Categorized | Fashion

Effects of Time Value of Money in lengthening loan period

Posted on 01 May 2011

The length of a loan is an important issue.

By Wilfred Ling


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.

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  • eric

    half the story. compounding over an extended period weighs out against the real value of money. it needs to be net off against expected inflation and real worth. the effects move in opposite directions.

  • Landon Leo

    Good article Wilfred. There is only 1 thing that I want to point out.

    ‘First, the HDB flat is a zero value asset on a long-term basis because it is a 99-years leasehold.’

    Its not 99 years. Its actually somewhere like 50 years, if you consider HDB flats lifespan from an engineering point of view. I was joking with my friend that the houses that we live in today = airspace rental!

    And like how Eric pointed out, cost and effect of inflation to be accounted for.

  • Wilfred Ling

    The required discount rate to take into consideration for the total amount of interest payable is taken into consideration when it is compared with the opportunity cost forgone as shown on the second table.

    I could have merged the discount rate of risk-free rate into the first table but nobody will understand the article.

  • Wilfred Ling

    Another way to interpret the article is to treat ‘interest rate’ shown above as the real discount rate. Than all figures are in real terms. The gist of the article is still the same. The longer the loan period, the more interest need to be paid.

  • Cheng

    another point to note is when you sell the flat, you have to add the figures in the 2 tables up for the total amount to be returned to CPF if you service the monthly instalment entirely by CPF, as the total amount you have withdrawn over the loan period would have earned interest in your CPF account if you didn’t use it, i.e. equivalent to investing the monies over the same period.

    So you might end up not getting any cash in your pocket if you sell it less than the total amount of CPF withdrawn + accrued CPF interest currently at 2.5%.

  • Ray

    Instead of looking as the HDB with a future value of zero in 99 years, you should look at its value in 20-30 years as that is how long most people hold them and makes for a more accurate comparison between possible investments.

    Over the past 20 years, the HDB Resale Price Index has increased a whopping 400%. Even factoring in interest expense, in the medium term, HDB is a much better store of value than almost any investment in the market.

    The only shame is that this benefit only accrues to owners. For newcomers, rising prices make it harder and harder to buy in the first place…. hence your post on long tenored loans!

    • Wilfred Ling

      20-30 time horizon is too short. If a person buys a HDB at age 30 yaers old and dies at age 90 (average life expectancy for female plus 8), that is 60 years. Assuming a straight line accounting, the asset would have depreciated by 60% all things being equal. This is a ‘lost’ for the next generation who is going to be the beneficiary of the estate.

      If a person sell half way, he still need to buy another one unless this is the second property.

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