A Misled Mind-Set?
There's a piece of conventional wisdom when it comes to housing loans – pay them off whenever you have spare cash because you'll be done with them earlier.
However, the opposite could ring true if you take into account the inflation factor. Simply put, a Ringgit 30 years ago has a higher value than a Ringgit today due to inflation. With the same logic, a Ringgit now would obviously be of higher value than a Ringgit 30 years down the line.
That means by paying ahead on your housing loan instalments, you'd be using Ringgit that would be worth more compared to years down the line.
Then, wouldn't you be losing out by paying more than you have to, despite shortening your loan tenure?
Inflation versus interest
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.
Let’s get technical to gain a clearer understanding of its impact.
We’ll take a home loan of RM450,000 paid over 30 years at a steady Base Lending Rate (BLR) of 4.2% (This is just an assumption, yeah). Your monthly repayment would work out to RM2,201. Now we’ll compare two hypothetical scenarios.
Scenario 1 – Standard repayments made to bank throughout tenure length
Scenario 2 – An overpayment of RM100 is added on each month throughout the tenure length
|Scenario 1||Scenario 2|
The table above shows that overpaying your monthly instalments consistently throughout tenure will save you RM30,729 in total.
What if you take inflation into account?
Let’s now look at the two different inflationary scenarios to get a picture of how much value you could actually save from repaying earlier. All calculations are based on the discounted cash flow of the mortgage repayment.
Based on the formula below, we had to run it 360 times (yeah, that many times).
* Discounted cash flow payment = Payment/ (1+ (inflation rate)) number of months
- We found out that if average inflation rate in Malaysia is at 4% throughout tenure:
The amount saved after taking inflation into account = Only RM157 in today’s Ringgit
This is the value of the amount saved based on present day value.
- However, if the average inflation rate in Malaysia is at 5% throughout tenure:
You actually don’t save any money but end up ‘losing’ money in a sense.
The total amount LOST after taking inflation into account = RM 2,786 in today’s Ringgit
How did we get here, you ask? If you're keen on getting the breakdown, you can refer here to get a better perspective.
Based on our findings, it becomes clear that by overpaying and saving that additional RM30,729 in the future, translated into today’s equivalent, the amount might be much less than you think.
Thanks a lot, inflation.
How can you work with inflation?
The above-mentioned scenarios were based on certain assumptions. What is more likely to happen is a random fluctuation in BLR and inflation rates over time. Still, the principles shown hold true.
You can make most of your moolah by following Loanstreet’s 3 simple rules.
In a nutshell, if the loan interest rates are higher than inflation, you should pay off your loan. If the loan interest rates are lower than inflation, spend that money, use it for investments or to treat yourself.
In most situations, keep a minimum amount of cash, be it in savings, or fixed deposits, as money generally devalues over time (of course, certain exceptions apply).
One more thing, don’t forget the importance of saving. There are times when you just might need that extra cash, or must save up for future use. Do, however, practice wisdom and save just enough for practical purposes
Don’t forget to check out our Home Loan Comparison tool to find the best Home Loans available for your needs.
*The above article is intended for informational purposes only. Loanstreet accepts no responsibility for loss that may arise from reliance on information contained in the articles.