With rising interest rates, should housing loans be repaid early?

The Fed raised the federal funds rate by 75 bps (0.75%) in June, the largest rate hike since 1994. Fed chairman Powell stated that he didn’t expect moves of this size to become the norm going forward but left open the door to another possible 75 bps hike, with the market now expecting a minimum 50 bps increase next month.

With the US Fed increasing interest rates in a more aggressive fashion to stave off global inflationary concerns, rates here have also crept up. That’s because Singapore rates tend to track that of the US.

With the volatility in this rising rate environment, some banks here have already stopped issuing fixed-rate home loans. The high interest rate environment creates a challenge for homeowners to refinance their property loan at attractive interest rates. With cash sitting in the bank account still earning low interest, would it be better for you to pay off housing loans?

Let us run through how prepayment works, the benefits and cost of paying off the loan early, and some of the personal considerations you should take before you decide to pay off your loan.

Pros of early loan repayment

1. Pay less interest

The logic behind this benefit is simple. By paying off your loan, you reduce your outstanding loan balance, and hence reduce the total amount of interest you have to pay for your loan. For example, if you have an outstanding 20 years loan at 2% interest, and are considering repaying $100,000 in cash, you can save up $21,412 in interest by doing so.

2. Peace of mind

After more than a decade of low interest rates, rates are on the up as inflation is still a pressing concern for now. It might be prudent to reduce your loan now to ease off the pressure that comes with monthly mortgage repayments.

Cons of early loan repayment

1. Early repayment penalty

Usually, penalties would be incurred when you partially prepay or fully redeem the entire mortgage within the lock-in period, which is typically 2 to 5 years. Generally, a penalty of 1.50% will be charged on the amount prepaid, or $1,500 for a $100,000 prepayment.

There might be special offers by banks that allow partial prepayments within the lock-in period, without incurring penalties. The quantum of partial prepayments varies across the banks; it ranges around 30% to 50% of the outstanding loan amount.

2. Reduces liquidity

For Singaporeans in their late 30s or 40s, it is important to stay liquid when it comes to their finances. The Endowus Wealth Insights survey showed that these individuals are squeezed by the challenge of managing the costs of raising children, and the needs of their ageing parents.

Paying off the loan early will reduce the amount of cash on hand. If you have need for cash in the future, you will have to consider selling your property or to take up a home equity loan.  

How to decide if you should repay your mortgage loan

Here are some key questions you have to ask yourself to decide if you should repay your mortgage loan.

1. Keep to 3-3-5 rule

One way to come to a decision is by using the 3-3-5 guideline. It outlines 3 key rules to follow before you purchase a new home and take a loan on it. The same rules can apply before considering loan repayment.

Rule 1: Monthly mortgage payments should not exceed a third of your salary

This is an especially important rule for you to consider especially with rising interest rates. For those whose fixed, low interest rate loans are expiring, you may want to use a mortgage calculator and use a higher and more conservative interest rate to determine if you can afford the monthly mortgage payment.

Rule 2: Available capital should be 30% of property’s cost price

Adapted for an existing housing loan, you should minimally have either paid off 30% of the property’s cost, or have enough liquid assets at hand to pay for 30% of property cost price. This guideline reflects a way to measure your ability to afford the initial property down payment. To be sure, it therefore may not be relevant for an existing mortgage.

Rule 3: Property cost should be less than 5 times your annual income

To see if your finances will meet this rule, consider your current job security and if one working adult may become a stay-at-home parent.

2. Check on your CPF withdrawal limit

If you service your bank or HDB loan using CPF savings, note that there is a threshold at which you can use your CPF for servicing your property purchase. This threshold is at 120% of your property price or value, whichever is lower. You may use the CPF calculator for housing usage to estimate this value.

With rising interest rates, you are more likely to run the risk of reaching the withdrawal limits before clearing out your home loan. When the withdrawal limits are reached, you would have to service the home loan in cash. You can consider “repaying” your CPF withdrawal with CPF voluntary housing refund to increase your debt headroom, if necessary.

3. Will your saved interest be invested to generate income?

The principle behind partially or fully prepaying a loan is to save on interest. You can also deploy spare cash into very safe or income-generating investments.

As the Income Portfolios are invested in unit trusts with no lock-in and no transaction costs, you would be able to easily liquidate your portfolios, should you change your mind. Note that these are investment portfolios with investment risk.

Refunding your CPF through voluntary housing refund

In 2021, a record number of CPF members refunded their CPF OA used for property investments to enjoy the higher interest rates for CPF. While this does not reduce your existing loan balance with the bank or HDB, you will still be able to repay loans using CPF in the future when you need to.

Read more: Spotlighting HDB loans amid rising rates

Conclusion

Managing property debt is one of the most important financial decisions we can make in our lives. Avoid the “asset rich, cash poor” trap — be careful not to hold too much wealth into our property, especially if we intend to stay in it long term.

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