance to a better package which is lower than 2.6% or any lower interest rates. Many banks actually offer loan packages which are less than 2% now. 


A lack of understanding of how interest rate works will make us poorer. Compound interest works its magic while amortisation on housing loans means interest paid is lesser than what is shown. For other loans such as car loans or credit card debt, the wisest decision is to pay it off or even better don't take any of such loans or owe the credit card company any money. Car loans are not amortised and is different from housing loans so the interest paid is always much more than housing loans. Credit card interest is even more scarier as it compounds at a very high rate. Have you made the right decision today?

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28 comments:

  1. If nothing better to invest, pay down the mortgage. When good opportunities come for investment, one can still re-mortgage and take out cash to build a large war chest.

    ReplyDelete
    Replies
    1. Hi,

      Yes we can do that. However, re-mortagage is only for private properties. For HDB, there is no way to take out cash.

      Delete
  2. Hi,

    Thanks for this article! simplicity at its best. have been wanting to explain this to my friends.

    Just one quick clarification.

    Based on my calculation, $100,000 at 2.5% interest compounded for 10 years is $28,008.45. How did you get $24,886? I may be wrong!

    ReplyDelete
    Replies
    1. Hi ang,

      You're right. I missed out one more year. Have edited the numbers. Thanks!

      Delete
  3. Hi,

    Thanks for this article! simplicity at its best. have been wanting to explain this to my friends.

    Just one quick clarification.

    Based on my calculation, $100,000 at 2.5% interest compounded for 10 years is $28,008.45. How did you get $24,886? I may be wrong!

    ReplyDelete
    Replies
    1. Hi ang,

      Yes you're right. I calculated for 9 years and missed out 1 more year. Have changed the numbers. Thanks!

      Delete
  4. Hi SGYI,

    Thank you for the insightful article. My thoughts on mortgage payment is that it is not so straightforward. One should not consider the repayment of mortgage using interest rates alone. There are other factors like cash flow and opportunity cost.

    Regards,
    SG Wealth Builder
    www.sgwealthbuilder.com

    ReplyDelete
    Replies
    1. Hi Gerald,

      Yes cash flow and opportunity cost are important as well.

      Delete
  5. You don't even know that you arewrong, and yet you wrote a lack of how interest rate works will make us poorer!"

    What's wrong ? Ammortisation comparing with compounding. You forgot to compare the monthly installment to make it same Cashflow comparison.

    ReplyDelete
    Replies
    1. Hi Peter,

      If you did not know, the interest for the mortgage in my example is already amortised. This is base on reducing mortgage loan amount yearly and then computing the interest.

      "Let's assume the mortgage is left with $100,000 for 10 years, total interest paid would be $13,657.79 at 2.6% (This is computed base on amortisation). For the same $100,000 left in the CPF OA to earn 2.5%, the total interest earned would be $28,008 (compounded interest)."

      Let me know if you still see anything wrong. Thanks!

      Delete
    2. Hi Peter,

      Lets be constructive here.

      Perhaps you want to explain in greater detail on your points?

      We are all here to learn.

      Thanks

      Delete
  6. I know what u written, but you don't know what I have written.

    Only in the world of fantasy where investing at 2.5% interest is better than paying off loan to save 2.6% interest. Logic tells it. Your calculation confuses it as you did not factor in cash outflow in comparing both.

    ReplyDelete
    Replies
    1. Hi Peter,

      World of fantasy? I'm talking about CPF OA which gives us 2.5% interest. It is not about we investing our own money because we can never be sure if we can get a ROI of 2.5%. I mention this clearly in my post too.

      Maybe you can elaborate more on your point by giving examples so we all can learn together.

      Delete
  7. U can read my comments as well as many examples here:

    https://frugaldedi.wordpress.com/2010/04/29/buying-cash-or-taking-loan/

    I wrote it 7 years ago. Although the % rate is different, nevertheless, the conclusion is the same.

    I repeat, "Only in the world of fantasies where investing and earn lower rate is better than paying off loan at higher rate."

    ReplyDelete
    Replies
    1. Hi Peter,

      I finally understood what you are trying to say after seeing your example. Yes the lump sum won't last for that 20 years like you mentioned. This is true only if we are not working and there is no extra money coming in monthly which we can use to service our loan.

      In the case of Singapore (I suppose you're not singaporean since you wrote your dollars in RM), the money we have in our CPF we can't take out until age 55. If we are still working and have monthly CPF contribution which can cover the loan instalment, then it would be wiser to leave the lump sum inside to earn interest than to pay up the housing loan. Also, housing loan taken from the HDB is fixed at 0.1% above the CPF OA interest which is 2.5%. This will ensure stability. If we are talking about bank loan, then i wouldn't suggest someone to delay paying off the mortgage as interest rates can rise and also we can't guarantee how much we can actually grow our money.

      Yes you are right that if we only use the lump sum to pay our mortgage, then what interest we get is no use because ultimately the lump sum amount decreases as well so it surely won't last for any amount of time if our return is lesser than the loan interest rate. Hope this clarifies :)

      Delete
  8. Glad you understand after reading my examples.

    Also glad you agree that the lump sum can't last if the return from the lump sum is less than the interest from loan.


    Let me give you another example.

    Suppose a person have $100k housing loan at 2.6% a year, and his monthly installment is $947.15 (as per your example above to finish the loan in 10 years and total interest as per your above figure).

    At the same time, that person have $100k in cash (or in CPF or wherever) , and he also saves $947.15 a month from his salary (to make it apple to Apple comparison). He can invest any or all these money to earn 2.5% interest a year.

    What's the most optimum return for him?

    Your article would say leave the lump sum $100k earning 2.5% a year while you use $947.15 monthly to pay the housing loan (which charges you a higher interest).

    I would propose the other way (if a person's investment return is less than the housing loan). Meaning, settling the loan (immediate kills off the 2.6% in liability), and then investing the $947.15 monthly saving earning 2.5% a year.

    You can calculate out which gives the higher final amount, but the answer is obvious to me because the highest interest is a liability on your article, while my suggestion employs capital to the highest interest/ return first.

    You may say that there's other benefits of not paying off the loan (like having more cash on hand, etc.), but it doesn't change the fact that you can't be better off investing if your liability interest is higher than your asset's return (if u compare apple to apple, of course).

    ReplyDelete
    Replies
    1. Hi Peter,

      Thank you for the examples. If we are using cash to pay for housing, then I would really suggest we pay it down as fast as possible and don't care about interest at all. Settling the mortgage will give us more cashflow which we can do a lot of things. However, in the case of CPF, it would be best to leave the lump sum inside to grow than to use the lump sum to pay down the mortgage.

      Delete
  9. I really can't find any sentence in your latest reply that i agree with. And worst, its not backed by any reasons. Now, let's get to what i disagree with your above reply.

    1. "If we are using cash to pay for housing, then I would really suggest we pay it down as fast as possible and don't care about interest at all"
    Imagine a person owns $100k of Berkshire Hathaway shares. They would have been poorer if they pay off their housing loans when Berkshire gives way more than that. You may check it out in any 10 years horizon. Not comparing returns is like a person buying an item without comparing price. It's so wrong that i feel dumb even explaining it.

    2. "Settling the mortgage will give us more cashflow which we can do a lot of things."
    Settling the mortgage (with your cash since your paragraph above refers to cash) kills your lump sum! Why would a person having $100,000.00 in Cash/ Berkshire Stocks "kills" his $100,000.00 goose so that he got $947.15 per month extra in cashflow ? You'll take extremely long time to accumulate $100,000.00 with that monthly savings (which you "killed" by paying off the loan regardless of whatever rate).

    You can also create your own synthetic cashflow by taking your $100,000.00 and invest in a place that earns 2.6% a year (or better yet, more), and withdraw $ 947.15 every month from your capital. Your capital will finish in 10 years (or longer if your investment return is higher), but so is your housing loan had you done the same thing with your housing loan.

    3. "However, in the case of CPF, it would be best to leave the lump sum inside to grow than to use the lump sum to pay down the mortgage."
    And why is that so? Because of your flawed comparison above ? I've already explained the flaws, and i'm not sure you understand it (although you mentioned above that you do). Let me explain in another way why your calculation comparison could give higher amount even at lower rate.

    In not paying off the loan and use your monthly salary to pay for your housing loan, you're having both $100k earning 2.5% a year AND your monthly saving of $947.15 earning 2.6% a year.

    And you compare it with a person who pays off the housing loan with their 100k (thus terminating the 2.6% interest a year) and a person's monthly saving of $947.15 EARNING NOTHING for 10 years!

    I'm not sure anyone agrees with your assumption above. There is an acronym, GIGO, which means "Garbage In, Garbage Out". Wrong conclusion because wrong input.

    Cash/ Stocks bought with cash is "free money" while CPF is "Prison money". I coined the term "Prison money" as you can't touch bulk of that money until you're 65. Using cash to pay off loan while keeping your CPF funds is like what Buffett would say, "saving up sex for your old age". It's one thing to keep when your assets are growing at 10% to 20% a year, while it's totally another thing when your assets are growing at a pathetic rate of 2.5% a year ! Hardly matches inflation, and definitely you won't get rich with such rate.

    While some are against debts thinking all debts are bad, while some takes maintain all debts, this is the first time i read someone propose to "kill" "free money" while keeping "prison money" regardless of what return the "free money" earns AND even when the "prison money" earns a rate lower than your loan. I guess there's first time for everything. :-)

    ReplyDelete
  10. Continued from above:

    p/s: This would be my last reply as i see that you're swaying off from the main topic of discussion which is the flaw in your comparison and thus your conclusion.

    When there's a disagreement between Munger and Buffett, Munger would tell Buffett, "I'm right, and you're smart, and sooner or later you'll see I'm right."

    p/p/s: Hope you'll correct / update your article. Otherwise, naive people might got wrong advice, and financially literate people might laugh at this article or take this article as a good lesson of a a mistake.

    Everyone does mistakes. It's whether that person learns from it, corrects it, and improve it.

    ReplyDelete
    Replies
    1. Hi Peter,

      Maybe I should apologize for generalising my above comment. Yes you are right that if we earn more interest in our investment, then we should still keep that lump sum since its making much more than the interest we are paying on our mortgage. Nevertheless, nothing is certain in investments while the interest we are paying on mortgage is a liability. Who can say for sure if the investments we have will be more than the interest we pay on a 20 year mortgage? 20 years is a long horizon.

      Delete
    2. And also, let me clarify my example again. All my assumptions are base on CPF money ONLY. No cash involved at all. The 2.5%, the 2.6%, 100k and monthly salary are all in CPF. No cash involved. What i see in your comment is you keep talking about cash which is not my purpose of comparison as it complicates matters. My example is simple, 100K in CPF earning 2.5% and using monthly contribution INTO CPF to pay for housing loan. Cash outside of CPF we can invest, save, spend in whatever ways we want. Not involved in mortgage at all.

      Delete
  11. Cash or CPF, it still doesn't change the examples:

    Tell you what. Calculate and compare which is better:

    1) your option: Leave $100k in CPF earning 2.5% a year, while your $100k loan is charging you 2.6% which you pay monthly with your CPF monthly contribution of $947.15, or

    2) settling loan option (and your monthly contribution earns 2.5% CPF returns):
    Settle the $100k housing loan since CPF is earning less than that, and your monthly contribution in CPF of $947.15 earning 2.5% a year.

    ReplyDelete
    Replies
    1. Hi Peter,

      I have done the calculations. It seems like the mortgage loan interest has to be much lower as compared to the investment interest in order to make it worthwhile.

      Even if investment return is higher than the mortgage loan, if using your example of saving the monthly cash flow to invest, it will always be better. For example, 100K growing at 2.6% compared to mortgage interest at 2%, if we have paid down the 100K in full and then save the monthly instalment to earn back 2.6%, the return will be about the same.

      I will remove the part in my article on the investment return of CPF and the interest earned.

      Delete
  12. Exactly my point. U should think of they "why" is it so? I could tell you, but you'll read but don't learn.

    By thinking it yourself, you'll learn.

    ReplyDelete
  13. I disagree with "Even if investment return is higher than the mortgage loan, if using your example of saving the monthly cash flow to invest, it will always be better. For example, 100K growing at 2.6% compared to mortgage interest at 2%, if we have paid down the 100K in full and then save the monthly instalment to earn back 2.6%, the return will be about the same."

    It seems you did not grasp the basics of time value of money (although you might think you have).

    There are 2 ways I can think why u come to the wrong conclusion 1) did not factor in opportunity cost like the mistake u did (which took me maybe 10 comments for u to get it), or you did not compare the same frequency of compounding.

    Which one gives higher results when comparing to pay off housing loan vs to invest couldn't be simpler. No calculation is needed if you truly understand the basics, if both rates are given.

    ReplyDelete
    Replies
    1. No matter what, mortgage is really dependable on personal circumstances. We can't say for sure what to do. Like I said, who can guarantee if your investment return will always be higher in the long term? What if you invest the 100k and you lose 20% this year? Are you certain you can make it back? It is always prudent to invest the money which we do not need. Else we will end up in a situation where we cannot sleep.

      Delete