Here’s What You Should Know Before You Pay Off Your Home Loan Early
Having debt can be a psychological burden. When you have something as large like your mortgage loan looming over you, you may be tempted to pay it off as soon as you can. However, this may not always be the best decision – here are a few things you should consider before settling your home loan early.
Settling your mortgage loan earlier means paying less interest
The faster you pay off your home loan, the less interest you pay.
Here are a few ways you can consider settling your loan earlier, and their impact on the amount of interest you will be paying.
Scenario 1: Refinancing or repricing to a shorter-term loan
Refinancing means replacing your existing home loan with a new home loan from another bank. Repricing also involves replacing your existing home loan with another home loan, but within your current bank.
When you refinance or reprice, you can switch to another home loan with a shorter loan tenure. Here’s how different loan tenures affect your interest payments:
A shorter loan tenure means paying substantially less interest. The difference between a 20-year tenure and a 25-year tenure in the scenario above, for example, is around S$46,000 in interest payments.
However, before you spring for a shorter loan tenure, you’ll need to make sure that you can cope with the higher monthly instalments that come with it:
|Monthly instalment for a S$600,000 loan at 2.6% interest rate p.a.|
|Loan tenure (years)||Monthly instalment|
Scenario 2: Making small, recurring partial capital repayments
What if you put away extra cash – such as your bonus – every year to pay down your mortgage? Over time, you could be saving thousands of dollars in interest. Here’s an example of how much you could save if you made an extra S$5,000 payment at the end of every year on your home loan:
Scenario 3: Making a large capital repayment
If you’ve amassed a large amount of savings and would like to put it towards paying off your mortgage, you’d be paying a lot less interest down the line. For example, here’s how much less interest you might be paying if you made a one-time payment of S$100,000 in the fourth year of your home loan tenure:
When should you not prepay your mortgage?
Although having to pay less interest on your home loan is a compelling prospect, here are a few situations in which it may not be the best route:
1. If it depletes your savings
You shouldn’t rush to pay off your home loan if that means depleting your savings. Having all your cash tied up in your home is not a good idea, as your home is an illiquid asset – it’s hard to convert it into cash when you need it. This can make it hard to deal with unexpected financial challenges, such as a loss of income or a medical emergency.
2. If you have higher-interest debts
Mortgage interest rates are relatively low. If you have other debts that command higher interest rates – such as credit card debt – it makes more sense to pay them off first.
3. If the penalties for prepayment negate interest savings
Your bank may impose the following penalties when you:
- Settle your mortgage loan before the expiry of your “lock-in period”. This is typically 1.5% of your outstanding loan.
- Make a prepayment during the “lock-in period”.
- Make a prepayment without giving your bank advance notice.
Even if you’ve passed your lock-in period and you’ve given your bank advance notice, depending on your bank, you can still be penalised for making a prepayment. Before you make a prepayment, check with your bank if these penalties apply, as they can negate any interest savings gained by settling your home loan early.
4. If you want to retain mortgage insurance
If you’re covered under mortgage insurance – that is, Mortgage Reducing Term Assurance (MRTA), or Home Protection Scheme (HPS) for HDB properties – your loan will be paid off in the event of death, terminal illness or disability. In such situations, you’ll be able to use your extra savings to support yourself or your beneficiaries.
However, if you’ve used your savings to pay off your home loan, not only will your savings be tied up in your home, you’d lose the financial buffer provided by your mortgage insurance.
Paying off your mortgage loan vs investing
Finally, you’d want to consider the trade-off between paying off your mortgage loan and using that money to invest instead.
The interest rates of mortgage loans are relatively low. HDB loans have an interest rate of 2.6% p.a., and bank loans have interest rates of around 1.8% p.a. If you can invest your money at a rate of return that outpaces your mortgage interest rates, then it might be worth doing that instead.
For example, let’s look at two scenarios:
- Paying off your mortgage: If you take out a S$600,000 home loan with a 25-year tenure at an interest rate of 2.6% p.a., making a one-time payment of S$100,000 at the start of the loan will save you S$77,955 in interest and pay off your loan 5 years and 5 months earlier.
- Investing: If you invest S$300 a month over the same time period of 25 years with an annual rate of return of 7% p.a. (if you’ve invested in the SPDR Straits Times Index ETF since 2002, for example, you would have had an annualised return of 7.09%), your portfolio would grow to S$244,439.
However, the investing scenario above assumes that you have a long investing horizon, and that you’re comfortable putting your cash in high-risk investments. If you have a long investing horizon, the power of compounding may mean that even with a relatively low rate of investment return, investing can outpace your mortgage interest rates.
But if these circumstances don’t apply to you – say, if you are nearing retirement, you may be looking to reduce your exposure to riskier investments. Limiting your portfolio to investments with less volatility may mean that you’ll have a smaller rate of return. If your returns do not outpace the interest rate you’re paying on your mortgage, then you should consider paying off your mortgage instead of investing.
So, should you settle your mortgage early?
In short, although paying off your mortgage early could save you a significant amount in interest payments, it may not be a good idea if it depletes your savings, or if you can use your money to service high-interest debts or to invest in a way that outpaces your mortgage’s interest rate.
You may need to make use of mortgage repayment calculators and compound interest calculators to help you determine if the trade-off between paying off your home loan and investing is worth it.
Of course, everyone’s financial situation is different – it might be helpful to talk to a wealth planner or financial advisor before you decide if you should direct your savings or spare cash into paying off your mortgage.