With mortgage rates staying high in 2023, should you pay down your home loan?

With home loan rates now above the 2.5% CPF savings rate, does it make sense to make a prepayment?

Jan 30, 2023

WE get asked this question on mortgage prepayment ever so often with mortgage interest rates now shooting over the 4 per cent roof here in Singapore.

The question is especially pertinent for those who have been diligently servicing their monthly repayments using cash, and stashing away their Central Provident Fund (CPF) savings to earn compounding interest at 2.5 per cent for retirement. Now that mortgage rates are way above this 2.5 per cent CPF OA (Ordinary Account) savings rate, does it still make sense to do that?

The natural tendency for home-owners is to prepay and reduce their outstanding mortgages quickly, especially when we’re facing a cost-of-living crisis with raging inflation. However, you might want to take a step back and ask yourself: how long are interest rates going to stay up?

The best way to explain this is to with a chicken-and-egg story:

A farmer has 50 chickens which lay 50 eggs daily. To make more money, he decides to buy a second farm that comes with 100 chickens – but he needs to borrow from the bank, which asks for 25 eggs per day as “interest”. He pays them off with the 25 eggs, leaving him with 75 + 50 = 125 eggs each day to sell for a profit. Everyone is happy.

Next year, global inflation results in eggs selling for more, which means more profit for the farmer. But the bank says they also require more eggs now as interest, and asks for double or 50 eggs per day – or for him to give them 50 chickens instead to “repay the loan”, after which he can then have the whole farm to himself. Angered by the greed, the farmer decides to give his own 50 chickens to redeem this loan.

How many eggs does he end up with per day now?

Whether he repays the loan or not, he has the same 100 eggs per day. The difference is: had he kept his own 50 chickens, he would have maximum output from a larger pool of 150 chickens. In the next year, the bank could have dropped the interest payment back to 25 eggs, or he could have also hatched some eggs into chickens to repay the loan later. By redeeming his loan now, his return or production capacity is now capped at only 100 eggs per day.

Of course, living within your means or staying relatively debt-free is espoused as a virtue, especially in Asia. It is also a subjective matter where the preference to take on more or less debt varies with age, so there’s really no right answer here. However, prepaying down your mortgage does come with opportunity costs or “reduced capacity” like in the case of the farmer.

There are three possible scenarios to consider before doing a prepayment, partial or full.

Scenario 1: Make money using Other People’s Money

In short, leverage. And if you think about it, secured lending on a property is the best form of leverage you could ever get, as it comes with the lowest interest and, as long as you keep up with the monthly repayments, your collateral will be “safe”. In other words, the bank is unlikely to do a margin call on your facility. And unlike unsecured lending on personal loans and revolving lines where the accruing interests is not just ridiculously high, it snowballs on you like a thief.

It is debatable, though, as investing is not for everyone. There are a lot more emotional roller coaster rides and challenges that most people underestimate. Still, if mortgage rates drop back soon and settle at a much more sustainable longer-run rate of 2-2.5 per cent, even relatively safe high-grade bonds, treasuries, and investments such as real estate investment trusts can beat that cost of funds rate.

The bottom line is, those using cash to prepay down on an outstanding mortgage have to ask themselves if they might have got better use out of their funds elsewhere.

Scenario 2: Your CPF stops growing and you become liable

It becomes a little trickier if you are thinking of using your CPF money to prepay in order to save on mortgage interest costs.

Mortgage rates now may be much higher than the CPF savings rate of 2.5 per cent to earn compounding interest. However, both are transient. Mortgage rates cannot stay high forever, as the situation causes economic pain and hardship. The CPF savings rate is more likely to stay at 2.5 per cent for longer as it’s pegged to the three local banks’ board rate for fixed deposits and savings accounts, which continues to stay meagre.

When you take S$200,000 from your CPF OA to repay your mortgage, you are still “borrowing”. The difference is, you are borrowing from yourself in the future, rather than from the bank. This is because when you sell the property one day, you will have to return this S$200,000 plus the accrued interest that would have been earned, had you not made the withdrawal.

This means, instead of Temasek and GIC taking on all the investment risk to pay you that risk-free 2.5 per cent compounded interest, you are paying it yourself, from your sales proceeds.

So remember, when the mortgage interest rate rises, you are really just paying the excess above 2.5 per cent because the Singapore government will be paying you that 2.5 per cent back. How long it stays above 2.5 per cent then becomes the question, which leads us to our final point.

Scenario 3: It might be harder to increase your loan later

Remember, interest rates go through cycles of peaks and troughs. Whether you use cash or CPF to prepay your mortgage, you might find it hard to “take back” that same leverage when interest rates eventually come down below 2.5 per cent or the prevailing CPF savings rate.

For Housing and Development Board (HDB) home loans, what’s repaid is repaid, as you can’t quite “gear up” or borrow against the equity portion of an HDB valuation even though it has risen. (Unless they change the laws.)

For private property owners, you can do a mortgage equity withdrawal loan, but you might encounter road blocks with reduced limits and ever more stringent rules in place, as such loans pose higher risks to banks. Your income situation might also change, which renders it hard for you to get the additional loan needed.

As periods of relatively low interest rates tend to be much longer than periods of interest rate escalations, as borne out by the interest rate cycle over the last 20 years, you might find that your ability to generate returns gets crimped in your most productive years. In the case of HDB home-owners, you will end up paying yourself that risk-free return if interest rates should fall back substantially below 2.5 per cent for long periods, like in the last decade.

The writer is the executive director of MortgageWise.sg