If you have extra cash, should you pay off your loan? The standard answer is ‘no’ if the extra cash can earn a higher return then your cost of interest of your debt. Wilfred’s answer is that it depends.
First, the debt (such as mortgage loan) is a ‘risk-free’ liability. In financial jargon, the word ‘risk-free’ refers to low volatility. When you borrow money from a bank, the debt level does not suddenly ‘drop’ like a stock market. In fact, if there is no repayment, the debt level increases steadily like a stock market bull run. Unfortunately, such ‘risk-free’ behavior of debt is not good for the borrower but excellent for the lender.
Second, the required investment for the extra cash is never going to be risk free. Mortgage loans’ interest rate is slightly higher than saving rate. So it is not possible to get a higher return by putting the extra cash in saving accounts. So you will need to take some risk. The common instruments to use for extra cash are:
- Stocks. But stocks have market risk and non-systematic risk.
- Bonds. But bonds have credit risk, credit spread risk, duration risk, call risk, etc
- Single premium endowment. The risk involved is liquidity risk.
- Regular premium endowment. The risk is liquidity risk and cash flow risk (because you need to pay regularly.) In fact, regular premium endowment creates an implied liability. So your debt level increases.
Most voodoo planners will keep on saying that the potential ROI for investing the extra cash is higher than the cost of interest of the debt. In other words, they only compare the returns. But investment has two sides of the same coin. You also need to compare the risks involved. As mentioned, debt like mortgage loan is ‘risk-free’ while investments are not risk-free. How to compare two items that are of not the same risk nature?
Another issue to consider is the leveraging effect. If the property has a loan, actually the buyer is leveraging his purchase. For example say he pays $200,000 downpayment for a $1m property, his leverage is 1000000/200000 = 5 times. If the property price goes up by 30%, he earns 150% in profit. If the property goes down by -30%, he’s return is -150%. This means he must top-up the shortfall otherwise the bank will foreclose. But wait, the investor supposed to have extra cash which he can pay off the shortfall anytime right? Wrong! Because his extra cash has already been invested, he could be forced to liquidate his investments at a wrong time. In fact, his stocks could be down too. If he bought a single premium endowment or regular premium endowment using his extra cash, he will be force to surrender his insurance policies resulting in hefty surrender penalty. So, did the voodoo planners tell you that? Of course not because voodoo planners only know of their own success stories but have no accountability to the readers and audiences of their seminars.
How will I advise my clients if they want to buy properties?
First, I always encourage my clients to pay off their loan as soon as possible for their own residential home. It can be HDB or private it does not matter. I encourage them regardless of the interest rate environment to pay off their residential mortgage because they need a physical place call home which is safe and not subject to any kind of risk such as foreclosure. For a fully paid up HDB, the property is protected from creditors. However, I will not advocate paying off the debt in a single lump sum as it can create a liquidity crisis. So I’ll have a proper pre-payment strategy in place for them. Say, if their loan was a 30 years loan, I’ll have a schedule of pre-payments over the next 10 years so that their mortgages will be cleared by 10 years instead.
Second, if they want to buy a second property, I’ll treat that as an investment decision. If the property purchase is to be funded through a mortgage, I treat it as a leveraged investment. The usual application of ability and willingness to take risk will be taken into account before I advise them on whether such decision is suitable for them or not.
I also found voodoo planners who encourage people to buy property to have vested interest. They or their associates are actually property agents. Second, they have a vested interest in helping the buyer get financing as they also receive commissions for transacting loans.
Important disclosure: For myself, I also have vested interest if clients buy properties because I get referral fees from property agents and as well as banks for referring them for mortgage loans. However, I’ll always be objective in all my recommendations despite the conflict of interest.
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