Wednesday, December 23, 2009

Should one reduce the home loan by making a lump sum payment? Make full use of your CPF.

A number of friends have been asking me this question. "Should I make a lump sum payment to reduce the home loan amount, so that I do not need to pay more on interest?"
There is actually no right or wrong answer. I will just share my personal view here.
Take for example, Mr Lim and his wife has worked for about 10 years and have accummulated $150,000 in each of their CPF ordinary account, $300,000 in total.
They have just bought a $500,000  flat and have two choices.
Choice A: Take an 80% loan of $400,000 at 2% interest.
Choice B: Pay up $300,000 and take a loan of $200,000 at 3% interest. (Normally, promotional rates are for higher loan amount.)
Hint: CPF is paying 4% interest for first $20,000 and 2.6% thereafter.

Calculation for the first year:
Choice A, interest paid will be $8,000. Interest earned in CPF is $5,760. Hence, actual interest paid $2,240.
Choice B, interest paid will be $6,000.

Hence, let's have a coke because "the choice is clear".

But how can we actually earn more by choosing choice A?
The answer, get a second property and  rent out.
After paying the downpayment for the flat, Mr Lim and his wife have $200,000 left in their CPF accounts. However, only about $140,000 can be used because they have maintained a minimum sum of $120,000 (ordinary + special account combined). They bought a $400,000 investment property and took a loan of $320,000, leaving $60,000 in their CPF OA to pay for both properties. The first year interest for second property is $5,120. The property is rented out at $2,400 monthly, earning $20,000 annually minus tax and maintenance. The $20,000 earned is in cash, while the monthly instalment is paid using CPF.

Assuming the couple are still working with monthly income of $4,500 each and they are paying $3,000 for both properties using their CPF. Hence in a year, they are paying $36,000 for both properties and have an income of $20,000. In actual fact, they are paying only $16,000 for two properies in a year.

You may ask, "Wouldn't the CPF be used up in a year?"
Because both are still working, hence they will still have CPF contribution of $2,340 into their OA account. Remember, the couple still has $60,000 in their CPF OA account that can be used to pay for their instalment. Only $660 is deducted from this $60,000 (which is still earning an interest rate of 2.6% annually) monthly. This $60,000 can last them for about 85 to 90 months of instalments, i.e. about 7 years.

Another hint: How much do you think both their properties will be worth 7 years later?

Now, the best choice still lies in the eyes of the beholder. This article is written to voice my personal views only, it should be used to affect your decision for the use of your CPF funds.

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