Buying your first home, or achieving mortgage freedom, may be a step closer following a National Pension Law amendment passed in the fall of 2011.
Caymanians can now borrow up to $35,000 of personal savings from private pension plans, like Silver Thatch, to buy or build a first home or to purchase residential land. Alternatively, Caymanians with a current mortgage on a home of $35,000 or less can borrow from their pensions to fully pay off the loan.
Before you jump in with both feet, however, there are some things to carefully consider. While borrowing from your pension may, at first blush, seem like a good idea, it can have a long-term negative impact on your pension savings.
As to whether borrowing against your pension is advantageous, there are financial experts on both sides of the fence – some for and some against. Ultimately, the best decision is one made with a full understanding of how pension loans work, and their impact on your personal financial well-being over the short and long term.
The amount you withdraw from your pension savings under the new program will be limited to the down payment required by your bank and may not exceed $35,000. For example, if the purchase price of the home is $300,000 and the bank requires a 10% down payment, then the most you may withdraw from your pension savings is $30,000.
If you withdraw funds from your pension savings, bear in mind that you are “borrowing” this money; you have to pay it back. In fact, you need to immediately increase your regular pension contributions by 1% of earnings until the earlier of the date you have:
- completed 10 years of additional contributions,
- added contributions equal to the amount borrowed from the plan,
- retired, or
- reached your normal retirement age (the first of the month on or after your 65th birthday).
Your employer is not required to make any additional contributions.
For example, if you earn $50,000 per year, your regular pension contributions are $2,500 per year, or $208 per month. Once you withdraw funds from your pension, however, your regular pension contributions will be increased to $3,000 per year, or $250 per month. That means that over the next 10 years, you’ll contribute an extra $5,000 (assuming your earnings remain unchanged).
Furthermore, if you sell your home or residential land before you reach age 65, you must pay back the full amount borrowed from your pension account, or 10% of the fair market value of the property, whichever is greater. For example, if you borrowed $35,000 from your pension savings and the sale price of your home or property is greater than $350,000, you’d have to pay back more than you borrowed. (This feature is designed to discourage speculators and keep the focus on helping pension plan members buy their first homes or pay off their mortgage.)
The impact on your pension…
Although you don’t pay interest on any funds you “borrow” from your pension, there is a hidden cost to your loan. For starters, you’ll miss out on the long-term, compound growth that money would have generated if it were left in the pension plan. For example, based on an annual return of 5%, $35,000 would grow to $57,011 over the next 10 years – an overall increase of $22,011. Over 25 years, that $35,000 would grow to $118,522 – an overall increase of $83,522.
The following graph illustrates how a $35,000 down payment loan would reduce your pension savings in the long term.
- The blue bars represent the compound growth of $35,000 as described above.
- The green bars represent the growth of the additional 1% contributions you would be required to make for 10 years. Assuming employment earnings of $50,000 per year and an annual return of 5%, these contributions would, over a 25-year-period, grow to $15,422.
- The gap between these blue and green bars represent the true cost of a $35,000 pension loan. The difference at the end of 25 years is $103,100 ($118,522 – $15,422).
Of course, this is an example only. The impact on your savings will depend on your personal circumstances, including your age and income. You’ll need to prepare your own estimate of how a down payment loan will affect your pension savings.
…versus the impact on your mortgage
On the other hand, withdrawing money to use as a down payment may have its advantages. Saving enough for a down payment can be a challenge, especially when home prices rise faster than you’re able to save. In this case, using money from your pension to meet the down payment needed may help you buy a home and start building home equity sooner.
Another advantage may be the chance to supplement other personal savings in order to reduce the overall size of your mortgage and its cost to you. To illustrate how this works, let’s assume you plan to pay $350,000 to buy a home and your bank requires a down payment of $35,000. Without borrowing from your pension savings, you will need $35,000 in cash savings to offer as a down payment and your mortgage will be $315,000. Amortized over 25 years at 5% interest, your mortgage will require monthly payments of $1,832 and cost you a total of $234,615 in interest.
By taking advantage of the new program, however, you could withdraw the $35,000 required down payment from your pension savings and supplement this with your $35,000 in cash savings. This would reduce your mortgage to $280,000. Again, amortized over 25 years at 5% interest, your mortgage will require monthly payments of $1,628 and cost you a total of $208,546 in interest. That’s a total savings of $26,069 in interest over 25 years when compared to the larger mortgage.
Alternatively, if you were to make higher monthly payments of $1,832 (based on the larger mortgage of $315,000), you could reduce the amortization period to just over 20 years and reduce the total interest charges to $162,948 – saving you more than $45,000 in interest costs.
In short, using money from your pension savings to make your required down payment could mean a smaller mortgage today. Keep in mind, however, the cost to do so is a reduction in pension income when you retire.
|You can borrow up to CI$35,000 from your Silver Thatch pension, provided:
Factors to consider
Before you make a decision one way or the other, here are some things to keep in mind.
- If your investment returns are higher than the mortgage interest you would pay, you may be further ahead keeping your savings in your pension plan. This is because the long-term, compound growth of your pension savings will likely exceed any reduction in interest costs associated with making a larger down payment.
- If the mortgage interest you would pay is higher than your pension’s investment returns, you may be better off borrowing money from your pension to reduce the size of your mortgage. This is because your mortgage savings will, over the long term, likely exceed the compound growth of your pension savings.
Additional factors to consider include:
- the cost of your rent versus mortgage payments;
- the rent you’ll have to pay in retirement if you don’t own your own home;
- your target retirement date (will you carry debt into retirement?);
- the cost of Stamp Duty (a 0% to 7.5% duty assessed on the transfer of title); and
- legal fees (1% to 3% of the property value).
If we look in the rear-view mirror, we know that investment returns have been higher, on average, over the past 10 years than current mortgage rates. That said, mortgage rates are at historic lows and investment returns have been relatively volatile – so it’s difficult to predict with any certainty what the future holds.
With that in mind, we encourage you to carefully consider all the factors before making any decision about using pension savings to buy a home or property, or pay off your mortgage.