The length of a loan is an important issue.

By Wilfred Ling

Courtesy: sporesays.blogspot.com

I found the recent election debates to be of most interesting. Not because I like politics but because there were quite a number of issues raised that are either related to economics or financial planning. Both are my expertise, favorite past-time and of course most importantly I earn a living giving advice to others on a professional basis with regard to financial planning. Based on my empirical experience, most Singapore residents are financially illiterate and thus have no clue what is happening and whether the debates make sense or not.

One of the issues raised was from this article Length of loan is not the issue. An individual was quoted as saying “It is not the length of the loan but the percentage of monthly income repayable to the housing loan that matters.” I disagree with this statement.

The length of a loan is an extremely important factor. Why? Because of the magic of compounding. Compounding can work both ways. If you are investing, compounding can work marvelously for you and even help one to retire as a millionaire without taking excessive risk. But if one is borrowing, the reverse is true. Compounding works for the investor but works against the borrower. The longer the period of the loan, the greater the compounding effect. To illustrate how compounding can work against a borrower, I have tabulated a table below:

In the above table, it showed that the monthly installment does go down if the loan period is lengthened. But what happens is that the amount of accumulated interest that is required to be paid goes up significantly. In the example above, for 10 year loan, the amount of interest to be paid is 16% of the original loan. For a 30 year loan, the amount of interest to be paid is a whopping 52% of the original loan!

Another aspect that has to be considered is the opportunity cost of committing so much money into that housing loan. First, the HDB flat is a zero value asset on a long-term basis because it is a 99-years leasehold. Second, the money used could have been invested into other investments. This is the opportunity cost. I have tabulated another table below:

In the table above, if the person would to utilize the mortgage installment to invest say in a 10 years investment he would have earned an interest equivalent to 17% of the capital. For a 30 years time horizon period, the interest earned would be 62% of the original capital. Thus, the opportunity cost forgone has to be taken into consideration.

Of course, the calculation of opportunity cost is merely an academic exercise; if a family needs a roof over the head, the opportunity cost is irrelevant. My advice is this: buy according to one’s affordability. Do not over leverage. Lengthening the loan period helps to improve one cash flow but merely pushes the problem of unaffordability to the later part of one’s life. Most importantly, always educate yourself to financial freedom.

For those who are still clueless as to what I am talking about, Credit Management is part of financial planning I do for others. Credit Management optimizes the tension between cash flow affordability and long-term compounding effect of interest cost. Credit Management is only for those who intends to borrow to purchase a property. For those who already purchase a property, there is not much I can do.

Visit Wilfred Ling’s website here.