Inflation affects loan installments – but should you pay off your home loan early?

Because it devalues a currency over time by increasing the prices of goods and services, inflation affects loan installments – even housing loans.

Singapore’s core inflation accelerated to 3.3 per cent year-on-year in April from a previous 10-year high of 2.9 per cent in March, official data released on May 23 showed, driven by higher energy and food costs.

Now, you might be wondering about the significance of inflation when it comes to loan repayments, and how you can utilise this knowledge, especially with large ticket items like home mortgages.

Inflation Can Help Borrowers

If wages increase with inflation, and if the borrower already owed money before the inflation occurred, the inflation benefits the borrower. This is because the borrower still owes the same amount of money, but now they have more money in their paycheck to pay off the debt. This results in less interest for the lender if the borrower uses the extra money to pay off their debt early.

When a business borrows money, the cash it receives now will be paid back with cash it earns later. A basic rule of inflation is that it causes the value of a currency to decline over time. In other words, cash now is worth more than cash in the future. Thus, inflation lets debtors pay lenders back with money worth less than it was when they originally borrowed it.

Inflation Can Also Help Lenders

Inflation can help lenders in several ways, especially when extending new financing. First, higher prices mean that more people want credit to buy big-ticket items, especially if their wages have not increased–this equates to new customers for the lenders. On top of this, the higher prices of those items earn the lender more interest.

For example, if the price of a television increases from $1,500 to $1,600 due to inflation, the lender makes more money because 10% interest on $1,600 is more than 10% interest on $1,500. Plus, the extra $100 and all the extra interest might take more time to pay off, meaning even more profit for the lender.

Now we know that inflation affects loan installments but lower- and middle-class households are often more negatively impacted by inflation than upper-middle-class families and extremely wealthy households.

There’s a piece of conventional wisdom when it comes to mortgage loans in that in that you pay them off whenever you have spare cash so as to finish paying off the home loan earlier. However, the opposite could ring true if you take into account the inflation factor.

Simply put, the Singapore Dollar 30 years ago has a higher value than a Singapore Dollar today due to inflation. With the same logic, a Singapore Dollar now would obviously be of higher value than a Singapore Dollar 30 years down the line.

That means by paying ahead on your housing loan instalments, you’d be using Singapore Dollars that would be worth more compared to years down the line.

Then, would you not be losing out by paying more than you have to, despite shortening your loan tenure?

Of course, the one major argument against this logic is that while you might save some money by outsmarting inflation, you would end up paying more anyway due to the huge amounts of interest over the years.

A loan, of any type, is a debt that one would typically want to repay at the earliest (preferably prepay i.e. pay before it’s due). However, a home loan should not be considered in the same light as a personal loan, car loan, etc.

A home loan offers a number of benefits which may make prepayment unbeneficial, even if inflation affects loan installments.

Housing loan early redemption, or what some call prepayment is a facility which allows you to repay your housing loan (in part or full) before the completion of your loan tenure.

Usually, customers opt for prepayment when they have surplus funds. But you have to think again before you do housing loan early redemption and consider important factors before deciding to prepay your housing loan.

FUNDING NEEDS

Before considering prepayment of your housing loan, you need to ensure that you have sufficient funds for your financial goals such as marriage, travel abroad, etc. You should avoid being in a situation where you have overextended yourself to prepay your home loan and, as a result, are funds-strapped when you need to meet a financial goal. Moreover, you also need to ensure that you have surplus funds available for medical emergencies, or unforeseen events such as job loss.

INCOME FROM INVESTMENTS

The cost of prepayment should also be compared with the returns that can be earned from investments. If you have the opportunity to earn returns which are higher than the home loan interest, then it is better to invest the surplus funds rather than using the same to prepay your home loan.

A home loan is a long duration loan; in order to make an ‘apples-to-apples’ comparison of your home loan cost vis-à-vis a comparable investment, equity investment should be considered. Equity investment is a long term investment where the risk reduces in proportion to the period of investment, i.e. the longer you hold your equity investment, the lower will be the risk.

Very often investing the surplus funds is more fruitful than housing loan early redemption, even if inflation affects loan installments.

STAGE OF THE LOAN

The main benefit of prepayment is the reduction in interest outflow. The interest component is highest during the initial stage of the home loan. Therefore, prepayment of loans in the mid-to-late stage may not give you the full benefit of saving on interest. In such cases, it is prudent to invest the surplus funds.

INTEREST RATE

Housing loans are easier to service – the interest rate on home loans is generally lower than the rate of interest charged on other loans such as personal loan or credit card loan. Therefore, if you want to reduce debt, it is better to prepay high interest-bearing loans on priority basis (as against housing loans which carry a lower rate of interest).

PENALTIES FOR EARLY REDEMPTION

The reason why most home owners do not prepay their housing loans is because of the penalties imposed by the lenders for prepayment. Always check your loan contract to ensure that you are not paying unnecessarily to fully redeem a loan, when you can save money by letting that money just sit in your savings account.

Mr Paul Ho, chief officer at iCompareLoan, said, “it is always good to check with a loan specialist if your housing loan early redemption is worth it. They can give you the best advise.”