Here’s an obvious statement that bears repeating – buying a property is a huge financial decision. In fact, official statistics show that, as of 30 September 2020, residential property comprised 42% of the average Singaporean household’s assets.
And like every financial decision, there is a degree of risk involved. Now, don’t get us wrong. We are not saying that buying property is risky. All we are saying is that, when you have to take on debt in order to buy an asset, there is an element of risk in play that you must account for before signing on the dotted line.
How do you that? Well, it all starts with understanding your personal “risk profile”. In this article, we will explain what that is, how to estimate yours, and most importantly, how to incorporate it in your home purchase and financing decisions.
Defining Your Personal “Risk Profile”
In a nutshell, your risk profile is a holistic measure that helps give you a better indication of how much risk you should be taking. It is not an objective metric that we can numerically define. Rather, it is a subjective and personal gauge you should use before making any significant financial decision – such as where you should park your investment portfolio or which property to buy.
We can break it down into two components – risk tolerance and risk capacity. The former has to do with your personality and psychology, while the latter is a bit more objective and quantifiable.
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Understanding Your Risk Tolerance – Personality and Psychology
Here’s the question to ask yourself that can give you some great insight into your own personal risk tolerance. If the value of my property dropped by 20%, how would I feel? Assume, of course, that this isn’t necessarily permanent – the property value could recover and even increase depending on market conditions.
The key word here is “feel”. Some people can stomach a 20% drop without flinching and get right back to their day. For instance, if you bought the property primarily as a home and are happy staying there for the long term if you need to, then it might not matter at all to you. If the price later appreciates significantly beyond your purchase price and you find a buyer, you would be happy to sell. But that’s just a bonus.
Others may break out in cold sweat when they see the fall in value. Maybe because they were planning on selling and making a profit in the near term. Or even if they weren’t, maybe they are just emotionally wired that way.
Risk tolerance is thus about your emotions. Your personality, temperament, age, life stage, and personal goals are the main factors that influence it. It is entirely subjective.
The Capacity for Risk – How Much Risk Can You Afford to Take?
While risk tolerance was about how much risk you can emotionally bear, risk capacity is about how much risk you can afford to take (given your specific financial circumstances). It is much more objective and thus easier to assess. The key factors that go into a person’s risk capacity are:
- Income sources / cash flow. The higher and more stable your income sources are, the more risk you can afford to take. Of course, income does not necessarily mean cash flows since income does not account for expenditures and other cash outflows.
- Debt levels. Simple, the higher your current debt levels are (i.e., the more leveraged you are), the less risk you can afford to take.
- Cash reserves / investment portfolio size. Other than cash flows, your cash balances and investment portfolio size also play a role. The higher they are (and the more liquid your investment portfolio is) the more risk you can afford to take. For example, a person with $500,000 in cash can take more risk than someone with a $500,000 property, all else being equal.
- Age. For most people who have a fixed retirement date, age determines how many years they have left they can generate income. In general, the closer you are to retirement, the less risk you can afford to take.
- Personal goals. Risk can only be defined in the context of a goal. Investors, for example, want to generate a good return on their capital. For people just looking to buy a home, their goal may be more toward financial stability. Whatever the case may be, getting a clear handle of your goal is necessary to evaluate your risk capacity.
Here’s a quick example to give you a better idea of risk capacity. Imagine two people – Mr Lim and Mr Tan. Mr Lim is 61 years old and one year away from retirement, after which he will solely be relying on his CPF savings to sustain him. On the other hand, Mr Tan is a 32-year-old investment banker who is also putting 15% of his net salary every month into an investment portfolio, and another 15% into a savings account.
Which person has a higher risk capacity? The answer is obviously Mr Tan. His best earning years are ahead of him. Plus, he also has a constantly growing investment portfolio that he won’t have to touch for decades (because he can sustain himself using his salary). Not to mention both his savings and CPF accounts are also steadily growing. His capacity for risk is thus much higher.
So, in a property context, because Mr Lim’s risk capacity is low, it might not be the best idea for him to look into buying a property (regardless of whether he would qualify for a loan or not). But for Mr Tan, this is not the case – he can most likely easily bear the risk.
Using Your Risk Profile to Make Better Home Financing and Purchase Decisions
By now, you should have a rough understanding of whether you have a low or high risk tolerance and risk capacity. Don’t worry about being precise – this is far from an exact science. Rather it should serve as guideposts for how you can think about buying property (and how to finance it).
- The price of the property you would buy. The higher your risk tolerance and capacity is, the higher the price of the property you would be willing to buy. To be more specific, you might be willing to have your property comprise a higher percentage of your total assets (i.e. less cash on hand/CPF/other investments by comparison).
By comparison, someone with a lower risk tolerance and capacity might prefer to keep more cash plus CPF savings and thus buy a lower-priced property. Of course, regardless of your risk profile, you must keep things affordable. Our Mortgage Affordability Calculator can help with that.
- Your post-purchase CPF balances. This is related to the above. In Singapore, it is common to use CPF balances to help pay for the downpayment, or even for the home loan itself. But as we’ve said before, there are opportunity costs to doing so. A person that can bear higher risk (such as having a stable high-paying career), might not mind using most of their CPF balances to help fund their dream home. On the other hand, a more conservative person (who may also have a less stable career) might naturally opt to preserve more of their balances instead.
- The amount of margin of safety you would give yourself. After servicing your home loan instalments, how much will you have left over each month? Or rather, how much are you comfortable having left over? A more conservative person is likely to give themselves a greater buffer when calculating this. You can read about the concept of margin of safety as applied to property in detail here. Remember, the last thing you want is to be “house poor”.
- The age you decide to buy a property. Living with your family until you purchase your own property is commonplace in Singapore. But at what age do you “make the leap” and buy your first property? Someone with a higher risk tolerance and capacity might do so much earlier than their conservative counterpart.
- Whether you decide to invest in property or not. Should you become a property investor? With cooling measures in place and the leverage required to get into the game, it’s not for everybody. Only those with high risk tolerance and capacity are likely to be able to afford (both financially and emotionally) to play the game here in Singapore.
The Nature of Risk is Personal
What is risky to one person may be considered safe to another. Risk, at its heart, always comes down to one’s personal goals and circumstances. This article was written to give you more tools to help you evaluate your own personal risk profile so you can make better decisions.
But of course, we can’t offer you personalised advice through an article. So, if you want more direct and personal advice, our Home Finance Advisors can help. Simply go this page, fill out the short form, and one of them will get in contact with you. You can share your specific goals and situation with them, and they will help show you a path forward.
And for more information on all things home financing, check out the rest of our guides.
Disclaimer: Information provided on this website is general in nature and does not constitute financial advice.
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This article was written by Ian Lee, an ex-banker turned financial writer who hopes to use his financial background and writing skills to help raise people’s financial literacy levels – a necessity in our modern world.