Let’s start with the basics of what a mortgage is all about for a soon-to-be 1st time home owner before delving into the advantages and disadvantages of fixed and floating rates.
What is a Mortgage?
When purchasing a home, you will pay a portion of the purchase price with cash (or CPF), while the remaining amount is funded with a home loan, otherwise known as a mortgage.
Components of a Mortgage
Firstly, the interest rate that is pegged to the home loan offered by the bank. The bank stipulates these mortgage interest rates and provides a range of packages.
The loan amount is the initial amount that you would borrow from the bank. Most mortgages are paid off over their lifespan, which means that every month, a portion of your monthly payment goes towards repaying the outstanding loan balance, while another portion contributes towards the interest rate on the loan. Borrowers are obligated by law to repay in full, otherwise the banks have the right to foreclose on the property.
Monthly mortgage payments are made over the Loan Tenure (the period of which the borrower wishes to repay the loan). A 30-year mortgage would have lower monthly payments as compared to a 20-year mortgage of the same principal as there is a longer period of payment. The downside is that the 30-year loan would experience interest payments over a longer period.
Banks earn money through interest payments, and therefore impose a lock-in period on mortgages to prevent early repayment of the loan. This period differs across packages, and an early repayment may sometimes result in a penalty charge, so be mindful with selecting your loan tenure!
Finally, the loan must be fully repaid at the end of its tenure, called the maturity date.
Mortgage Packages
Banks offer either fixed or floating interest rate packages. While these two product packages each present some benefits, they are not without their limitations.
Fixed Interest Rates
In these packages, the interest rate charged on the mortgage does not change throughout the tenure of the mortgage. Fixed rates are set by the bank. They are offered for a duration of 1-3 years.
Benefits
There is a degree of certainty for the duration in which the interest rate is fixed, providing greater stability in your monthly interest payments.
This is most useful in a rising interest rate environment. A fixed interest rate package charging 2.0% interest rate will remain stable throughout the fixed period (often 1-3 years). If the market interest rate increases to 3.0%, you will benefit by paying a lower interest rate.
Limitations
Fixed interest rate packages typically charge at a higher rate than the given floating rate at the time of which the loan is processed. There is also the lack of flexibility, since you are locked into this loan, for the price of certainty.
In a falling interest rate environment, the borrower may end up paying a possibly higher interest rate. Suppose a fixed interest rate package charges 2.0% per annum. The borrower will be obligated to pay that 2.0% for the lock-in period even if interest rates fall below 2.0%.
Some banks may offer a penalty-free option to switch between floating and fixed rates, but there are additional clauses within each mortgage package, so do make sure to read your documents carefully before making your final decision.
Floating Interest Rates
For floating interest rates, there are 3 different types of rates. They are your board rate, fixed deposit rate and SORA.
Board rates are a bank-managed rate, and the bank has full discretion on how they want to move it.
For fixed deposit rates, this is the same interest rate that banks pay their fixed deposit customers. The banks will use this rate, plus a spread added on top of it to give you your mortgage rate.
SORA is based on interbank transactions. It offers better visibility on interest rates and thus, your mortgage loan instalments.
Benefits
SORA can be found on the MAS website and can be easy referenced. This makes floating rates more transparent.
When interest rates are relatively stable or falling, SORA allows you to capitalise on lower monthly repayments. This also provides greater flexibility for early or partial prepayments on the mortgage without incurring any penalty.
Limitations
With a floating rate package, there is the loss of certainty that can be seen in a fixed rate mortgage. Consequently, you may expect to see greater fluctuations in your monthly loan payments depending on the interest rate environment.
It is also important to note that banks charge a spread on top of the quoted SORA. These spreads are subject to change over the course of the loan tenure, which may lead to higher monthly payments than what was initially expected.
In a rising interest rate environment, borrowers with a floating rate package would be vulnerable to these interest rate hikes.
Optimising your monthly payments on your mortgage
Refinancing at a lower interest rate
Imagine that you have a fixed rate mortgage which charges a 3.0% interest rate, and you have just completed your lock-in period. You spot a floating rate package which currently offers a 1.5% interest rate. To effectively reduce your monthly payments, you could choose to refinance your property.
The savings generated through refinancing could be a few hundred dollars monthly, but the long-term savings may be significant over the tenure of the loan if benchmark rates remain low.
Conclusion
It would be time-consuming and stressful to continuously monitor the movements of the interest rates. However, with proper financial strategizing, as well as the right help, it is possible to secure your finances well while paying off your mortgage loan.
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