Meet Alison, a 45-year old insurance agent.
On average, Alison earns RM 20k a month in sales commission. Today, she has 1 investment property, where she owes a mortgage balance of RM 450k incurring 4% in interest costs per year. After deduction of property-related costs, Alison is earning RM 1.5k a month in netted rental income (before interest & taxes).
Recently, Alison had amassed RM 100k in excess cash-in-hand. Thus in her case, the question is: ‘Should she use this cash to lower her mortgage balance and by doing so, reduce her interest costs?’.
Here, let’s examine:
Base Case Scenario:
For 2023, Alison’s maximum tax bracket would be 25%. This is because her level of annual income is RM 100k-RM 250k.
For her investment property, Alison’s declaration of rental income would be RM 0. This is because her netted rental income of RM 1.5k a month (RM 18k a year) is offsetted in full with RM 18k a year in interest costs (RM 450k x 4% a year). In other words, her rental income would not be taxed at the moment.
Net Annual Rental Income = RM 1.5k x 12 months = RM 18k a year.
Annual Interest Costs = RM 450k x 4% a year = RM 18k a year.
Annual Taxable Rental Income = RM 0
What if Alison Reduces Her Mortgage Balance?
If she opts to do so, Alison’s mortgage balance shall be reduced to RM 350k. So, instead of RM 18k, her interest cost will be reduced to RM 14k a year. Thus, this would amount to RM 4k a year in gross interest savings.
Net Annual Rental Income = RM 1.5k x 12 months = RM 18k a year.
Annual Interest Costs = RM 350k x 4% a year = RM 14k a year
Annual Taxable Rental Income = RM 4k a year
This RM 4k is taxable at the rate of 25%. Hence, Alison shall pay RM 1k a year in income tax. Thus, her net savings achieved would be RM 3k a year.
Annual Taxable Rental Income = RM 4k a year
Tax Payable at 25% = RM 4k a year x 25% = RM 1k a year
Net Savings Achieved = RM 3k a year
As she’d used RM 100k in excess cash to derive RM 3k a year in interest savings, the yield Alison is attaining shall be 3% per annum.
Net Savings Achieved = RM 3k a year
Capital Used = RM 100k
Net Yield = RM 3k a year / RM 100k x 100% = 3% per annum
It is quite close to FD rates that are currently offered by most local banks. If let’s say, Alison chooses to place the RM 100k in FDs, she shall enjoy the flexibility of having the ‘cash-in-hand’ as the process to terminate FDs is much simpler. So, it could be much better to place the RM 100k in FDs than to pay off her loan.
What if Alison Places Her Money into EPF?
Let’s say, Alison chooses to park RM 60k into her EPF account and place RM 40k into FDs. She could expect around RM 4.4k a year in passive income and hence, yielding as much as 4.4% for her RM 100k.
Annual EPF Dividends = RM 60k x 5.35% = RM 3,210 a year
Annual Interests = RM 40k x 3% = RM 1,200 a year
Total Passive Income = RM 4,410 a year
Capital Used = RM 100k
Net Yield = RM 4.41k a year / RM 100k x 100% = 4.41% per annum
Based on mathematics, this would be ideal as compared to paying off her loan.
But What About Investing for Higher Returns?
What about stocks, unit trusts, ETFs, cryptos, and so on and so forth? Could she get better returns from investing into these vehicles?
The answer is yes and no.
This is because the returns from investing into such vehicles are quite reliant on many factors, both internal and external. Internal factors are factors that are on the investor himself, which refers to his mindset, skills, and experiences when it comes to investing. External factors are factors beyond the investor’s control. In most cases, this refers to changes in market and economic situations.
Because of this, it is not feasible to say ‘Investing in stocks is better than making loan repayments’.
If Alison invests in stocks that pay dividends consistently and appreciate in price over time, this move is great. But, if Alison buys herself bad stocks that resulted in price declines, then such a move is detrimental to her financial health. Hence for Alison, the choice to be made is dependent on what she perceives ‘investing in the stock market’ is.
The same goes with all other vehicles as stated above.
One Factor to Consider: Emotional Satisfaction
The above is a discussion that factors in mathematics, which is logical.
Although reducing mortgage balances is not the wisest move financially, for her case, what if she feels a huge emotional relief to see that her mortgage balance had been reduced by RM 100k. Such an emotional relief may lead to her feeling accomplished, upbeat, confident, hopeful and significant. They may translate to better physical and mental health for Alison.
Such returns are unquantifiable, but yet, could be meaningful to Alison.
Conclusion: Should Alison Reduce Her Mortgage Balance?
I believe the answer depends on what Alison values more. If she wants to profit more without the concern of volatility, Alison may consider EPF, FDs and even a load of digital cash management platforms such as KDI Save. But, if Alison is not concerned with volatility and wishes to invest savvily, she may invest her capital wisely in her preferred vehicles based on her knowledge and expertise.
But, if she values the emotional benefits of reducing mortgage balance more, in her case, Alison could choose to utilise RM 100k for that purpose.
So, would you reduce your mortgage balance with excess cash-in-hand?
Let us know by posting your comments below:
