There are many websites and books that claim you should “pay off your home loan early”. This is a bit like the survival advice that tells you charge at a bear while banging pots and pans: maybe it does work, but if it doesn’t the consequences will be insanely painful. Here’s a more balanced look at rushing your home loan repayment:
Why isn’t paying off your home loan early always a good thing?
Think about this for a moment: if paying off the home loan early is always good, why do even multi-millionaires or billionaires take home loans?
It’s not as if they couldn’t pay for the whole house at one go. Instead, they opt to have a loan. The reason is liquidity. When you tie up too much of your money in one asset, you are worse off financially. Here’s an example:
Let’s say you have $200,000 outstanding on your home loan. You are 45 years old, and after diligent saving, you’ve managed to put together around this amount. You then put all your $200,000 worth of savings into finishing off the loan repayment.
What a relief!
But a year later, one of your loved ones develops a medical condition. You need $15,000 to handle the medical fees. At the same time, one of your children gets accepted into a prestigious university and needs $35,000 for tuition fees. How will you pay for it?
Well, you don’t have any cash because you poured it all of it into the house. Now you’re stuck with either using personal loans (always more expensive than a home loan) or selling the house to unlock the cash*.
Had you kept the $200,000 in savings, and carried on repaying the home loan the usual way, you’d have enough money to pay for the medical emergency. You could send your child to university. And you wouldn’t need to sell the house you worked so hard for.
Nevertheless, we acknowledge that many of you want the comfort of knowing the home loan is settled. There’s a comfort in knowing you don’t have to pay $2,000 or $4,000 every month to the bank, we get that. But you need to make sure you’re in the right situation before rushing it:
*To be precise, there is an alternative called cash-out refinancing. But it’s complicated, difficult to qualify for, and involves using your house as collateral for a loan. This is called a second mortgage, and it defeats the purpose of rushing home loan repayments in the first place.
So when can you rush your home loan repayment?
There are four situations when you might want to speed up your home loan repayment:
- You have savings even after prepaying
- The prepayment penalty is not too steep
- You have retirement plans besides your property
- Interest rates are rising significantly
1. You have savings even after prepaying
Always remember that homes are illiquid assets. They’re the worst asset to try and sell for “emergency money”, as the process could take weeks or months.
As such, you should never prepay your home loan if you don’t have a savings fund. Be sure to accumulate at least six months of your income, to deal with situations like retrenchment, medical emergencies, or litigation; only after that should you consider prepaying your home loan.
2. The prepayment penalty is not too steep
Most banks will impose a prepayment penalty when you try to pay off your home loan early. An exception would be HDB loans, which have no prepayment penalty.
You’ll have to check with the bank for specific details, but a typical amount is 1.5 times the un-disbursed loan amount. So if there’s $150,000 not disbursed, you might face a penalty of $75,000.
If the prepayment penalty exceeds the interest paid on the loan, it’s not worth paying. After all, you can’t save on the interest even by paying early.
3. You have other retirement plans besides your property
If you have the cash to spare, consider making other investments instead of just putting all of it into your property.
For example, say you have a loan of $400,000 for your resale flat. At 2% interest on a 30-year loan, the repayments are $1,478 per month. You decide to pay off your loan faster and opt for a 20-year loan instead. Now, your repayments become $2,024 per month.
That’s a difference of $546 a month.
Now let’s look at two scenarios:
Scenario 1: Instead shaving 10 years off your loan repayment, you go ahead and take a 30-year loan instead. You then use the extra $546 saved, by putting it into a retirement product (speak to a financial adviser for more details).
$546 a month comes to $6,552 a year. Assuming you put it in a retirement product that compounds at 4% per annum, a fairly realistic expectation, that comes to almost $381,349 at the end of 30 years.
You would eventually have a fully paid up flat, and around $380,000 to retire on.
Scenario 2: You pick a 20-year loan and pay off the house fast. During the next 10 years, you take the $2,024 you’d normally use for loan repayment and put it in a retirement product compounding at 4% per annum.
At the end of those 10 years, you’d have around $301,885, and a fully paid-up flat. That’s $78,115 less compared to Scenario 1.
The absolute worst-case scenario is to end up with a fully paid-up flat, but zero retirement funds at the age of 55 or 60. You can’t eat your house, unfortunately; and nothing hurts more than paying your whole life for a home, only to have to sell it and downsize a few years later.
Don’t sacrifice your retirement plans just to pay off your home a few years earlier.
4. Interest rates are rising significantly
This is more for investors (landlords) than homeowners). In an environment of rising interest rates - which is the case in 2017 - you may want to quickly pay off the loans, to prevent them from eating into rental income. Remember that the current low-interest rate environment was sparked by the Global Financial Crisis in 2008/9, and with home loans being at record lows for almost a decade, they are bound to rise again eventually.
Note that historically, home loan rates in Singapore are near 4% per annum, with the past decade being something of an oddity.
For homeowners, your concern is of course not rental rates. You may want to try and pay off your home before monthly repayments rise past sustainable levels. Before you do that, however, you should realise there are other options in the form of refinancing.
Read: 5 reasons why you should refinance your home loan
You can switch your bank loan, to a package that’s more affordable; and that might be easier and more prudent than wiping out your savings to rush repayment.
In fact, you can take advantage of refinancing right now. Three of the best options (at the time of writing) are the UOB 15 month FD loan (1.28% per annum), DBS FHR loan (1.3% per annum), and the Maybank Variable Rate Package loan (1.38% per annum). You can apply for them on GoBear.com.
Talk to a financial professional before rushing to prepay your home loan.
It’s not as simple and clear-cut as many personal websites and books would claim. Pre-paying your home loan is a major financial decision, and it should never be done lightly.