The Central Provident Fund (CPF) has been tweaked to allow for more options. Whenever this happens, there are two predictable responses on the internet: the first is to assume it’s a secret government plot, because there isn’t enough money to pay everyone. The second is to assume it’s a secret government plot, because taxpayers’ money needs to be re-invested elsewhere. We can speculate on these conspiracy theories, but we do know the changes help some home buyers:
How the CPF matters to home buyers
The most obvious relation between the CPF and your home is that it’s used to make the downpayment. The 10 percent down payment on a HDB loan can be paid through the CPF Ordinary Account (CPF OA), and 15 percent of the down payment on a bank loan can be paid the same way.
But there’s more more to it than that: many Singaporeans also use the CPF OA to make monthly mortgage repayments. And that’s where the interest rate starts to matter.
CPF rates and loan rates
The CPF OA has an interest rate of 2.5 percent per annum. Upon getting your first combined earnings of $60,000 across different CPF accounts, the interest rate rises to 3.5 percent.
This is important to home owners, as it determines the affordability of their mortgage.
Now, home buyers can pay for their mortgage using their CPF OA (yes, even if you are using a private bank loan). A fair number of Singaporeans don’t even track their home loan repayments, as they just set it to be automatically deducted from the CPF.
But this can result in the occasional nasty shock: sometimes, the CPF OA can run out. And when you get that letter, it means two things:
The first is that you now have to set aside a substantial sum each month. If you don’t see it coming, having to set aside an extra $3,000 a month for your condo can be a lifestyle changer (and not in a good way).
The second issue is more frightening: with the CPF OA wiped out, you may have no retirement fund. Everything has become tied up in the house.
In order to avoid both…
Home buyers need the CPF to significantly beat their mortgage rates
Over the long term, the CPF interest rate should beat the mortgage rate, because home loans are amortised (they become smaller as they are paid off), while savings compound. However, it is possible to end up with a loan so expensive, it wipes out your CPF OA long before the loan is paid off.
Now the interest rate on a HDB Concessionary Loan is 0.1 percent above the CPF OA rate, revised on a quarterly basis (although the CPF rates have remained unchanged for a long time). This means a rate of 2.6 percent per annum.
Most Singaporeans have accumulated the necessary $60,000 to get a bonus one percent, so they will beat this (their CPF OA grows at 3.5 percent, but their loan only costs 2.6 percent per annum).
Private bank loans have, since 2008, offered mortgage rates at around 1.8 percent per annum. This is one of the contributing factors to the high demand for property: at 3.5 percent, most people have CPF growth that significantly outpaces their mortgage. Many can pay for their mortgage via the CPF, and still be accumulating a small sum for the retirement fund.
But can Singaporeans always count on this happening?
With those on HDB loans, they may be able to. The government will no doubt take steps to prevent HDB loans from getting too expensive. But for those on private bank loans, it’s a bit of a worry: the historical home loan rate from banks is between three to four percent. It’s only been low because of the Global Financial Crisis in 2008/9. If it were to rise back up, the mortgage rates would outpace their CPF growth.
And even if the CPF can keep up with the mortgage, there is the question of how much is left for retirement. If everything is going into the house, that means the retirement plan is probably to sell it and downsize. That’s a heavy bet on property prices rising, or the market being good when it’s time to retire.
That’s why the new change to CPF investments is important to home buyers
This month, the Straits Times reported two changes to the CPF scheme. The first was an option to delay initial payouts, in return for payouts that rise at two percent per annum. We’ll leave that to financial advisors and wealth managers to discuss with you. What interests us is the second initiative: the CPF Lifetime Retirement Investment Scheme (CPF LRIS).
The CPF LRIS allows you to invest your CPF monies in diversified funds. These will provide higher returns for your CPF.
Many mutual funds are able to provide returns as high as five percent per annum, and the Straits Times Index Fund (ST Index Fund) has a cult following among some local investors (annualised returns of 8.4 percent per annum over 10 years, although this has since dropped and is not likely to continue in the long term).
Going back to what we said about CPF growth and your mortgage, you can probably see the appeal: getting more in your CPF means you’re ultimately saving faster than you’re spending on your house. You can retire with both a home, and a decent retirement income.
Now the idea of investing CPF monies is not new. The CPF Investment Scheme (CPF IS) has been in place for some time (you can see more about it on the CPF website). But most of the Singaporeans who put money into the CPF IS did not come out on top – many failed to beat the standard CPF interest rates.
For a time, this left many Singaporeans between the proverbial rock and a hard place: if they didn’t invest their CPF monies, they risked their retirement income as their home loan rates rose, and took up most of their savings. If they did invest the money, they risked getting an even worse rate.
The LRIS may resolve many of the issues of the existing scheme. Low cost, diversified mutual funds tend to be quite consistent in their returns – they are spread out among lowly-correlated stocks, so it takes a market wide recession to really make a dent in many of them. And if they are anything like Indexed Funds, we can expect low Total Expense Ratios (TERs).
The TER is the cost of the fund, and accounts for many Singaporeans getting unexpectedly low returns (e.g. If a fund has returns of five per cent, but the TER is two per cent, you would only be getting three per cent per annum. This underperforms even the CPF OA rate of 3.5 percent).
But most Indexed Funds have TERs as low as 0.5 percent, and their passive nature means investors don’t need to be experts on buying and selling. A simple buy-and-hold strategy may suffice to allow their CPF to outpace their housing costs.
Home owners with private bank loans should pay close attention
The period of low interest rates will not last forever. The only reason rates are not soaring right now is a temporary delay caused by the uncertainty of Brexit. And with home loan rates being at historical lows for almost a decade, they have few directions to go but up.
As such, home owners who are still in the early stages of their mortgage (the first five years) should give serious thought to the future. Once rates rise, it will be insufficient to use the old, lazy approach of just assuming the CPF can cover the costs. They need to pay close attention to the new investment options that open up, and be a little more hands-on with the money.