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Sunday, May 4, 2014

Effect Of Inflation On Loan Installments

“RM5 for a bowl of curry noodles? In my day, it was 50 sen!” Sounds familiar? No doubt you hear your parents and grandparents griping about today’s prices more often than not.

This phenomena does not happen miraculously only in Malaysia, but rather throughout the whole world. The reason for the price differences is simple and straightforward: inflation. We won’t go into the mechanics of inflation and its causes here; all we need to know in this context is that it devalues a currency over time by increasing the prices of goods and services.

Many of us were taught that when it comes to housing loans - paying them off whenever you have spare cash and the more the better because you will be done with them earlier; and you "save" a lot of interest. But is this true? It is only true if and only if inflation is at 0%, which we all know not possible. With inflation, the opposite could ring true simply because RM10 thirty years ago has higher value than a RM10 today simply because of inflation; and with this logic 30 years later the RM10 definitely has lower value.

Eg. RM1 today might get you 100 candies, but next year the same RM1 will get you 96 candies if the inflation is at 4%.

Next year: RM1 = 100/(1+4%) = 100/1.04 = 96 candies
Following year: RM1 = 100/(1+4%)^2 = 100/1.08 = 92 candies

From the above, you can see that every year you are getting less candies from the previous year, with the same amount of money; simply because of inflation.

If this is the case, is it advisable for one to pay more for housing loan; just to pare the interest? Will we lose out by paying out more and shortening loan tenure? One major argument against this logic is that while you might save some money by outsmarting inflation, you would end up paying more anyway due to the huge amounts of interest over the years.

To gain a clearer understanding of the impact of inflation here, we have to get a little technical.

Let’s take a home loan of RM450,000 paid over 30 years at a steady Base Lending Rate (BLR) of 4.2%. Your monthly repayment would work out to RM2,200.58

For argument’s sake, let’s compare two hypothetical scenarios.

Scenario 1 – Standard repayments made to bank throughout tenure length
Scenario 2 – An overpayment of RM100 is added on each month throughout the tenure length

Monthly Installment 2200.58 2300.58
Tenure 360 331
Total Repayment 792208.8 761492 30716.82

From the table above, it can be noted that overpaying your monthly installments consistently throughout tenure will save you RM30,716.82 in total.

But does that value reflect the actual value saved when taking inflation into account?

Let’s now look at the two different inflationary scenarios to get a picture of how much value you actually stand to save from repaying earlier. All calculations are based on the discounted cash flow of the mortgage amortization.

* Discounted cash flow payment = Payment/[ (1+ (inflation rate)) ^ number of months]

Assuming the average inflation rate in Malaysia is at 4% throughout tenure:

The amount saved after taking inflation into account = Only RM157.17 in today’s Ringgit

This is the value of the amount saved based on present day value.
However if the average inflation rate in Malaysia is at 5% throughout tenure:

You actually don’t save any money but end up ‘losing’ money in a sense.
The total amount LOST after taking inflation into account = RM 2,790.50 in today’s Ringgit

From here, it becomes clear that by overpaying and saving that additional RM
30,716.82 in the future, not necessary translate into savings but might ended up "paying more" or "losing" just because of the effect from inflation! I've attached the sample calculation as well.

The above-mentioned scenarios were based on certain assumptions. What is more likely to happen over the duration of thirty years is a random fluctuation in BLR and inflation rates over time

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