Since young, the media has always espoused the virtues of being debt free. Most likened taking up debt to burning cash for interest expenses. Contrary to what the media is suggesting, taking on debt can be a good thing.
The truth is, taking on a shorter mortgage or paying more than the minimum is probably one of the riskiest things you can do for your finances. The more you pay the bank, the more risk you create for yourself by putting your cash into an illiquid asset like property. Let me explain why.
Let me share with you a case study.
James and Andy own two distinct condo apartments next to each other that cost the same.
James has a shorter mortgage term and makes extra payments whenever he can. He hates debt and is trying his best to pay off his mortgage early.
Andy just pays off his minimum mortgage obligation with no amount extra.
Looking at these two individuals, one would suggest James is making the wiser financial decision than Andy since James is likely to incur much lesser interest expense.
Looking from the bank’s perspective, who do you think the bank will benefit the most from in the event of a foreclosure?
It is James! Why? In the event of a mortgage default, banks are more incentivized to take James’s apartment.
The reason is that James has less unpaid debt. As a result, the banks can recover their owed mortgage regardless of the selling price.
For Andy’s house, the bank has more “skin in the game” because of the larger amount of unpaid mortgage owed. The mortgagee bank will need to put up the property for auction with a higher reserve price to recover the debt owed to it.
In the end, it still left both James and Andy without a home.
In another example.
John and Jane are married, they got their BTO flat and they are looking forward to starting their family in their new home.
They have 2 children and they are thinking of finishing their mortgage obligation by paying down their HDB loan within 5 years.
Assuming they are taking a HDB loan with 90% loan to value. Their home cost $450K. In order to complete their mortgage obligations, they will need to pay approximately up to $7,200 per month.
However, in the 2nd year of completing their mortgage obligation, John was involved in a fatal accident on his way home.
What most people don’t realize is that if you are using your CPF savings to pay for their monthly housing loan instalments, it is a must for you to be insured under Home Protection Scheme (HPS).
In this situation, there will be zero payouts from HPS since there is no outstanding mortgage payment.
The money that Jane could have used to raise their 2 kids are stuck in an illiquid property asset. The only way they could use the cash is when Jane sells their matrimonial house.
If John and Jane had decided to just repay the minimum monthly mortgage obligation, John could have left Jane with a fully paid home using the payout from HPS and have over $300K cash savings to tide them through this tough time.
The truth is, case study 2 is not just a hypothetical situation. I personally witnessed this kind of situation happening during my time in the real estate industry.
This is also one of the main reason why I decided to start this blog, which is to bring about greater awareness to my readers.
Don’t get me wrong! I’m not against paying off your mortgage early. I’m simply advocating for a different method, one that doesn’t leave your money sitting in an illiquid asset like property.
You can choose to save the money on the side (preferably in a high-interest rate account that isn’t tied to anything volatile).
One example, you can also contribute your money towards Singapore Government Savings Bond. This will allow you to gain interest income without risking your principal. You would’ve ended up having more options and control over your finances.
If necessary, you could’ve redeemed your government savings bond and paid off his mortgage in one fell swoop. In the event of financial hardship, you can withdraw your cash savings and continue to pay off your monthly mortgage obligation. You can keep remaining money for other uses.
The key thing is that you will not risk default and foreclosure.
The concept at heart is all about managing risk.
When it comes to mortgages, people think that all debts are bad and seek to minimise paying unnecessary interest to the bank.
In my opinion, paying additional cash in an illiquid asset class like property is riskier.
You can consider investing your money in a strong dividend paying stocks or REITS that provide you with dividends that can outpace the rate of the current mortgage interest.
I don’t deny that some might think that investing is riskier. Which leads to my next follow up question.
When it comes to financial hardship, which one will you liquidate first to tide you over?
I think most will rather choose to retain their home and liquidate their investments.
Ask yourself if you have the financial will and discipline to invest the surplus cash into other assets? It is important that you make your money work for you at a rate that outpaces the mortgage interest rate.
If the answer is no, then you are probably better off just paying off your debt early and minimise the interest expense. If you decide to pay off your mortgage debt early, then it is recommended that you keep sufficient cash to cover 6 months of your expenses. This is to cover any unforeseeable financial hardship because of illness or economic downturn.
Set up a separate account to capture the cash you would typically use to extra to the loan. It can be another joint savings account, so long as it’s not commingled with your other funds. The key is to prevent you from accidentally spending it. Have this money drawn into the new account automatically.
The general guideline is to prioritise on your principal liquidity. What this means is that you should look at interest generating assets that allow you to liquidate your initial principal with minimal penalty.
For endowment policy, they rarely provide the best return during the first few years because of the early surrender penalty clause.
However, if you have a longer investment timeline, an endowment policy can provide a reasonable rate of return and provide additional death protection safeguard.
For people who are considering putting their money in SRS, you need to be mindful that while putting money in SRS grants you tax relief, any early withdrawal will incur a 5% penalty and 100% of the withdrawal before 62 will be taxed.
If you’re trying to pay off your mortgage early, the worst thing you can do is give the bank extra. It puts you at risk. When you need access to that cash, it’s now the bank that controls the money, not you.
Using the 3 steps I’ve laid out, I hope you can now learn how to maintain control of your money, keep your options open, maximize your tax savings, and pay off your home faster and safer.
As a realtor working in a continuously changing economic landscape, it is increasingly important to advise my clients beyond transactions. Every client’s financial situation is unique, there is no one size fits all solution for every case. As a realtor myself, my job goes beyond transactions, it is important to go beyond my duties and assist my clients to seek the best outcome possible beyond property-related matters.
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