Meet Alison, a 45-year old insurance agent. On average, Alison earns RM20,000 a month in sales commission.
She has one investment property, on which she has a mortgage balance of RM450,000 that incurs 4% in interest per year. After deduction of real estate costs, Alison earns RM1,500 a month in net rental income, before interest and taxes.
More recently, Alison has amassed RM100,000 in excess cash in hand. Should she use this money to lower her mortgage and, by doing so, reduce her interest costs?
Let’s examine the facts. For 2023, Alison’s maximum tax bracket would be 25%, given that her level of annual income is between RM100,000 and RM250,000.
Alison’s declaration of rental income would be RM0, given that her net rental income is RM1,500 a month, which is offset in full with RM18,000 a year in interest costs. In other words, her rental income is not taxable right now.
Now, if she opted to reduce her mortgage balance, it would be lowered to RM350,000. Her interest, accordingly, would be reduced to RM14,000 a year – or RM4,000 in annual gross interest savings.
This RM4,000 is taxable at the rate of 25%, meaning she would pay RM1,000 a year in income tax. As such, her net savings would be RM3,000 a year.
As she would have used RM100,000 in excess cash to derive RM3,000 a year in savings, this equates to a yield of 3% per annum. This is quite close to the fixed-deposit rates offered by most local banks.
If Alison were to place the RM100,000 in FD accounts, she would enjoy the flexibility of having cash in hand as the process to terminate such accounts is relatively simpler.
As such, it would be wiser for her to place the RM100,000 in a fixed-deposit account than to reduce her mortgage.
Now, let’s assume Alison were to park RM60,000 into her EPF account and place RM40,000 into an FD account. She could then expect around RM4,400 a year in passive income, or as much as 4.4% for her RM100,000.
The breakdown would be as follows:
- Annual EPF dividends = RM60,000 x 5.35% = RM3,210 a year
- Annual interest = RM40,000 x 3% = RM1,200 a year
- Total passive income = RM4,410 a year
- Capital used = RM100,000
- Net yield = RM4,410 a year / RM100,000 x 100% = 4.41% per annum
Based on the maths, this would be more ideal compared with paying down her loan.
Investing for higher returns
Could Alison get better returns by investing in vehicles such as stocks, unit trusts, ETFs, cryptocurrency and so forth? The answer is yes and no. This is because the returns from such investments depend on many factors, internal and external.
Internal factors are those that relate to the investor – namely his or her mindset, skills, and experience when it comes to investing. External factors are those beyond the investor’s control, e.g. market and economic conditions.
Owing to this, it is not feasible to claim that investing in stocks is better than making loan repayments. If Alison invested in companies that paid dividends consistently and appreciated over time, then great. But should the opposite be the case, then such a move would be detrimental to her financial health.
One final consideration…
So far, the above takes into account the maths, which is logical. But there’s also much to be said for the emotional relief one might feel at seeing one’s mortgage reduce by RM100,000.
This in turn could lead to positive feelings – accomplished, confident, hopeful, of value – which translate to better physical and mental health. Such returns are unquantifiable but can ultimately be the most meaningful outcome.
Ultimately, it depends on what you want – so, would YOU opt to reduce your mortgage with excess cash in hand?
This article first appeared in KCLau.com. Ian Tai is a financial content writer, dividend investor, and author of many articles on finance featured on KCLau.com in Malaysia, and ‘Fifth Person’, ‘Value Invest Asia’ and ‘Small Cap Asia’ in Singapore.