how to structure a housing loan

If you are new to this blog, please see this entry (just below) first. You may also be interested in the decision process that led to choosing HDB over Condo.

May, Varushka, Otto, Prata and Xiaoming are quintuplets. (Nevertheless in order to be politically correct they have been given multi-ethnic names, but which in no way dictates their level of intelligence in the decisions to come.) In true sibling fashion, they have all chosen to get married on the same day (to different people) and have bought identical flats at the same time. However, they have chosen different approaches to taking up the housing loan.

Each married couple has savings of $100k. Their flats all cost $250k. As they all do not qualify for the HDB Loan, they can take a maximum loan of $200k (80% loans have better interest rates), leaving them with $50k to save or invest. They also have spare income of $2k each month to pay off the loan, save, or invest. (In this calculation the exact numbers are not important, as long as they are kept constant.)

May does not like to be in debt for too long. She decides to take the full $200k loan amount for a 10-yr period. She puts her remaining $50k into a diversied portfolio of unit trusts managed by her financial advisor, along with the balance of $2k left over from monthly payments.

Varushka decides to do the same thing as May, but over a 15-yr period.

Otto consults an investor friend and is advised to take the longest loan possible, so that he can use more of his monthly income towards investments. So he also takes the maximum $200k loan, but over a 20-yr period. (Can go up to 35 years but that would mean a lot more Excel columns to fill. 20 yrs should suffice to measure the desired result.)

Prata decides to follow Otto's method. But because he is debt-averse, he decides to sink his remaining $50k into the purchase, so that he only takes a $150k loan over the 20-yr period.

Xiaoming also wants to follow Otto's lead, but he also plans to refinance his loan every three years. Hence he takes a $200k loan over 20 years with refinancing every three years.

The question in all their minds is this: at any point in time over the next 20 years, if something happens that requires them to terminate the housing loan (most likely selling the house), what would be the total value of their assets? And how would this vary over time depending on the loan structure?

There are a number of other variables that affect the calculation, the two biggest being the variable interest rate of the housing loan (currently 4%) and the return on investment. The following two graphs (using OCBC loan calculator) show two opposite cases of the possible outcomes.

For the first graph, the return on investment consistently exceeds the interest rate by 4%. In this case, interest rate is 4% and investment return is 8%.

For the second graph, the investment return underperforms the loan interest rate by 4%.

It can be seen that the performance ranking of each strategy is almost entirely dependant on the relative performance of investment and interest rates. If investments underperform, the short-term loans and smaller loan amounts do better, and vice versa. The only consistent thing is that a loan with refinancing performs marginally better than a loan without refinancing.

When the quintuplets buy their property, they know that there are two likely outcomes. Either they will stay there for the rest of their lives or they will upgrade to private propertly in approximately five years. Hence, let's zoom in on the total asset value for each strategy for these two time frames.

In this case, the choice is pretty clear. If you think you can reap a good return on investment for spare capital, then clearly you should take the largest possible loan over the longest possible time period. For added kick, you should also refinance periodically. And if you decide to terminate early, then it doesn't really matter which loan you took.

So which bank should you go to? Most are quite competitive, but the following comparison between DBS, OCBS and Maybank shows quite a clear leader over 20 years, but in the short term it doesn't really matter.

In summary, the brevity of this post does not quite belie the depth of analysis it is based on. Nonetheless there is no time to go into further detail, or I'd never get this out. So I hope it provides a useful starting point for other people thinking about such things. The two key points to note:

1) If you are not averse to investment risk, take the largest possible loan with the longest possible duration and dump all your savings and spare capital into the investment market. If you are risk-averse, then just take the smallest and shortest loan possible.

2) If you qualify for a loan direct from HDB, just take it. If you can't get the HDB loan, get the Maybank one. (Correct at the time of writing.)

And pray that my appeal for the HDB loan goes through :)

25,000 Excel cells went used the making of these calculations.