In my most recent financial planning case, one of the items in the plan is with regard to property purchase planning. My client did not own any property and he wishes to buy one. His budget for a mortgage loan was $3m. I want to share some of the details of the plan through my discussion with him.
His desire was to have a maximum loan period of 30 years but with the intention of early payment so that he can clear his loan within 10 years. He said that his plan was to periodically but partially pay off the loan. My suggestion was NOT to partially pay off the loan but rather accumulate the required amount to pay off the ENTIRE loan in one lump sum. Why? First, prepaying a loan does not improve one’s net worth. Second, prepaying a loan using cash decreases one’s liquidity but the monthly mortgage obligation remains. In the event of cash flow problem such as lost of job, the borrower will be in for big trouble since he no longer has sufficient cash to continue with the instalment. Hence, my suggestion is to:
1) Continue with the plan of borrowing $3m over 30 years. Assuming 4% pa interest monthly rest, the mortgage instalment is A = $14,322 every month.
2) Assuming no change in mortgage interest rate, by the end of 10 years, the loan outstanding will be $2,363,519. In order to accumulate this sum of money to completely pay off the entire loan outstanding, an amount of B = $15,998 monthly investment is required over 10 years assuming 4% per annum in return.
3) The total monthly commitment is C = A + B = $30,320
4) Using the above strategy, the entire loan outstanding is to be pay off at the end of 10 years.
The question is this: If the mortgage loan is 10 years, what will be the mortgage instalment? Assuming 4% pa monthly rest, the mortgage instalment is D = $30,374 of the same loan amount.
If you look at the figure closely, the difference between D and C are extremely close. In fact, D is $53 more than C! However, there is quite a big difference in its implication. If strategy (1) to (4) is used, it implies that the monthly compulsory burden to service the loan is only A which is $14,322. On the other hand, the compulsory burden for a 10 years loan is doubled. Thus, the former is more cash flow friendly. In a world which jobs are created and destroyed depending on the volatility of the stock market, having a lower burden is very useful. There are also other advantages. By the end of 10 years, the borrower can either elect to use his accumulated cash to pay off the entire loan outstanding or invest it somewhere to generate a better return. This means that the borrower has an option. In other words, there is a “right” but not the obligation to pay off the loan in its entirety. Such an option is valuable.
So, what is the fine print since it appears that the suggested strategy looks too good to be true? Of course there are some risks involved. The risks are:
1) The cost of borrowing is always positive and generally tracks the interest rate environment. On the other hand, the rate of return in investing can be negative.
2) What the borrower would fear is a rise in interest rate. To hedge this risk, the borrower needs to short interest rate. Frankly speaking, I do not know how this can be done for the man-in-the-street although it can be done by institutions such as shorting bond prices or long FRA (Forward Rate Agreement).
3) An increasing interest rate is bad for bonds. A high interest rate dampens economic activity and that means bad news for stock investors. Hence, one’s investment whether in bonds, equities or both are likely going to be affected when interest rise.
So, what’s the conclusion? For those who are investment savvy and is confidence to get a reasonable return over the 10 years period may want to consider the above strategy. For those, who are not confidence but does not wish to be burden of servicing long period of loan and high amount of mortgage instalment may simply want to borrow at a lower amount which one is most comfortable in.
Whatever the choice, I personally feel that financial planning for property purchase is increasingly important as so much money is involved. This is especially so for those individuals who are getting their first home as they have completely no experience dealing with money management matters.
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