Sunday, 20 December 2015

Is CPF Accrued Interest Double Counting of Housing Loan Interest?

This question has baffled me for quite a long time. When you use your CPF money to service your housing loan, CPF will compute accrued interest on the amount you withdraw from CPF until you sell the house. The accrued interest reflects the amount of interest you would get in your CPF account had you not used it to service the loan. When you sell the house, the principal and accrued interest have to be returned to CPF. This raises several other related questions – should accrued interest affects the attractiveness of the housing purchase and is better to use CPF or cash to service the housing loan?

To better appreciate and answer these questions, it is best to consider a typical scenario and leave CPF out of the picture for the time being. Let us assume that you intend to purchase a HDB flat for $500K. HDB agrees to loan you 90% of the purchase price. You will need to fork out the remaining 10% as downpayment. However, your kind-hearted parents, who have been working for several years and have accumulated some savings, willingly offer to pay the downpayment for you. You relunctantly agree, promising to pay them interest for the money loaned so that they could have sufficient money for their retirement. Thus, HDB pays 90% of the purchase price while your kind-hearted parents fork out the remaining 10% and you do not need to pay a single cent.

The HDB loan is a formal loan which requires monthly repayment, whereas the loan from your parents is an informal one which does not have any fixed payment terms, except for your promise to return the full amount borrowed plus accrued interest to them when you sell the house. Each month, you have to make repayment to HDB to pay down the formal loan. Again, your kind-hearted parents offer to service the monthly repayment so that you do not need to fork out a single cent every month. Thus, over time, as you pay down the HDB formal loan, you borrow more and more informal loan from your parents, with accrued interest growing increasingly with time and size of the informal loan. When you have fully paid off the HDB formal loan, you no longer need to borrow additional money from your parents, but the accrued interest continues to accumulate, until you sell off your house.

Assume further that you sell off the house for $1 million and the principal borrowed from your parents plus accrued interest amounts to $800K. As promised, you return $800K to your parents and retain the remaining $200K. Your kind-hearted parents accept the money, but assure you that whatever money they have will eventually belong to you as inheritance. Thus, it does not really matter whether you return $800K or $600K to them, because you will eventually get the full $1 million. 

Now, kind-hearted parents tend to have kind-hearted children. Assume that you decide to use a generous interest rate to compute the accrued interest such that the principal plus accrued interest amounts to $1.2 million. As this exceeds the sales proceeds from the house, you will return the full $1 million to your parents and get nothing. Your parents do not require you to cough up the remaining $200K owed to them. From your perspective, this looks like a "lousy" investment as you end up losing $200K on the housing purchase. However, can this really be considered a lousy investment, since the house doubles in value from $500K to $1 million? The computation of accrued interest merely affects how the sales proceeds are distributed to your parents and yourself. Considering that you will eventually get back the full $1 million, the accrued interest does not affect the attractiveness of the housing purchase.

Now, let us suppose from the beginning that you actually have some cash and do not need to rely on your parents' savings to service the downpayment and/or monthly repayment. Which of these would be a better option to service the loan – using your cash or your parents' savings? It all depends on who can grow the money at a higher rate. If you are able to invest your cash at a higher rate of return than your parents, then it is better to use your parents' savings to service the loan. Conversely, if your cash is left in the bank earning 0.05% interest rate while your parents' savings are able to grow at 2.5% annually, then it is better to use your cash to service the loan. 

We have come to the end of the story. Now, please replace the kind-hearted parents in the story above with your own CPF savings. It becomes a whole lot clearer what the CPF accrued interest is all about and whether it affects the investment and financing decisions. To summarise,
  • CPF accrued interest arises because you are taking out a second, informal loan from your CPF account to service the downpayment and/or monthly repayment so that you do not need to draw down your cash. It is not double counting of interest on your formal housing loan.
  • Computation of CPF accrued interest and return of principal plus accrued interest after the sale of the house merely affects the distribution of the sales proceeds between your CPF account and yourself. It does not affect the attractiveness of the housing purchase. The key interest rate that affects the investment decision is the housing loan interest rate, not the CPF interest rate used to compute the accrued interest. 
  • Whether to use CPF or cash to service the housing loan depends on their relative rates of return. Use the one with the lower rate of return to service the loan.

By the way, topping up your and/or your family members' CPF accounts with cash allow you to enjoy income tax reliefs of up to $7,000 (top-up for yourself) + $7,000 (top-up for family members) next year. If you have not done so, please hurry, before the year ends!


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30 comments:

  1. Hi Chin Wai,

    That's a good analogy you have shown there.

    Logically, the CPF accrued interest should not be a big factor especially if one is going to use the proceeds to buy another house.

    ReplyDelete
    Replies
    1. Hi 15HWW,

      Thks. Yes, that's right. The accrued interest can be used for the next house purchase.

      Delete
  2. Replies
    1. Hi Frugal Daddy,

      Thks for your compliments!

      Delete
  3. Hi Chin Wai,

    Wah, how come CPF board didn't ask you to be their writer to explain this? It makes it so much easier to absorb and understand that the often talk-down method of explaining, haha!

    Well done :)

    ReplyDelete
    Replies
    1. Hi La Papillion,

      Thks. I only thought of it a few weeks ago when a reader asked me a related question, which triggered a rethink from fresh perspectives.

      Delete
  4. Hi. What if I dont sell my flat ever? Accrued interest keeps snowballing. Will there be a demand to return the accrued interest at some point?

    ReplyDelete
    Replies
    1. Hi,

      If you don't sell your flat, the accrued interest will keep on increasing. No, CPF won't demand that you return the principal plus accrued interest, unless you sell off your flat.

      Delete
  5. the return accrued interest will be channeled back to our cpf OA account?

    ReplyDelete
    Replies
    1. Yes, the accrued interest will be returned to the OA account when you sell the house.

      Delete
  6. Hi there, Nice article.
    Question i have if using CPF to pay for my housing.
    If there were any type of 'crisis' where i am forced to sell my HDB for zero profit and move in with my siblings, and i will definitely need to return the accrued interest after i sell the house. What if i do not have enough to return the interest portion to CPF?

    ReplyDelete
    Replies
    1. Hi, you need to return the accrued interest to CPF. But if you don't have enough profit to return it, CPF won't ask you to cough up cash for it.

      Delete
    2. So what happen to the Not enough portion? It will be wavied off? No more payment for it?

      Delete
    3. The accrued interest will still be there, but you don't have to cough cash to return to your CPF account.

      Delete
    4. So how do we pay for it? Or when we have to pay for it?

      Delete
    5. When you sell the house, the sales proceeds will go back to your CPF account to refund the principal and accrued interest. But if you don't sell the house, you are not required to top-up cash to refund them.

      Delete
  7. Hi, correct me if I am wrong. So it make more sense to take hdb loan since the accrual interest of 2.5% will eventually return to your own cpf account if you sell your hdb. For bank loan, whatever interest rate paid is to the bank.

    ReplyDelete
    Replies
    1. Hi Izaac,

      No, that is not correct. Regardless of whether you take a loan from HDB or bank, so long as it is serviced using CPF funds, CPF will compute accrued interest. Interest for the loan paid to HDB or bank will not be returned to your CPF account. Only accrued interest will be returned when you sell your flat.

      Delete
    2. Hi,

      I think that there are 2 parts to this;
      i) HDB vs bank loan
      ii) repayment mode; cash or cpf

      Cld i clarify if izaac is asking about i or ii? Separately, while accrued interest does go back to the OA (i.e. Still ur money regardless), how's generated is different. Leaving the same amount in the OA (instead of using it to repay the bank/HDB loan) means the govt pays u the "accrued interest" instead of it coming from the (future) sale of the property. In short, either your assets or the govt pays the 2.5% interest.

      Whether one shld use cash or cpf depends really on whether u can _consistently_ generate more than 2.5% on the loan amount for X no. of years.

      Delete
  8. hi if parents were to passed away in future... what will happen to the accrued interest n principal payment if the kids were to sell off?

    ReplyDelete
    Replies
    1. Hi. There is no need to repay the principal withdrawn and accrued interest to CPF in that case. It is not a formal loan.

      Delete
  9. There is a flaw in the analogy here. The parents cannot be replaced with CPF because the parents provided their money with the assumption that there is no contribution you. CPF on the other hand is using your own money to loan you and yet you have to pay back interest on your own money.

    This is like putting money into your own bank account and you would need to pay back the interest of your withdrawal.

    ReplyDelete
    Replies
    1. The analogy is correct. You can treat the money the parents have as coming from monthly contributions from you. It does not change gist of the story.

      Essentially, CPF accured interest is paying interest from your left pocket (cash account) to your right pocket (CPF account). Whether the interest rate is 0%, 2.5% or 5%, it does not change the total amount of money that you rightfully own.

      Delete
    2. There is some opportunity cost component right? Because the right pocket is a special pocket that earns 2.5% interest that magically appears (from govt).

      I'll use flat rates and simple calculations for my analogy.. Assume I have $300k in my left pocket (cash) and $300k in my right pocket (CPF). Today I go buy a flat for $300k and I pay in full.

      Method A: I pay full with cash
      Method B: I pay full with CPF

      Scenario 1: 10 years later, I sold the flat for same price, $300k.
      Method A: Left pocket has $300k. Right pocket has $375k. <-2.5% interest over 10 years
      Method B: Left pocket has $300k. Right pocket has $300k. <-accrued interest shows I still owe $75k to my CPF but they will not ask me to repay with cash.

      Scenario 2: 10 years later, I sold the flat for $375k.
      Method A: Left pocket has $375k. Right pocket has $375k. <-2.5% interest over 10 years
      Method B: Left pocket has $300k. Right pocket has $375k. <-accrued interest shows all paid

      I know the calculations are not that accurate because there are interest tiers and compounding, but is the principle correct?

      Delete
  10. With the new 99year lease equating zero value.
    In worst case scenario, when the lease ends, house cannot be sold, the owners or inheritance need to cough out the accrued interest to cpf?

    ReplyDelete
    Replies
    1. No, there is no need to cough up the accrued interest and return to CPF.

      Delete
  11. Hi Chin Wai,

    Let's say I have "borrowed" 300K from CPF. Accrued Interest = 50K.

    Scenario A: Flat is sold at 300K.
    Q: Will the 50K continue to be accrued?
    Q: If I buy another new flat, will I be able to use the full 300K (in my CPF) to fund my purchase?

    Scenario B: Flat is sold at 270K.
    Q: Will the interest accrual be based on 30K or 80K?
    Q: If I buy another new flat, will I be able to use the full 270K (in my CPF) to fund my purchase?

    My apologies if the questions are too elementary :)

    ReplyDelete
    Replies
    1. Hi Hymn 4TW,

      The accrued interest indicates how much interest you would have earned in your CPF account had the funds not been used for housing. Hence, based on the above understanding, the answers to your questions above are as follows:

      Scenario A: Yes, the $50K will continue to accrue interest. You can use the full $300K for the next flat.

      Scenario B: Accrual will be based on $80K. You can use the full $270K for the new flat.

      Delete