I came across a post from Turtleinvestor which had piqued my interest: Picking the better loan – which on will you choose? 2.5% or 2.6%

In that article, he showed that the interest gained from $200,000 CPF OA is the same as the interest paid for a $200,000 loan with a fixed interest rate of 2.6%.

CPF OA is a retirement account that guarantees a 2.5% interest per annum. On top of that, the first $20,000 in the account earns an extra 1% interest, which is 3.5% per annum.

Because of that bonus interest, the math works out to be the same:

Interest paid to the loan: $200,000 x 2.6% = $5,200

Interest earned from CPF OA: $20,000 x 3.5% + $180,000 x 2.6% = $5,200

So, instead of paying off your loan as soon as possible, we could maintain the housing loan and let your CPF OA account compound.

## What is CPF OA?

CPF, which stands for Central Provident Fund, is an investment scheme by the Singapore government designed to help Singaporeans and permanent residents set aside funds for retirement.

There are three accounts within CPF:

Account | Interests | Purpose |
---|---|---|

CPF Ordinary Account (OA) | 2.5% p.a. | Housing, CPF insurance, investment, education, investments |

CPF Special Account (SA) | 4% p.a. | Retirement, retirement specific investments |

CPF Medisave Account (MA) | 4% p.a. | Hospitalization expenses, approved medical insurances |

The discussion will be focused on OA because it is commonly used for paying towards your mortgage.

However, your CPF is illiquid. Whatever you transfer to your CPF OA, CPF SA or CPF MA, you can not take it out until you have fulfilled particular requirements.

## CPF Interests

The interest from CPF OA is 2.5% per annum.

However, do note the following:

- Interests are calculated monthly. But it is only credited to your account on 1st January.
- Withdrawals and deductions from this month will not earn you interest from this month onwards.
- Contributions in this month will not earn you interest this month. It will only make you interest from next month onwards.

So if you had a balance of 10,000 and you paid $800 for your housing loan and contributed 1,000, you will only earn interest on $9,200. Next month, you will earn interest on $10,200.

When you are below the age of 55, the first $60,000 from your combined OA and SA accounts earns you an additional 1% interest. The bonus interest is capped for the first $20,000 of your OA.

Now, let us talk about HDB housing loan.

## HDB Housing Loan

When you purchase a HDB, which is a government-subsidized home by the Singapore government, you may have the option to take a HDB loan or bank loan.

There are strict requirements to be eligible for a HDB loan. That will be another post for another time. Sometimes, the only option is a bank loan if you do not want to finance it yourself.

You will pay towards your loan monthly either with cash or with the funds from your CPF OA.

## HDB Housing Loan Interests

A HDB loan offers a fixed interest rate of 2.6% per annum.

In each monthly payment, a portion of it is interest payment, and another part of it will be towards paying your principal amount.

For example, for a 30 year $200,000 loan with 2.6% interest, your monthly payment will be $800.68. $433.33 ($200,000 x 2.6%/12) will be paid as interests, and the remaining $376.35 is paid to your principal. Your loan amount will be reduced to $199,632.65.

The interests payments depend on your principal loan amount – the higher your principal, the higher your interest.

As your principal reduces, a more significant portion of your monthly payments will go towards paying off your loan, and a smaller part will be interest payments.

So, you will be paying most of your interest for the first few years, that is why bank loans usually have a prepayment penalty for the first five years. A prepayment penalty is incurred when you make extra payments to pay down your loan earlier than the loan duration.

In this example, I used a HDB loan because it does not have any prepayment penalty. So, you can pay it off whenever you can.

## Scenarios

I will explore a few set of scenarios. You may click to skip to each section:

- Prepay loan or keep your money in your CPF OA account?
- Prepay loan or transfer your money to your CPF SA account?
- More realistic scenarios: A strategy that focuses on prepaying the loan vs a strategy that focuses on maximizing your CPF SA.

### Prepay or Keep Your Money With CPF OA

Let us imagine a scenario where you just bought a new house and need an additional $200,000 to finance your home. So you took up a HDB loan.

A month later, you somehow won $200,000 in a lottery. However, that $200,000 lottery is contributed to your CPF OA.

Let’s assume your CPF SA has $40,000 and with a monthly salary of $5,000, your monthly contributions to your OA and SA are: $1,150 and $300

So with this new windfall, what decision is the best?

- Do not prepay the loan. Let your money compound in CPF OA.
- Prepay your mortgage in half, i.e. pay $100,000, let the other half compound in CPF OA.
- Prepay your loan in full. Empty your CPF OA and start from scratch.

I have created a google spreadsheet that calculates the interest gained in the following scenarios. Let us compare the results.

### Comparison of these scenarios

Scenario | Interest Paid To Loan | Interest Accrued (OA) | Interest Accrued (SA) | Net Gain | Detailed Data |
---|---|---|---|---|---|

No loan prepayment | $88,244.59 | $287,880.04 | $153,153.83 | $352,789.28 | Source |

Prepay $100,000 | $17,028.46 | $222,200.00 | $153,153.83 | $356,337.23 | Source |

Repay loan fully | $0.00 | $207,314.42 | $153,153.83 | $360,468.26 | Source |

Hence, the faster you prepay your loan, the more interest you will gain for the next 30 years.

If you pay in full, you will get $7,678.98 more in net interests than taking on the entire loan.

If you pay in half, you will get $5,536.10 more in net interests than taking on the full loan.

Hence, it is better to prepay the loan than keep your money in your CPF OA for the duration of the loan.

For scenario 3, you own the house from the start because you had fully paid off the mortgage. However, your funds have been significantly depleted. You could also use your house as collateral to borrow at a lower rate if you needed cash.

### Prepay or Fund Your SA Account?

What if instead of prepaying your loan, you chose to fund your CPF SA account instead.

Let’s assume that your CPF SA account has $40,000. The conditions are the same as the first scenario: $200,000 in OA, $200,000 loan for 30 years. Contribution to OA and SA are $1,150 and $300 respectively.

The CPF SA account earns you 4% interest per annum and 5% interest per annum on the first $40,000.

In this scenario, you decided to put your lottery money to work by transferring to a higher interest account:

- Transfer $141,000 to your CPF SA (maximum transferable amount is $181,000 which is the FRS) and keep $59,000 in OA and do not prepay the loan.
- Pay the loan in full. But transfer from your OA to your SA regularly.

### Comparison of these scenarios

Scenario | Interest Paid To Loan | Interest Accrued (OA) | Interest Accrued (SA) | Net Gain | Detailed Data |
---|---|---|---|---|---|

Maximize SA, keep the loan | $88,244.59 | $133,079.18 | $408,025.60 | $451,728.66 | Source |

Pay loan in full, then maximize SA | $0.00 | $121,370.52 | $288,174.72 | $409,545.25 | Source |

If we factor in the CPF SA, it is better not to prepay the loan but to maximize your CPF SA and let it compound from the start. The 4% interest makes a huge difference in 30 years.

If you paid off the loan, you would lose out on giving your CPF SA a headstart to compound over the 30 years.

The interest from CPF SA in the first case is $408,025.60 while the interest from CPF SA in the second case is $288,174.72. The difference between the two cases is $43,314.93, which is huge.

### More Realistic Scenarios

Ok, not everybody can win the lottery. So for the average person who had nothing in their CPF and had to borrow from HDB, which is the better option?

Let us assume the following:

- Amount in CPF OA: $20,000
- Amount in CPF SA: $40,000
- Monthly contribution to OA: $1,150
- Monthly contribution to SA: $300

With that, let us crunch the numbers and find out how much interest you would earn for the following scenarios:

- No loan prepayment, no transfer from OA to SA. (Base case )
- Prepay $10,000 whenever your OA accumulates to $30,000. No transfer to SA (Maximize prepayment)
- No loan prepayment. Transfer your $10,000 from your OA to SA whenever your OA collects to $30,000. (Maximize SA

### Comparison of these scenarios

Scenario | Interest Paid To Loan | Interest Accrued (OA) | Interest Accrued (SA) | Net Gain | Detailed Data |
---|---|---|---|---|---|

Base case | $88,244.59 | $90,259.59 | $153,153.83 | $155,168.83 | Source |

Maximize Prepayment | $50,798.00 | $55,397.22 | $153,153.83 | $157,753.05 | Source |

Maximize SA | $88,244.59 | $45,814.28 | $223,212.84 | $180,782.52 | Source |

If maximizing interest is your objective, you should always aim to transfer to your SA. The difference between the base case is $25,613.69

However, transfer to SA is irreversible so you might want to think twice before you make that move. Once the fund is in your SA, you will not be able to withdraw it until you reach retirement age.

Hence, the other option, prepay as soon as you can is another great option. HDB loans have no prepayment penalty so you should always take full advantage of it. With this option, you will make an extra $2,584.23

Even if you did not do anything – no prepayment or transferring your funds from OA to SA – you will still accrue $90,259.59 interests which is more than the interest you paid for the loan ($88,244.59).

I have not talked about investing your CPF OA in equities instead. The expected return will be higher than your CPF SA. However, it also comes with more risk, and you may end up losing more.

## Conclusion

Feel free to make a copy and play around with my comparison sheet. If you would just like the calculator, you could use this sheet.

When it comes to debt, there are two main costs to consider:

- Cost of financing the debt – this is the interest paid towards your loan
- The opportunity cost of equity – the money used to pay your loan could be invested elsewhere to earn a higher return. It is represented by the interest from the CPF SA and CPF OA.

Hence, if you could guarantee higher returns, e.g. the CPF SA account, you could always move more of your cash to higher-yielding assets.

If you could not find any higher-yielding assets, you should aim to prepay as much of the loan as possible, provided that there are no prepayment penalties.

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