Let’s say, you’re now in your 40s.
Years ago, you bought a property for RM 300k where you funded your purchase with RM 30k in down payment and RM 270k in home mortgage. Your mortgage installment is RM 1,200 a month. In addition, you incur RM 500 per month on a list of property-related expenses: service fees, sinking funds, land & assessment taxes, insurance, and repair & maintenance.
Today, your property is worth RM 500k. You owe RM 200k in mortgage balance. You earn RM 1,400 a month in rental income from the property. Also, you make RM 200k a year in employment + business income and have around RM 200k in excess cash.
The question is: “Is it financially smart to settle the RM 200k in mortgage in full, using the RM 200k in excess cash?”. Let’s examine:
Option 1: Use RM 200k to Settle Mortgage in Full
In a glance, you’ll receive positive monthly cash flows from your property, upon full mortgage settlement. Here, you may think that you’ll collect a monthly cash flow of RM 900 or annual cash flow of RM 8,100.
Annual Cash Flows
= (Rental Income – Property-related Expenses) x 12 months
= (RM 1,400 – RM 500) x 12 months
= RM 8,100
But in reality, your final annual cash flow is lower as the RM 8.1k is subjected to income tax. In your case, as you earn RM 200k in active income, your maximum income tax bracket is 25%. So, you’ll pay RM 2,025 in income tax for the income received from this property. Thus, your final annual cash flow is RM 6,075. Such works out to be RM 506.25 a month.
Final Annual Cash Flows
= RM 8,100 – Income Tax
= RM 8,100 – (RM 8,100 x 25% (Maximum Income Tax Bracket))
= RM 8,100 – RM 2,025
= RM 6,075
Option 2: Keep RM 200k in FDs
Now, let’s say you choose to place RM 200k into FDs which earn 3% interest per annum. After a year, you’ll earn RM 6k in interest income.
As for your property, you earn RM 1,400 in rental income. In addition to the RM 500 in property-related expenses, you’ll incur interest cost from your mortgage. Based on your mortgage instalment of RM 1,200 a month, let’s say:
- Interest Costs = around RM 900 a month (tax-deductible)
- Debt Repayment = around RM 300 a month (non-tax deductible)
Therefore, your net rental income is calculated as follows:
Net Rental Income
= (Rental Income – Tax-deductible Property Costs – Interest Costs) x 12 months
= (RM 1,400 – RM 500 – RM 900) x 12 months
= RM 0.
As such, you’ll pay RM 0 in income tax from your property.
For this option, your final annual cash flow is calculated as follows:
Final Annual Cash Flows
= FD Interest + ((Rent – Mortgage – Property-Related Costs) x 12 months)
= RM 6k + ((RM 1.4k – RM 1.2k – RM 500) x 12 months)
= RM 6k + (-RM 300 x 12 months)
= RM 6k – RM 3.6k
= RM 2.4k
Sure, your annual cash flow is lower. But remember – You have RM 200k in FDs.
Keeping Cash is Smarter
Here, it is smarter to keep cash, not settling the loan in full.
Firstly, the cash placed in FDs can be used as reserve funds.
Secondly, interest income from FDs are tax-free. Sure, mortgage interests today, at 4+% a year, are higher than FD interest of 3% a year. This encourages some in this situation to settle the mortgage and enjoy interest savings. But by doing so, they fail to consider the following:
- Net rental income is subjected to income tax.
- Investors can deduct mortgage interest costs to reduce income tax.
- FD interests are tax-free income.
Actually, if you think about it:
“Saving 4% interests but are subject to 25% tax” would bring you 3% in real and actual interest savings a year. It’s the same rate that you’ll get with FDs. But you would enjoy liquidity with FDs and not with mortgage settlement.
What If You Choose to Invest RM 200k?
This highly depends on your investment skill and experience.
First, let’s assume that you know nuts about investing. You can choose to put as much as RM 200k (Year 1: RM 100k + Year 2: RM 100k) into your EPF account. It would generate 5%-6% in EPF dividend yield (2023: 5.5%) per annum. Hence, in this case, you’ll receive 5-figure EPF dividends starting in Year 3, after you made your EPF contributions.
Second, if you have a dividend portfolio and have the confidence to generate as much as 5%-6% in dividend yield, obviously, you’ll generate 5-figure dividends a year from an additional RM 200k in your portfolio. Unlike EPF, you may collect a steady stream of dividends on a quarterly / half-yearly basis and enjoy liquidity, just like FDs. However, the price to these is “some level of price volatility” when holding onto your portfolio.
Third, if you are building a growth portfolio, you’ll have less dividend income. In your case, it is about building your net worth as you expect your stocks to grow, increase, and expand their business operations for the long-term. Such requires more investing skill, patience, and experience to make it work. If it works, there is a possibility for your RM 200k to grow significantly in 3, 5 or 10 years time.
As you can see, there are more options to utilize cash than just to settle debt.
Conclusion:
The ideal net rental income for investors with high annual income to have is RM 0. This is possible if investors are aware of tax-deductible expenses. The one big expense that is tax-deductible is mortgage interest. Because of this, it’s sensible for investors to not settle mortgages in full quickly. There is no real need to aim, strive and achieve “the debt-free status”.
As such, the excess cash can be kept as reserve funds or be invested in stocks to earn dividends and long-term capital appreciation. But, they require some skills and experiences. For some who don’t want to learn, EPF contribution can be an ideal option as it consistently pays out 5%-6% in dividend yield.
By Ian Tai Financial Content Machine. Dividend Investor. Produced 500+ Financial Articles featured in KCLau.com in Malaysia and the Fifth Person, Value Invest Asia, and Small Cap Asia in Singapore. Regular Host and Presenter of a Weekly Financial Webinar with KCLau.com.
