How To Select a Housing Loan Package

After selecting our desired condominium, the next step is to choose a housing loan package. There is a variety of loan packages, such as fixed or floating interest rates. For fixed interest rate packages, you could choose whether to fix the interest rates for 1, 2 or 3 years, after which the loan reverts to floating interest rates. For floating interest rate packages, you could select whether to peg the interest rates to the Singapore Interbank Offered Rate (SIBOR), Swap Offer Rate (SOR) or fixed deposit rates. Assuming that you choose a SIBOR or SOR package, you have to further decide whether to peg to the 1-month or 3-month SIBOR/ SOR. Likewise, for fixed deposit rate packages, you can choose between 9-month, 15-month or 36-month fixed deposit rates. The choices can be fairly overwhelming.

Step 1: Fixed or Floating

The first step to decide is whether to go for a fixed or floating interest rate package. Given that US Federal Reserve (Fed) has increased interest rates 5 times since Dec 2015 and plans to increase them another 4 times this year, we decided it is prudent to choose a fixed interest rate package instead of a floating interest rate package.

Step 2: Fix for How Many Years

This is a tricky question. Thankfully, there are some hints. Besides setting the current interest rates, the US Fed governors also provide their projections of future interest rates. By plotting the interest rate projections, we can see how US interest rates are likely to move in the coming years. Fig. 1 below shows the current Fed dot plot, which indicates that the median interest rate projections will rise from 1.375% in 2017 to 2.125% in 2018, 2.6875% in 2019 before finally peaking at 3.0625% in 2020. Having said that, do note that these are just projections by individual US Fed governors. The actual interest rates may differ from the projections depending on how strong the economy is in the coming years.

Fig. 1: US Fed Dot Plot

Given the rise in interest rates over the next 3 years, it makes sense to fix the interest rates for 3 years. However, on the other hand, a 3-year fixed interest rate package is naturally more expensive than a 2-year package, since banks bear the risks of interest rates rising rapidly. Using the bank that we chose as an example, the interest rates for a 2-year and 3-year package are as follows:

	2-Year	3-Year
Year 1	1.48%	1.68%
Year 2	1.48%	1.68%
Year 3	15M FD+1.43%	1.68%
Afterwards	15M FD+1.43%	15M FD+1.55%

As shown above, not only is the fixed portion of the interest rates higher, the margin for the floating portion of the interest rates is also higher (note: not all loan packages are as such). For a $650,000 loan over a 25-year tenure, we will end up paying $11,867 more in total interest if we were to select the 3-year loan package. That is equivalent to an extra interest of 1.83% on the $650,000 loan. For the 2-year loan package to be more expensive than the 3-year loan package, the 15-month Fixed Deposit (15M FD) rate, which is currently 0.25%, has to reach close to 2.0%.

We decided on the 2-year loan package. In the event interest rates continue to rise, we can choose to re-finance and fix the interest rates when the lock-in period expires. If conditions permit at that time, we might also choose to pay down some of the loan.

Step 3: Peg to Which Base Interest Rate

As discussed above, we selected a loan package that is pegged to the fixed deposit rates. Fixed deposit rates are actually board rates set by individual banks and are therefore less transparent compared to SIBOR and SOR, which are set collectively by a group of banks. The conventional wisdom is that if banks were to raise their fixed deposit rates to earn more interest on the loans, they would also have to pay more interest on the fixed deposits. Hence, banks are less likely to raise fixed deposit interest rates. However, the reality is that 98% of local banks' deposits have maturity of less than 1 year. Raising the interest rates on fixed deposits of more than 1 year maturity will not hurt them. See Behind Fixed Deposit Home Loan Rates for more info.

On the other hand, although SIBOR and SOR are more transparent, they are more volatile compared to fixed deposit rates. The shorter the SIBOR/ SOR tenure (i.e. 1-month vs 3-month SIBOR/ SOR), the more volatile the rates are. Also, between SIBOR and SOR, SOR is affected by the USD/SGD exchange rate and therefore fluctuates more than SIBOR. See Why Singapore Interest Rates Might Rise Faster than Expected for more info.

Comparing between the transparency of SIBOR/ SOR loan packages and the stability of fixed deposit loan packages, we went for stability as they provide greater visibility on the amount we have to pay every month, which helps us in planning other expenses.

Conclusion

There is a large variety of housing loan packages. It can get overwhelming at times, especially since you have to decide on a loan package quickly after you sign the option to purchase the property. Choosing the right loan package can save you some money and offer greater visibility in later years.


See related blog posts:

• Behind Fixed Deposit Home Loan Rates
• Why Singapore Interest Rates Might Rise Faster than Expected
• Housing Loan Servicing – Cash or CPF?

How to Avoid Cleaning Out Your CPF Balance When Taking HDB Loan

When you apply for a loan from HDB to buy a flat, it will take all the money from your CPF Ordinary Account (OA) before giving you the loan. This is to reduce the loan amount that you need to service. If you wish to avoid an empty OA account, you can temporarily transfer some of your OA balance out of CPF before you apply for the HDB loan. The pros and cons for either approach are discussed in Clean Out CPF Balance When Taking HDB Housing Loan?

A reader recently asked me how to temporarily transfer some of the OA balance out of CPF. Note that I am not encouraging you to do it, but if you have a real need for keeping some money in the OA to meet future financial obligations such as buying/ servicing insurance policies or financing your family members' tertiary education, below is one approach for doing it.

The approach I used is to invest in some safe investment instruments. As the objective is to temporarily park the cash outside of OA, the overriding principles are safety and liquidity of the investment. As there is a foreseeable use for the money in the future, it is of utmost importance that most of the money can be returned to your CPF account subsequently. Making a positive return on the money, although welcomed, is not crucial. Secondly, you also do not wish for your money to be locked-in in that investment for longer than is necessary. Typically, the aim is to withdraw the money 1 month before the HDB appointment date and return it 1 month after the HDB appointment, making it approximately 2-3 months of investment period. The longer the money is invested, the higher is the risk.

The instruments that you can invest 100% of your OA balance (note: you cannot invest the first $20,000 of the OA balance) are fixed deposits, government bonds, statutory board bonds, some insurance products and unit trusts. I chose short-term government bonds known as Singapore Government Securities (SGS). They have no credit risks and foreign exchange risks and have local banks providing liquidity as secondary traders. However, SGS are extremely difficult to trade. Before they were listed on the Singapore Exchange, I could only trade them by making a visit to the banks. Staff at the local bank branches practically never heard of them and had to consult their Treasury department at the headquarters every time I traded SGS. Moreover, bond trading is very different from share trading. There is the concept of clean price and dirty price. Clean price is the price that you see quoted on the market. Dirty price is clean price + accrued interest and is the price that you actually pay. It is complex enough, right? For this reason, I would not encourage this approach.

The simpler approach is to buy unit trusts that have the lowest risks and are eligible for CPF-OA investment. Suitable unit trusts are those that invest in (1) bonds, that are (2) short-term, (3) issued in Singapore dollars, and preferably (4) by the government. Bonds will reduce the price volatility compared to shares. Short-term (or short-duration) bonds will minimise the risk of interest rate going up and leading to a drop in bond prices. Bonds denominated in Singapore dollar will eliminate foreign exchange risks, and government bonds will avoid the risk of companies going belly-up. It is probably difficult to find a unit trust that invests in Singapore government bonds solely, so the next best is to have a mix of government and corporate bonds. Since most unit trusts invest in a lot of bonds, the risk of any one company going belly-up and affecting the price of the unit trust significantly is usually small. A good resource for finding suitable bond unit trusts is Fundsupermart.

So, after you have invested in the unit trust, complete the appointment with HDB, and 1 month later, after you have confirmed that HDB has completed its work, sell the unit trust and return the money back to your CPF account.

Lastly, please note that no investment is 100% capital guaranteed. There will be some transaction costs from buying and selling. And if interest rate rises during this period, some capital loss is unavoidable. But by choosing unit trusts that invest in short-term Singapore dollar denominated bonds, the risks are minimised.

See related blog posts:

• Clean Out CPF Balance When Taking HDB Housing Loan?
• Housing Loan Servicing – Cash or CPF?
• Is CPF Accrued Interest Double Counting of Housing Loan Interest?

Behind Fixed Deposit Home Loan Rates

Fixed Deposit Home Rate (FHR) loans are loans with interest rates tied to fixed deposit interest rates. Recently, such loans have become quite popular among property owners looking to finance their properties. They like such loans because the interest rates are much more stable than those of the Singapore Interbank Offered Rate (SIBOR) loans. In addition, it is perceived that if banks were to raise the FHR rates, they would also incur higher interest costs for their source of funds, thus making such moves unlikely. However, is that really the case?

Currently, the FHR loans available in the market are DBS' 18-month FHR and OCBC's 36-month FHR loans. The figure below shows the breakdown of bank deposits by maturity, using OCBC's latest financial statements, which have a more detailed breakdown of bank deposits than DBS'.

Fig. 1: Bank Deposits by Maturity

As shown above, a great majority of bank deposits have maturity of less than 1 year. Deposits with maturity of 1-3 years, which form the basis of FHR loans, constitutes only 1% of all bank deposits. Thus, by tying FHR rates to that of fixed deposits with maturity greater than 1 year, banks will actually not feel the pinch should they raise the FHR rates. 

The reason for the short maturity of bank deposits is shown in Fig. 2 below.

Fig. 2: Bank Deposits by Type

Among the bank deposits, current accounts constitute 31% of all deposits while savings deposits constitute another 18%. Together, such short-term on-demand deposits make up 49% of all bank deposits. Fixed deposits constitute 43% while other types of deposits make up the remaining 8%. Thus, although fixed deposits represent the largest source of funds for the banks, they do not form the bulk of the funds.

In conclusion, banks still come up tops by offering home loans with rates that are tied to fixed deposit rates.

See related blog posts:

• Why Singapore Interest Rates Might Rise Faster than Expected
• Is CPF Accrued Interest Double Counting of Housing Loan Interest?
• How To Select a Housing Loan Package

Is CPF Accrued Interest Double Counting of Housing Loan Interest?

This question has baffled me for quite a long time. When you use your CPF money to service your housing loan, CPF will compute accrued interest on the amount you withdraw from CPF until you sell the house. The accrued interest reflects the amount of interest you would get in your CPF account had you not used it to service the loan. When you sell the house, the principal and accrued interest have to be returned to CPF. This raises several other related questions – should accrued interest affects the attractiveness of the housing purchase and is better to use CPF or cash to service the housing loan?

To better appreciate and answer these questions, it is best to consider a typical scenario and leave CPF out of the picture for the time being. Let us assume that you intend to purchase a HDB flat for $500K. HDB agrees to loan you 90% of the purchase price. You will need to fork out the remaining 10% as downpayment. However, your kind-hearted parents, who have been working for several years and have accumulated some savings, willingly offer to pay the downpayment for you. You relunctantly agree, promising to pay them interest for the money loaned so that they could have sufficient money for their retirement. Thus, HDB pays 90% of the purchase price while your kind-hearted parents fork out the remaining 10% and you do not need to pay a single cent.

The HDB loan is a formal loan which requires monthly repayment, whereas the loan from your parents is an informal one which does not have any fixed payment terms, except for your promise to return the full amount borrowed plus accrued interest to them when you sell the house. Each month, you have to make repayment to HDB to pay down the formal loan. Again, your kind-hearted parents offer to service the monthly repayment so that you do not need to fork out a single cent every month. Thus, over time, as you pay down the HDB formal loan, you borrow more and more informal loan from your parents, with accrued interest growing increasingly with time and size of the informal loan. When you have fully paid off the HDB formal loan, you no longer need to borrow additional money from your parents, but the accrued interest continues to accumulate, until you sell off your house.

Assume further that you sell off the house for $1 million and the principal borrowed from your parents plus accrued interest amounts to $800K. As promised, you return $800K to your parents and retain the remaining $200K. Your kind-hearted parents accept the money, but assure you that whatever money they have will eventually belong to you as inheritance. Thus, it does not really matter whether you return $800K or $600K to them, because you will eventually get the full $1 million. 

Now, kind-hearted parents tend to have kind-hearted children. Assume that you decide to use a generous interest rate to compute the accrued interest such that the principal plus accrued interest amounts to $1.2 million. As this exceeds the sales proceeds from the house, you will return the full $1 million to your parents and get nothing. Your parents do not require you to cough up the remaining $200K owed to them. From your perspective, this looks like a "lousy" investment as you end up losing $200K on the housing purchase. However, can this really be considered a lousy investment, since the house doubles in value from $500K to $1 million? The computation of accrued interest merely affects how the sales proceeds are distributed to your parents and yourself. Considering that you will eventually get back the full $1 million, the accrued interest does not affect the attractiveness of the housing purchase.

Now, let us suppose from the beginning that you actually have some cash and do not need to rely on your parents' savings to service the downpayment and/or monthly repayment. Which of these would be a better option to service the loan – using your cash or your parents' savings? It all depends on who can grow the money at a higher rate. If you are able to invest your cash at a higher rate of return than your parents, then it is better to use your parents' savings to service the loan. Conversely, if your cash is left in the bank earning 0.05% interest rate while your parents' savings are able to grow at 2.5% annually, then it is better to use your cash to service the loan. 

We have come to the end of the story. Now, please replace the kind-hearted parents in the story above with your own CPF savings. It becomes a whole lot clearer what the CPF accrued interest is all about and whether it affects the investment and financing decisions. To summarise,

• CPF accrued interest arises because you are taking out a second, informal loan from your CPF account to service the downpayment and/or monthly repayment so that you do not need to draw down your cash. It is not double counting of interest on your formal housing loan.
• Computation of CPF accrued interest and return of principal plus accrued interest after the sale of the house merely affects the distribution of the sales proceeds between your CPF account and yourself. It does not affect the attractiveness of the housing purchase. The key interest rate that affects the investment decision is the housing loan interest rate, not the CPF interest rate used to compute the accrued interest. 
• Whether to use CPF or cash to service the housing loan depends on their relative rates of return. Use the one with the lower rate of return to service the loan.

By the way, topping up your and/or your family members' CPF accounts with cash allow you to enjoy income tax reliefs of up to $7,000 (top-up for yourself) + $7,000 (top-up for family members) next year. If you have not done so, please hurry, before the year ends!

See related blog posts:

• Housing Loan Servicing – Cash or CPF?
• Clean Out CPF Balance When Taking HDB Housing Loan?
• How to Avoid Cleaning Out Your CPF Balance When Taking HDB Loan

Stretch Loan & Invest the Rest

You probably have heard of the phrase "buy term and invest the rest". It means to buy a term insurance instead of a whole life insurance and use the savings in insurance premiums for investment. Can this advice be applied to loans as well? Meaning, instead of paying off your loan over a short period of time, you stretch your loan over a longer period and use the reduction in loan repayments for investment.

Let us consider the following scenarios:

Loan
Loan Principal	$400,000
Loan Interest Rate	2.60%
Loan Tenure (Short)	15 years
Loan Tenure (Long)	30 years
Yearly payment (Short)	$  32,545
Yearly payment (Long)	$  19,367
Investment
Yearly Available Sum	$  32,545
Yearly Rate of Return	7.00%

The loan principal is $400,000. You have a sum of $32,545 yearly which can be used to either service the loan or invest in a portfolio of stocks and bonds. The loan interest rate is 2.6% while a balanced portfolio of 50% stocks and 50% bonds can return 7.0% each year on average. You can choose a short loan tenure of 15 years, in which you will pay off the loan in 15 years, after which you can channel all the money to investment for the next 15 years. Alternatively, you can choose a long loan tenure of 30 years, in which you channel $19,367 to service the loan and the remaining $13,178 to investment every year for 30 years. Which option would be better for you? The figure below shows the loan and investment amount for the 2 options.

Loan & Investment Amount for 2 Loan Tenures

As discussed earlier, the shorter loan gets paid off earlier by Year 15, whereas the longer loan is only paid off after Year 30. However, the investment amount only grows to $818,000 at Year 30 for the shorter loan option, compared to $1.24 million for the longer loan option. In terms of the total loan interest payable, the shorter loan incurs a smaller interest of $88,000 whereas the longer loan incurs a larger interest of $181,000, which is nearly $100,000 more than the shorter loan. This means that there is nearly $100,000 less available for investment. Yet, due to the longer period of compounding, the longer loan option is able to generate $849,000 in investment gains, as compared to $330,000 for the shorter loan option. This example shows that the time period available for the investment to compound can be more important than the amount of money available for investment.

From another perspective, the servicing of loan can be considered a form of investment. The "return" from this "investment" is the loan interest rate, which at 2.6% is lower than the 7.0% return available from the balanced portfolio of stocks and bonds. Hence, it is more beneficial to channel most of the money to the investment with higher returns, which is the balanced portfolio. Conversely, if the rate of return from the balanced portfolio is lower than the loan interest rate, then it is better to channel most of the money to pay off the loan as soon as possible. In essence, loans and investments are 2 sides of the same coin and should be assessed in the same manner.

See related blog posts:

• Housing Loan Servicing – Cash or CPF?
• Clean Out CPF Balance When Taking HDB Housing Loan?
• Is CPF Accrued Interest Double Counting of Housing Loan Interest?

Why Singapore Interest Rates Might Rise Faster than Expected

Beginning this year, a friend asked me what I thought about interest rates. My reply was it should not exceed 1% this year and 2% next year. Of course, I was referring to the US federal fund rate instead of Singapore housing loan rates. Still, when the Singapore Interbank Offered Rate (SIBOR) shot up to 1% in Mar, I was quite surprised. Now, I think I know the reason why.

Before explaining the reason, let us first understand the basics of Singapore housing loan rates. There are 2 ways of getting a SGD loan. The first and most straightforward way is to borrow in SGD and repay in SGD. This is the basis for SIBOR loans. The bank that loans you the money will borrow from other local banks at the SIBOR rate and loan you the money with a spread above SIBOR, e.g. SIBOR + 0.75%. The alternative way is to borrow in a foreign currency, say, USD and convert it into SGD. When the loan is due, convert the repayment from SGD into USD and settle the loan which is actually denominated in USD. This is the basis for Swap Offer Rate (SOR) loans. The bank that loans you the money will do the borrowing in USD and conversion into SGD (and the reverse path) for you, so you will only see the middle portion in which you borrow from and repay to the bank in SGD. As there is conversion between currencies, there is forex risk involved in such loans. If USD were to rise against SGD when the loan is due, more SGD is needed to repay the USD-denominated loan. The bank will hedge this currency risk at the point of initiating the USD-denominated loan by buying USD in advance through a currency forward. The cost of converting between the currencies is included into the interest rate known as SOR. Thus, SOR includes the USD interest rate and a currency factor. The general formula for computing SOR is as follow:

The precise formula for computing SOR, which takes into account different loan tenures, by the Association of Banks in Singapore can be found in this link.

Usually, the tenure of the USD-denominated loan is a short one, ranging from 1 month to 6 months. At the end of the loan tenure, the bank will repay the original loan and initiate a new loan at new interest rate and new currency forward rate, so the roll-over is transparent to borrowers. The term 1-/ 3- /6-month SOR refers to the tenure of the USD-denominated loan and reflects how frequently the SOR will vary. Generally, the SOR for longer tenure will be higher than that for shorter tenure, to reflect the greater uncertainty in credit risks and forex rates. Also, since forex rates are volatile, SOR tends to be more volatile than SIBOR and the shorter the tenure, the more volatile is the SOR.

While it appears that SIBOR is not affected by forex rates, capital flows freely in and out of Singapore. Just as a Singapore borrower can borrow money in USD, a US borrower can also borrow money in SGD at SIBOR-pegged rate and convert to USD if SIBOR is much lower than SOR. Eventually, both SIBOR and SOR must converge for capital flows to be in equilibrium. Thus, both SIBOR and SOR will move in tandem with each other.

Having understood the workings of SIBOR and SOR, we can go on and discuss the recent movement of SIBOR and SOR. Since SOR is directly affected by forex rates, a rising USD against SGD will lead to higher SOR (and SIBOR). The figure below shows the movement of USD against SGD (orange line) since mid last year. 

USD Movement against SGD (orange line)

As shown in the figure, USD has risen by nearly 7% against SGD, with a small spike in Mar. This coincided with the spike in SOR and SIBOR in Mar. USD has since retreated slightly, which is again reflected in the slightly lower SOR and SIBOR after Mar. See the figure below from HousingLoanSG.com on SOR and SIBOR movements.

SIBOR/SOR Rate Movements

Moving forward, USD is likely to keep on rising against major international currencies as discussed in Getting Ready for US Interest Rate Rises. On the other hand, SGD cannot rise too much against regional currencies to avoid losing competitiveness. This means that SIBOR and SOR are likely to rise faster than the US federal funds rate. Add on to the fact that the federal funds rate is likely to start increasing in Sep or Dec, it can only mean that SIBOR and SOR will rise further.

See related blog posts:

• Getting Ready for US Interest Rate Rises
• Behind Fixed Deposit Home Loan Rates
• How To Select a Housing Loan Package

Clean Out CPF Balance When Taking HDB Housing Loan?

When you take a housing loan from HDB, it will take all the money in your CPF Ordinary Account (OA) before giving you the loan. This is to reduce the loan quantum that you need to service. To avoid having an empty OA account, you'll need to transfer some or all of the OA balance to somewhere else before you apply for the loan. One way is to invest in some bond or money-market unit trusts that will not drop too much in value while you're holding them. But the key question is, do you want to leave some money in your OA account or clean it out? It depends on whether you have any need for the OA money in the future and your risk preference.

There actually isn't a lot of approved uses for the OA money. Besides building up your retirement nest egg, you can buy properties, service insurance policies, invest in stocks and unit trusts and finance your family members' tertiary education. If you foresee that you need to use the OA money for such needs in the short- and long-term, then it's better to keep some money in the OA. This is because if you have an empty OA account, it'll take a fairly long period of time to build it up again as the monthly loan repayment will take a portion of your monthly CPF contributions. In any case, assuming you keep some money in the OA but later find that you have no other need for it, you can always make a lump sum repayment to reduce the loan quantum.

The second factor that you need to consider is your risk preference. Do you prefer a bigger debt burden (and bigger OA balance) or a near-empty OA balance (but smaller debt burden)? Some people will prefer to have a smaller debt burden so as to reduce the amount of interest payable over the loan tenure and/or to become debt-free earlier. Personally, I prefer to have a bigger OA balance. The main reason is it takes a long time to build up the OA balance when you start to service the loan as explained earlier. If, for some reasons, you are in between jobs for several months, the OA balance will quickly become insufficient to service the monthly repayment and you might risk losing your flat (I understand HDB is quite forgiving if you miss a few monthly payments, but the risk exists). Not only that, you might also default on other financial commitments such as insurance premiums, risking your insurance coverage as well. For this reason, I prefer to live with a bigger debt burden than to risk a snowball default. Of course, you can always make up any shortfall with cash, but it would be a constant worry over the low OA balance.

It also helps that the HDB loan interest is only 0.1% higher than the OA interest rate. At 0.1%, you pay an extra $100 for every $100,000 in your OA balance that is not being used to repay the loan. Over a 25-year loan tenure, this works out to be $3,112. This extra payment is like insurance premium, to guard against a snowball default and constant worry over the low OA balance. Not only that, you get to save the money for some other uses in the future and have the flexibility of making a lump sum repayment. And if you manage to invest the OA money at a rate higher than the loan interest, you get to grow a bigger retirement nest egg as well!

See related blog posts:

• How to Avoid Cleaning Out Your CPF Balance When Taking HDB Loan
• Housing Loan Servicing - Cash or CPF?
• Is CPF Accrued Interest Double Counting of Housing Loan Interest?

Housing Loan Servicing – Cash or CPF?

Should you use cash or CPF to service your housing loan? Most people would use CPF, so as to conserve the cash for other purposes. Moreover, CPF money is considered as being "locked up", so you cannot use it for most other purposes. However, if you have the cash, does it make financial sense to service the housing loan using cash?

The main argument for using cash to service the housing loan is because interest rates for cash savings are so low, at around 0.05%, whereas the interest rate for CPF Ordinary Account (OA) is at 2.5%. By using cash to service the loan and keeping CPF untouched, effectively, you gain 2.45% on the loan repayment annually. Considering the effect of compounding over time, this can add up to quite a bit of money over the length of the loan tenure.

Besides these 2 options, there is a middle option, which is to service the loan using CPF and top-up the CPF using cash. Effectively, you are servicing the loan using both cash and CPF. (Note: the cash top-up into CPF goes into the Special Account (SA). When the upper limit for SA is reached, the balance will overflow into OA that is used to service the loan. But when the limit is reached, it also means that no further top-ups are allowed under the Minimum Sum Scheme). When you top-up CPF using cash, you can also claim for tax deduction for up to $7,000. If your marginal tax bracket is 7%, that means a tax savings of $490 annually. That can also add up to quite a bit of money over time. So, the question is which option makes the most financial sense -- servicing the loan using cash, CPF or CPF top-up?

To answer this question, let's consider the following scenario:

Loan Details
Loan Principal	$200,000
Loan Tenure	25 years
Loan Interest Rate	2.60%
Annual Loan Repayment	$  10,980
Income Details
Annual Income	$  60,000
CPF	$  12,000
Annual Taxable Income	$  48,000
Annual Income Tax	$    1,110
Cash	$  46,890
CPF Top-up	$    7,000
Cash Interest Rate	0.05%
CPF Interest Rate	2.50%

Let's further assume that all the cash earned is not spent but saved in the bank. At the end of the 25-year loan tenure, the total amount of cash + CPF for the 3 options are as follows: 

	Using Cash		Using CPF		CPF Top-Up
Year	Cash Bal	CPF Bal	Cash Bal	CPF Bal	Cash Bal	CPF Bal
0	$             -	$             -	$             -	$             -	$             -	$             -
1	$      35,910	$      12,000	$      46,890	$        1,020	$      40,380	$        8,020
2	$      71,838	$      24,300	$      93,803	$        2,066	$      80,780	$      16,241
3	$     107,785	$      36,908	$     140,740	$        3,138	$     121,201	$      24,667
4	$     143,749	$      49,830	$     187,701	$        4,237	$     161,641	$      33,304
5	$     179,731	$      63,076	$     234,685	$        5,363	$     202,102	$      42,157
6	$     215,731	$      76,653	$     281,692	$        6,517	$     242,583	$      51,231
7	$     251,749	$      90,569	$     328,723	$        7,700	$     283,084	$      60,532
8	$     287,785	$     104,833	$     375,777	$        8,913	$     323,606	$      70,066
9	$     323,840	$     119,454	$     422,855	$      10,156	$     364,148	$      79,838
10	$     359,912	$     134,441	$     469,956	$      11,430	$     404,710	$      89,854
11	$     396,002	$     149,802	$     517,081	$      12,736	$     445,292	$     100,121
12	$     432,110	$     165,547	$     564,230	$      14,075	$     485,895	$     110,644
13	$     468,237	$     181,685	$     611,402	$      15,447	$     526,518	$     121,430
14	$     504,381	$     198,227	$     658,598	$      16,854	$     567,161	$     132,486
15	$     540,543	$     215,183	$     705,817	$      18,295	$     607,825	$     143,819
16	$     576,724	$     232,563	$     753,060	$      19,773	$     648,508	$     155,435
17	$     612,923	$     250,377	$     800,327	$      21,288	$     689,213	$     167,341
18	$     649,139	$     268,636	$     847,617	$      22,840	$     729,937	$     179,545
19	$     685,374	$     287,352	$     894,930	$      24,431	$     770,682	$     192,053
20	$     721,627	$     306,536	$     942,268	$      26,062	$     811,448	$     204,875
21	$     757,898	$     326,199	$     989,629	$      27,734	$     852,233	$     218,017
22	$     794,187	$     346,354	$  1,037,014	$      29,448	$     893,039	$     231,488
23	$     830,495	$     367,013	$  1,084,422	$      31,204	$     933,866	$     245,295
24	$     866,820	$     388,188	$  1,131,855	$      33,005	$     974,713	$     259,448
25	$     903,164	$     409,893	$  1,179,311	$      34,850	$  1,015,580	$     273,954
Cash + CPF	$1,313,057		$1,214,161		$1,289,535

As shown in the scenario above, using cash to service the loan is still the best option. Using only CPF to service the loan is always the worst option because of the higher CPF interest rate. Although the CPF top-up option generates tax savings, the amount of tax savings is insufficient to compensate for the loss in interest for keeping as much money in the CPF as possible.

There could be other scenarios in which the CPF top-up option might be better than the cash option. Some of the factors that could affect the outcome are as follows:

• Cash interest rate versus CPF interest rate. By design, the CPF interest rate will always be higher than the cash interest rate. The higher the CPF interest rate relative to the cash interest rate, the more beneficial it is to keep as much money in the CPF as possible. But when the cash and CPF interest rates are close to each other, the tax savings from CPF top-ups will make this the best option.
• Amount of CPF top-up versus CPF draw-down for loan repayment. In the scenario above, the amount of CPF top-up is $7,000 while the amount of CPF draw-down to service the loan is about $11,000. Hence, $7,000 of the loan repayment is serviced by the cash top-up into CPF while $4,000 is serviced by money originally in the CPF. Over the loan tenure of 25 years, the tax savings from CPF top-ups is insufficient to compensate for the loss in net interest from a smaller CPF balance. If the amount of CPF top-up and draw-down is close to each other, the tax savings from CPF top-ups will make this option the best one.
• Loan tenure. As explained above, the longer the loan tenure, the larger is the compounding effect of the higher CPF interest rate.
• Marginal tax bracket. In theory, the higher the marginal tax bracket, the greater the amount of tax savings from CPF top-ups. However, you will need a really high income for the tax savings to outweigh the loss in net interest and the effects of compounding.

In conclusion, based on the current interest rates and policies, using cash to service the housing loan usually makes the most financial sense. Nevertheless, servicing the loan using CPF and topping-up the CPF using cash provides greater flexibility in the future when interest rates and policies might change.


See related blog posts:

• Clean Out CPF Balance When Taking HDB Housing Loan?
• Is CPF Accrued Interest Double Counting of Housing Loan Interest?
• Stretch Loan & Invest the Rest