For those of you having a mortgage loan, you may come across the situation whether you should utilize the money you save to pay off mortgage loan or make some investment instead. Unfortunately, there is no quick and straightforward answer and here are 7 factors that you should consider
This scenario is also applicable if you are considering to withdraw money from your retirement fund (in case of Malaysians, this is your EPF, Employees Provident Fund) to pay off your mortgage loan. Ultimately the principle is the same, i.e. whether to keep the money in investment or use to settle your mortgage loan.
1. Rate of return
Most important factor is of course which decision would bring you higher rate of return
It is very often that people make judgement by directly comparing expected return rate from investment to interest rate of mortgage loan (for example “my investment can provide annual return of 6% but my loan interest is only 3%, of course I will use my money for investment!”). However it cannot be an apple-to-apple comparison due to the ways how rate of return of investment vs how your mortgage installment is calculated.
It is best to illustrate by case study. Let’s consider a case as below
- $200,000 mortgage loan with 30 years loan tenure and 4% loan interest rate
- Fund investment with expected annual rate of return of 5.5%
Scenario 1: You have $10,000 of available cash to either invest or pay off mortgage loan.
- $10,000 can reduce your loan tenure to 27 years 3 months
- $10,000 additional payment to mortgage loan can save loan interest of $21,407
- $10,000 in investment with annual return of 5.5% can bring you return of $33,131 after 27 years 3 months
- As a result, $10,000 in investment is a better financial decision by $11,724 in return
Scenario 2: You have $60,000 of available cash to either invest or pay off mortgage loan.
- $60,000 can reduce your loan tenure to 16 years 10 months
- $60,000 additional payment to mortgage loan can save loan interest of $91,235
- $60,000 in investment can bring you return of $88,292 after 16 years 10 months
- As a result, $60,000 to pay off mortgage loan is a better financial decision with better return by $2,953
So what is the key of making the difference? Rather than amount of money, it’s more because of the impact to loan tenure. For investment, compound interest needs time to show the true strength of snowball effect. Mortgage loan, on the other hand, is calculated using amortization formula such that larger extent of monthly installments from borrowers will be used to pay for interest rather than reducing loan principal at the beginning. You may search for amortization calculator online (or here) to see amortization schedule of your mortgage loan.
Based on amortization formula, when there is sufficient money to pay off your mortgage loan to significantly reduce its tenure, you are essentially skipping the initial part of amortization table and immediately make your subsequent monthly installments contributing more to loan principal reduction than paying for interest (i.e. big chunk of interest savings). On the other hand, if money does little to reduce loan tenure, compounding effect from investment will defeat interest savings from loan prepayment in the longer run.
Note that I’ve performed the case study by excel. You can also perform your own analysis using financial calculators readily available online. Otherwise you may also use my excel template which is available at the end of this blog post.
2. Loan type (Basic term loan, semi-flexi loan, flexi loan)
Note that explanations below are based on loan types available in Malaysia.
- Basic term loan: There is no flexibility to reduce your loan interest. Extra money paid to the loan will be classified as early payment for upcoming monthly installments so there is no benefit of doing so.
- Semi-flexi loan: You can make extra payments to your mortgage loan to save interest incurred in the long run. This loan type also comes with facility to withdraw additional payments that you have made to your loan with some restrictions and charges (e.g. amount and frequency of withdrawal).
- Flexi loan: It is almost similar to semi-flexible loan except there is no restrictions on withdrawal of additional payments made to the loan
As you can see, if you are holding a basic term loan, there is no room for interest saving so question about whether to pay off mortgage loan or to invest is no longer applicable. This kind of term loan is no longer popular in Malaysia however it is still worthwhile to check your loan agreement.
As a side note, it is recommended to go for semi-flexi loan for most of the people to have some flexibility for financial planning. For business owners, flexi loan can be a consideration if nature of your business will generate short term free cash flow, so that your free cash from business can be deposited into the loan account to save interest for short term but can taken out freely whenever you want to meet business need.
3. Lock in period
With reference to definition given in Property Guru website here, lock in period is time period in which you’ll have to pay a penalty, if you somehow wish to end you home loan earlier than agreed in your contract. This is a term that banks or financial institutions impose in the contract to ensure minimum profit from lending money to you.
Therefore, when judging whether to use your money to invest or to pay off your mortgage loan, be sure that you have checked lock in period agreed in your contract with bank or financial institution. If your extra payment to mortgage loan reduces your loan tenure shorter than lock in period, penalty will be imposed and thus greatly reduce your interest saving by making additional loan payment. In worst scenario, penalty from lock in period may even make your decision to pay off your loan doing more harm than good financially.
Amount of loan tenure shortened by additional loan payment can be easily calculated by financial calculator online, or you may also use my excel sheet attached at the end of this blog post.
4. Mortgage assurance
With reference to definition given in Property Guru website here, Mortgage Assurance is a type of insurance that will cover any outstanding property loan amount if you’re unable to do so (death or total permanent disability). There are 2 types: Mortgage Level Term Assurance (MLTA) and Mortgage Reducing Term Assurance (MRTA).
You should consider two points below related to mortgage assurance.
- Mortgage assurance is often included in our loan with an agreed coverage period. If your loan is fully settled within the period, you are entitled to get some money back. For instance, you have purchased mortgage assurance for 30 years but manage to fully pay off your loan in 18 years, the mortgage assurance amount associated with the unused 12 years of coverage is refundable. So this is another plus point for paying off your mortgage loan earlier.
- On the other hand, in the unfortunate event of death or total permanent disability, mortgage assurance will cover outstanding amount of your loan but additional payments that have been paid to the mortgage loan will not be refunded by mortgage assurance.
5. Investment risk
All investment comes with certain extent of risk and predicted rate of return of your investment will not always be accurate. On the other hand, interest saving you can obtained from additional mortgage loan payment is fixed and can be calculated.
6. Liquidity
Liquidity is a measure of how quickly your asset can be converted to cash. It should always be taken into consideration for any financial decision, especially if you already know there is a possibility that you want to withdraw this money from either investment or loan account for other use. Liquidity of investment depends on the type of investment, and withdrawal facility for different loan types has been explained above in point 2.
7. I just want to be debt free!
Who does not want to be debt free? Mortgage loan is typically a very long-term commitment and could be overwhelming. If you just want to get rid of the debt, there is nothing wrong to focus on paying off mortgage loan rather than anything else. At the end of the day, only you know what is your financial goal!