3 Reasons Not To Pay Off Your Mortgage Early

“Dear, are you sure we should take a 30-year home loan? Perhaps we should seriously consider a 25-year or even a 20-year loan instead. With our incomes, the higher monthly instalments shouldn’t be a problem. Otherwise, we could use some of our cash reserves to reduce the loan quantum. Somehow, stretching this debt to the time when we turn 55 doesn’t seem that great an idea to me”

Mrs 15 HWW was really concerned when we collected the keenly anticipated keys to our brand-new BTO flat in Punggol. In exchange for a humble abode, we also had to commit to almost $300,000 of debt. All these at the tender age of 26. No wonder she was nervous and had some doubts on our decision-making ability. And she did have a point, since she’s even more risk-averse than me. With a prudent habit of keeping at least a 5 digit figure in her bank accounts, she saw little sense in paying a 2.6% interest on a home loan while the cash idles unproductively in the bank.

So why am I advocating not to pay off the mortgage early then?

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1. It’s the loan with the lowest interest rate

Traditionally, the mortgage is the one type of consumer debt with the lowest interest rates. Currently, the HDB Concessionary Loan at 2.6% is the most expensive home loan out there (a clear oxymoron?). If you’re more adventurous, the floating home loan rates out there are hovering at around 1.2% to 1.4%. What about the other types of loans then?

Credit Card Balances – Yes, it has a place here since one is effectively borrowing money from his credit card. The banks charge interest of up to 24% a year (They prefer to advertise as 2% a month to trick some into thinking it’s a small price to pay)

Personal Loans (aka Cashline, pay advances etc) – Banks easily charge >10% interest in a year

Renovation Loan – Effective Interest Rate (EIR) of 5% in a year is common

Car Loan – EIR of >4% in a year (The headline rates quoted are generally 2-3%. But that’s just the flat rate since car loans are not ammortizing loans and the effective interest rate is generally almost double the flat rate)

Before tackling the mortgage debt (lowest interest), you should first eliminate all the other loans that charge a higher interest. This is just simple math and logic.

At that point in time, there was a chance (although really small) that we could be buying a car. Furthermore, renovation expenses were also looming. Therefore, I was able to convince the Mrs that we should conserve our cash reserves to minimize any potential renovation or car loans.

2. Liquidity and good probablilty of higher returns

You never know when a financial need might crop up, isn’t it? One of us might get laid off or our astute family planning might fail? Therefore, I do value the liquidity that money in the bank provides. And to me, the liquidity is definitely worth more than the 1.7% POSB currently charges for my home loan.

Those cash could also be used for investments when opportunities knock. This happened in the past few weeks when the stock market corrected amidst fears of QE tapering and military action in Syria. I was able to get a 10% discount on the shares I bought, which easily covers the opportunity cost: 1.7% of mortgage interest.

3. OA rates provide a higher return

Okok, you might well argue that you are not using cash for your mortgage instalments. In fact, few do that in Singapore. Most Singaporeans (including yours truly) utilise their CPF OA contributions for home financing. Since we can’t touch them until we are 55 (or even 65), why not just use everything to reduce our debt burden!

It appears that there’s some merit to this thinking. I mean, the OA rate is only 2.5% a year whereas the HDB Concessionary Loan is pegged at 0.1% higher.

But upon closer scrutiny, this view is pretty flawed. Firstly, you could easily get a better loan deal somewhere with lower rates. As mentioned earlier, floating loans in the market charges below 1.5%. Even if you’re slightly risk-averse like me, there is a product from POSB potentially more suitable for your needs.

Actually, I am even willing to go for a 40, 50 or even 99-year loan to take advantage of this low interest rate environment. As long as there isn’t any pre-payment penalties, the math tells us that we should preserve as much of our OA contributions in our CPF accounts to earn the higher 2.5% interest rate. For example, if I have a mortgage debt of $100,000 (at 1.5%) in 2013 and have $90,000 in my OA account (2.5% interest), I can just do nothing and wait for another 10 years to be debt free (both amounts increase to about $115,000 and cancel out). Waiting longer would yield even more benefits. And if interest rates rise above 2.5% anytime, you always have the option to reduce the mortgage with a lump sum payment from your OA account.

Secondly, if you’re just starting out (less than 5 years in employment), your OA monies are likely to attract another 1% of Extra Interest* from CPF Board. So, even if you’re sticking to the HDB Concessionary Loan, you’re also earning a minimum of 0.9% in interest differential. And these monies do add up over the long run.

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So if you’re thinking of redeeming your housing loan or are already making extra payments for your mortgage, it might be time to reconsider, especially if the above reasons apply to your unique situation.

 

*The first $60,000 of your combined CPF balances, with up to $20,000 from your Ordinary Account (OA), will earn an extra 1% interest. Therefore, if your Special and Medisave Accounts have less than $40,000, up to $20,000 of your OA balances would attract this extra interest. Extra Interest is credited to the Special Account to boost our balances for retirement needs.

 

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    2 thoughts on “3 Reasons Not To Pay Off Your Mortgage Early

    1. Musicwhiz

      Good points, thanks. Yes it would indeed be useful if we are disciplined enough to leverage on cheap money to invest to obtain higher returns. The fact that interest rates are so low now doesn’t mean it would always stay so, though. One thing to bear in mind is refinancing may be tougher once you are subject to the new TDSR rules, and this may happen for couples 2-3 years down the road. In such cases, repricing may be the only option and the bank has the upper hand in raising rates (perhaps even significantly!).

      While I do advocate having a cash buffer to tide over emergencies, one must also consider if the loan can be progressively reduced so that you limit your downside risk should either spouse get retrenched, or suffer a pay cut. If that happens, you would not be able to afford the instalments purely through CPF and may have to dip into savings. If the loan quantum was gradually reduced, it means you may be able to renegotiate the loan terms or refinancing with a lower mortgage instalment, giving you more flexibility overall.

      Regards.

      1. My 15 HWW Post author

        Hi Musicwhiz,

        Once interest rate rises to lets say ~4%, it would then be time to aggressively tackle the debt! Agree that it’s prudent not to keep debt levels too high (i.e. don’t consume too much house).