Good debts? Bad debts?
A couple of days ago, a client of mine brought up a topic of his HDB loan.
His question was, which is more worth it? - To take up a longer or shorter loan term? And to take up a higher or lower loan?
His argument is, since stretching the loan term and taking up a higher loan would mean paying more interest in total, it wouldn't make sense to do so, right?
Let's do some comparisons here.
Assuming if you're buying a house that costs $300,000, you have a capital of $50,000 in cash, and a $2000 monthly budget for this house.
Let's assume HDB loan fixed at a 3% p.a. interest, investment returns annualised at 9% p.a., and minimum downpayment at 10%.
(Take note that the Time-Value-of-Money calculations below require the use of a financial calculator or a an Excel spreadsheet to calculate. If anyone is interested on how to do the calculations, feel free to drop me a line or message.)
Let's take 4 scenarios :
1) Minimum loan of $250,000 after $50,000 downpayment, minimum loan term of 15 years
2) Minimum loan of $250,000 after $50,000 downpayment, maximum loan term of 30 years
3) Maximum loan of $270,000 after $30,000 downpayment, minimum loan term of 15 years
4) Maximum loan of $270,000 after $30,000 downpayment, maximum loan term of 30 years
Scenario 1 :
With MINIMUM of $250,000 and a MINIMUM loan term of 15 years, your monthly installments will work out to be $1,726.45 per month for the next 15 years.
That leaves you with $273.54 every month to invest.
Investing $273.54 monthly for the next 15 years would yield you $103,511.34.
Now reinvesting this yield as the new capital, as well as a new cashflow of $2000 (since the loan has been cleared), for the next 15 years, your yield by the end of the total of 30 years would be :
$1,154,092.56.
Scenario 2 :
With MINIMUM loan of $250,000 and a MAXIMUM loan term of 30 years, your monthly installments will work out to be $1,054.01 per month for the next 30 years.
That leaves you with $945.98 every month to invest.
Investing $945.98 monthly for the next 30 years would yield you at the end of total of 30 years :
$1,731,864.87.
Scenario 3 :
With MAXIMUM loan of $270,000 and a MINIMUM loan term of 15 years, your monthly installments will work out to be $1,864.57 per month for the next 15 years.
That leaves you with a measly $135.42 every month to invest every month, but this time you start with a $20,000 capital to invest.
Investing $135.42 monthly for the next 15 years along with a starting capital of $20,000 would yield you $128,008.19.
Now reinvesting this yield as the new capital, as well as a new cashflow of $2000 (since the loan has been cleared), for the next 15 years, your yield for the total of 30 years would be :
$1,248,112.53.
Scenario 4 :
With MAXIMUM loan of $270,000 and a MAXIMUM loan term of 30 years, your monthly installments will work out to be $1,138.33 per month for the next 30 years.
That leaves you with $861.66 every month to invest, along with a starting capital of $20,000 to invest.
Investing $861.66 monthly for the next 30 years along with a starting capital of $20,000 would yield you :
$1,872,106.06
As we can see from the comparisons of the scenarios, stretching out the loan term as well as taking on a higher loan significantly outperform trying to cut down on interests by reducing the loan term and taking a lower loan.
Why is that so?
The key idea here is that, a loan can be considered a good debt, IF you have invested the remaining budget in an instrument that can OUTPERFORM the loan interest. And at a mere 3% p.a. on the loan, there are many instruments in the market that would allow you to beat that interest rate fairly easily, and helping you achieve a higher retirement nest egg.
Now before we end off this session, it is important to note that there are other factors that one should consider before making such decisions, such as your age, debt ratio, the type of loan, budget, type of housing etc. You should still consult a trusted financial advisor who is well-trained in the subject (note that by "financial advisor" here I do not refer to insurance agents, who are generally competent within only the scope of insurance, or bank agents who are only concerned about sales), before making such decisions, especially if you are not versed in the subject yourself.
Cheers. =)