Many of us have always been taught to pay our debts, spend within our means and not to owe others—especially in the matter of loans. However, in the 21st century, it is almost impossible to live without some form of leverage or credit—such as credit cards, hire purchases, and the main focus of this piece: your home loan, otherwise known as your mortgage.
A mortgage is a long-term loan, and usually results in a significant amount of interest being paid on top of the principal. There is, therefore, always a temptation to reduce that considerable interest amount by cutting short the time it takes to pay off a loan—with one lump sum for example.
Is this necessarily the ideal course of action, though? Could there actually be a case for holding on to your mortgage and not paying it off ahead of time?
Why Pay off Your Mortgage?
Let’s start by looking at the key arguments for paying off your loan quickly.
1. Being Debt-free Feels Good
The liberation you feel when you have no liabilities and payments to meet cannot be discounted. It feels good. You don’t have to mentally deduct the amount you actually have to spend each month from your salary. You don’t have to lament about how little your disposable income actually is after the mortgage payment is subtracted. Your money is yours. So why not?
2. You Pay Less Interest
Given the large sums usually involved in mortgages, even a low interest rate amounts to a considerable amount of money. For example, a $1 million loan at 2.5% over 30 years will see you pay back over $1.4 million when you include interest. The argument for paying off your mortgage early comes from the prospect of reducing the amount of interest you need to pay.
Need help to work out the sums? You may find PropertyGuru’s mortgage affordability calculator useful.
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It’s a true and compelling argument; however, note that your bank may have imposed a penalty or charge for prepayment of loans to compensate for their potential loss of profit, which may eat into the amount you think you are saving on.
Still, that’s not necessarily a deal-breaker. What’s important is to know precisely how much you stand to gain in terms of interest reduction, and weigh it against the prepayment fee. If you still stand to gain, then you may indeed want to make the prepayment as planned.
Either way, to discern the course of action to take, you will need to read and understand your loan agreement thoroughly.
Not sure whether to refinance or pay off your home loan entirely? Reach out to PropertyGuru Finance’s Home Finance Advisors, who can advise you on your best steps forward in managing your home loan.
Why Hold On To Your Mortgage?
Having seen the reasons for paying off your loan, why would anyone want to hold on to a loan and continue owing and paying? Believe it or not, there are also compelling and sensible reasons for this.
1. Using CPF to Pay Off Your Loan May Defeat the Purpose
Your CPF Ordinary Account (OA) generates a certain amount of guaranteed interest per annum—the current rate is 2.5%. This represents a return that you will lose out on if you use it to pay back a loan that may actually have a lower interest rate, like 1.2% for example. In essence, there is an opportunity cost—you are foregoing potential CPF earnings that may be more than the interest rate you are saving on.
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To make the argument more convincing, consider also that if you decide to sell the house, you will not only have to return the principal sum you took from your OA to pay off the loan, you will also need to pay back the accrued interest that that principal sum could have earned over the years if it had remained in your OA.
For example: If you paid off your loan with $20,000 from CPF and then sold your property 20 years later, you would have to pay back over $32,000 (that’s $20k plus compound interest at 2.5% for 20 years)!
While the savings you might have made from prepayment would not be “lost” per se, they would go back into your CPF. The money remains yours, but can only be used for a limited range of reasons, such as in purchasing another property or for retirement. Would this lack of freedom to use your own money be an issue? If yes, then you may wish to reconsider using your CPF in this manner.
However, there is one specific scenario where using your CPF to pay off your loan all at once and saving on further interest payments could make sense: if you do not intend to sell your current property ever again. In that case, you will not be required to pay back the CPF you took out, and the amount you saved in interest payments will not be eaten into or return to your CPF. You would then be free to also use the cash you have saved.
2. Money Is Warmer in Your Own Pocket
It’s worth reminding our readers that loans like mortgages are useful because they defer and spread out single large expenditures over a period of time. They also allow you to make a purchase you need/want first, instead of having to save up for much longer to buy it outright with cash. This ensures that you have spare cash for immediate day to day spending, and as a buffer for unforeseen circumstances.
There’s no point in completing a $150k lump sum property purchase in cash if $150k was all you had and you can’t even afford to pay your other bills—or even eat—after that.
In conclusion, it may be worth it to just continue with the loan period if paying it off early leaves you tight on cash for the near future (especially once you factor in potential pre-payment charges). It’s always good to free up cash and keep a reserve every month so you have the means and flexibility to react in case of any unforeseen events, such as accidents or illnesses.
3. Appreciating Property Value Could Make Prepayment Unnecessary
Your mortgage helps you purchase an asset (i.e. property) whose value could appreciate if you had played your cards right. If your property gains in value over the years, that appreciation may cover your interest, or even turn you a profit. Meanwhile (see point 2) you have cash freed up every month for your expenses. So if your interest is covered, why not consider holding on to the loan and avoid paying extra charges like prepayment fees that may erode your gains?
Of course, for this to apply, you have to be confident that the property you’re purchasing will indeed appreciate because you will not be able to reap any benefit from any potential appreciation until your property is sold—but that’s where risk appetite and doing your homework in advance comes in.
Do note also that while such appreciation would have been a strong possibility during property booms like in the 80s and in the early 2000s, with the present growth in income inequality and the economic headwinds buffeting the globe, this factor may not be in play for some time to come.
4. Interest Rates Are Low
With interest rates being the lowest they have been in recent years, there exist opportunities to pay it off and make a profit by investing in assets that give even higher returns. Of course, we’re in no position to give you investment advice, but if that is something you’re considering and exploring, this is a point worth noting.
For example, if you pay 2% in home loan interest but with the spare cash, can earn higher returns in another asset, then the loan gives you flexibility without actually costing you.
In fact, in this argument, the loan is instrumental to your profit because without the cash you freed up thanks to the loan, you may not have the means to invest in this second asset.
To Pay off, or Not to Pay Off?
Your own answer to that question will depend on your circumstances. Do you have a way to earn more than the interest costs? If yes, you may find it more useful to hold on to the loan and continue to free up cash. If you don’t, then you are probably better off lowering the interest cost as far as you are able to, and as far as the banks allow you to.
One middle-of-the-road approach may be to increase the payments you make each month as far as you are allowed to without penalty, in order to shorten the tenure period, resulting in lower interest costs in the long run. It still frees up cash flow for you day-to-day expenses, but without the extreme expenditure of a lump-sum payoff with its attendant penalties and inconveniences.
Nevertheless, whichever way you choose in the end, always remember—know the terms of your loan, and what you can and cannot do! Do your homework now to prevent frustration later.
For more advice tailored to your unique financial situation and home loan, reach out to PropertyGuru Finance’s Home Finance Advisors.Chat with us on Whatsapp Fill up an online form
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