Discussed my one of my long held belief with my parents today.
It was regarding interest rates and how to minimise amount of money used to purchase an item, especially big ticket items like a house or a car.
Theory:
Instead of buying them by installments, save up enough and buy them in a 1-off payment.
Pros:
-> Pay a total of less money
-> Reduce the hassle of installment paying and fear of not being able to pay the next installment
-> You will probably "finish paying" earlier than if you bought by installment
Cons:
-> Will not have the item until you have saved enough
How does it work? Lemme illustrate with some figures:
[Note: The following are simply figures to explain my idea, not real figures]
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Assume the money are in real terms (i.e. taking into account of inflation),
Item to purchase: A 5-room HDB flat
Price (NOW): S$60,000
Price (20 years later): S$140,000
[Assuming property prices rise, which is quite common, at an average rate of S$4,000 per year. Furthermore, SG being small and densely populated, property prices increase rather quickly]
Installment Plan: (20 years) S$10,000/yr or around S$833/mth
Total amount paid (by installment over 20 years): S$200,000
Amount put aside to buy the item in 1-off payment: S$10,000/yr or around S$833/mth
Time taken to save enough to buy in 1-off payment: 10 years
[Price (10 years later): S$60,000 + 10x S$4,000 = S$100,000]
Total amount paid (by 1-off payment): S$100,000
Amount saved: S$100,000
Time saved: 10years
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Of course, the example may not be reflective of the real world, but that's the gist of the idea. Save time, save money, just endure without it for a while.
Some things that my parents put forward (they disagree with my theory and say it was childish, naive thinking =\):
-> Random events
Like suddenly 5million people decided to come to SG to stay, hence ramping the prices up by a heck lot in a short moment. In that case, payment by installment will be cheaper as the rate is already fixed while the payment by 1-off is dependent on the price at the point of purchase.
-> Amount of interest paid in total is less than the amount of appreciation of item
For example, in total, you pay S$40,000 in interest over the years. However, after you have paid finish, the item had appreciated by S$50,000, hence you have "profited" S$10,000. Meanwhile, the payment by 1-off may end up paying more than by installment due to the unexpected increase in value of the item.
To discuss about the above argument, there are some things to be squared-off.
First off, what's the use of interest rates? They are to ensure that the seller does not lose out, if not profit, from the buyer after the buyer has completed paying back everything. This means that the total amount paid by the buyer should be equal, if not more, than the price of the item in the future. Hence, the seller will only lose out if there is an unexpected increase in price of the item after the installment rates have been agreed upon.
Secondly, in the above example, it has been assumed that the interest rate is more than the appreciation of the house. If not, HDB will be "losing" by selling the house at that installment rate.
Thirdly, just to clarify matters, it is a fact that people who buy HDB on installments realise they pay up to 2~3 times the actual price in total after they finish their installments. For example, they buy a 5-room at S$50,000 with installment. After clearing their installment, they have effectively paid a total of S$150,000. This is a real life example. So er, even if my example may not be perfect but it is sort of realistic, in the way that the total payable is insanely high.
Also, the installment rate is decided when you buy the house at S$60,000. So you have to follow up the plan till you pay finish all the installments. Meanwhile, the price will likely to be always lower than the final total amount paid, so 1-off payment will allow you to get the item faster, given that you save/pay at the same rate.
Okay, now to touch on the points put forward by my parents:
1) Random events are beyond our control and hence can hardly be considered as an arguing factor against/for the theory
2) My parents are very very sure that property prices will definitely rise faster than the amount of interest rate payable, hence it will definitely be more expensive to save and buy in a 1-off upayment. Sure, I agree that unexpected appreciation of item is the only factor that will probably upset the theory. However, the whole point of interest rate is to ensure that the seller does not lose out, or even gain, in the transaction. So, the difference between the interest rate payable and the appreciation should be negligible if not having more interest rate than appreciation. Furthermore, it is foolish to simply assume that property prices will always rise at rates that are quicker than the interest rate. Just take a look at the property prices in US. It is FALLING. Of course SG has less space and rising population, but still, one cannot simply assume prices will rise forever, just like the case of the US property bubble.
Regarding the disadvantage of not having the item till you can save up enough to buy in 1 shot. There's a "shortcut". Borrow from your parents/relatives to chalk up enough to buy in a single payment first. Then pay them back at the rate you would have saved to buy it previously. That way, you would get the item cheaper (since it hasn't appreciated yet) and immediately. While whoever lent you the money will get a nice interest rate (after all, the person will get S$100,000 in 10years for lending S$60,000 now, which is around 6.7% annual interest. Neat huh).
Hence, I still believe that my theory will hold.. Anyone got comments on it? What do you guys think?
