Interest-only home loans disappeared from Singapore in September 2009. The arithmetic of why a smaller instalment is not a cheaper loan still applies to every repayment decision you make.
Interest-only housing loans are no longer available
In September 2009 MAS barred interest-only loans for uncompleted private property. Officially, completed homes were left alone; in practice the banks stopped offering interest-only loans on those too, at the same time, so nothing below can be taken up today. The arithmetic is kept because it is still the clearest illustration of how amortisation works, and of why a lower monthly payment is not the same as a cheaper loan.
Most people, when considering which housing loan to go for, will usually decide on a principal and interest housing loan. Many are not aware of the option of interest servicing only housing loan packages; of those who do, the majority would summarily dismiss the idea. The notion of never paying off your housing loan can be stomach churning.
However, are interest servicing only housing loans really that bad? Interest servicing only or interest only packages do have a primary advantage. The monthly payment is minimised, freeing up your cash for entertainment, investment and other purposes. In fact, proponents of interest only packages believe that such packages give higher Returns on Investment (ROI) compared to a principal and interest housing loan. Let us look at a comparison between the two types of housing loans to see whether this is the case.
| Over 3 years | Loan left | Interest paid | Total paid |
|---|---|---|---|
| Principal and interest (P&I) | $470,177 | $50,927 | $80,750 |
| Interest only | $500,000 | $52,500 | $52,500 |
Assumptions
On those figures the interest-only loan leaves you $1,573 worse off: that is the interest on the principal you did not repay. Measured as a return on the cash put in, it looks better, because less cash goes in: $46,016 on $177,500 is 26%, against $47,589 on $205,750, or 23%, for P&I. But a higher percentage on less money is not more money. The question is what the $28,250 it leaves in your pocket, about $750 to $820 a month, does while you keep it.
Suppose the interest-only borrower invests each month’s difference as it arises. Both have then put in the same $205,750, and which comes out ahead depends on what the investment earned:
| Return a year | 1% | 3.5% | 5% | 10% |
|---|---|---|---|---|
| Earned on the $28,250 | $425 | $1,524 | $2,209 | $4,640 |
| Interest only against P&I | −$1,148 | −$50 | +$635 | +$3,067 |
The break-even is about 3.6% a year, close to the 3.25% to 3.75% the loan itself charged. Below it, repaying the loan was the better use of the money; above it, investing was.
So interest-only pays only when the money you keep earns more than the loan costs, and that is the fallacy: a lower instalment is not a cheaper loan. The interest you save by repaying is certain; the return on an investment is not. And because the loan never shrinks, a fall in property prices leaves the interest-only borrower with less equity to absorb it.
The same arithmetic applies to a choice you can make today: whether to use spare cash to pay down part of your loan, or keep it invested, allowing for any prepayment penalty in your lock-in. Ask an advisor to run it against your own loan’s rate.
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