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.
Hi Zod,
ReplyDeleteThe difference is $5,042 to the advantage of the shorter loan option. If the investment return is lower than the loan interest rate, then it is better to pay off the loan as soon as possible. Nevertheless, there are other considerations in which you might want to keep some money in CPF instead of paying off the loan. You can refer to Clean Out CPF Balance When Taking HDB Housing Loan? for some of these considerations.
Up to 361,000 have lost their money. This is not a small number of people and they were investing in supposedly "less risky" stocks. The recent KIT pref shares were not even qualified for CPFIS.
ReplyDeleteToo many CPF members feel 2.5% is a low investment return to beat and they may also think that their investing mind is strong enough to hold bleeding stocks.
Once they started having nightmares; the only medicine to cure them of these nightmares is sell. No?
Read? 361K CPF members lost their hard earned saving!
Noted your point. I agree that not everyone can invest for the long term and generate returns higher than the loan interest rate. They would be better off paying off the loan as soon as possible and/or leave the money in CPF.
DeleteMy loan has 30 yr repayment period. Figured 0.1% was worth paying for the flexibility, in case I wanna buy STI ETF via CPFIS. With extra 1% interest for first $20k, added bonus!
ReplyDeleteRegards,
Turtle Investor
I have the same thinking as you. But I forgot that there's extra 1% for the first $20K. That makes the CPF interest rate higher than the loan interest rate for Ordinary Account balances less than $200K. Thks for highlighting!
DeleteHi Chin Wai
ReplyDeleteThe basis is true if that's the case but debt interest is usually fixed while investment returns are usually not, not unless we are talking about specific govt rated triple A ratings bond :)
Hi B,
DeleteIn the short term, investment returns may underperform the loan interest rate, but in the long term, they will revert to the mean. So the longer loan option should be quite safe for periods above 20 years.
I'd love this scenario in Germany, where it is quite common to fix your home loan interest rate for 15, 20 or 30 years. The customer chooses.
ReplyDeleteI have not found such an option here in Singapore though, where banks do offer maximum 3 years fixed.
In the present interest rate environment where the only way is up (the rates could hardly drop below 0%, but then you never know), the 2.6% average for the 30 year period is quite "ambitious". For such a long loan tenure it would be more prudent to take the mean housing loan rate of Singapore which I reckon is more in the range of 4 to 5% (8+% in the 90s).
And then the question everyone has to answer for themselves is: Are you emotionally disciplined enough to keep up your regular investment plan month by month, rain or shine for the next 30 years and at the same time can you resist the temptation to use the investment for other purposes like a new car, a nice holiday, or ... If your answers are yes, then this is a viable option to grow your nest egg.
Always remember when taking up a loan the magic of compounding works against you. Guaranteed.
A 15 year mortgage on your home is only a little more costly per month than a 30 year mortgage. The difference in the cost of the total interest you pay is enormous ($93,000 in the above scenario assuming 2.6% fixed throughout).
Before signing on the dotted line everyone should punch in the numbers into an online calculator to see the difference first.
I agree with you that this option is only viable for those who are disciplined enough to invest regularly. Also agree with you that everybody should understand the numbers thoroughly before committing to this approach.
Delete