After selecting our desired condominium, the next step is to choose a housing loan package. There is a variety of loan packages, such as fixed or floating interest rates. For fixed interest rate packages, you could choose whether to fix the interest rates for 1, 2 or 3 years, after which the loan reverts to floating interest rates. For floating interest rate packages, you could select whether to peg the interest rates to the Singapore Interbank Offered Rate (SIBOR), Swap Offer Rate (SOR) or fixed deposit rates. Assuming that you choose a SIBOR or SOR package, you have to further decide whether to peg to the 1-month or 3-month SIBOR/ SOR. Likewise, for fixed deposit rate packages, you can choose between 9-month, 15-month or 36-month fixed deposit rates. The choices can be fairly overwhelming.
Step 1: Fixed or Floating
The first step to decide is whether to go for a fixed or floating interest rate package. Given that US Federal Reserve (Fed) has increased interest rates 5 times since Dec 2015 and plans to increase them another 4 times this year, we decided it is prudent to choose a fixed interest rate package instead of a floating interest rate package.
Step 2: Fix for How Many Years
This is a tricky question. Thankfully, there are some hints. Besides setting the current interest rates, the US Fed governors also provide their projections of future interest rates. By plotting the interest rate projections, we can see how US interest rates are likely to move in the coming years. Fig. 1 below shows the current Fed dot plot, which indicates that the median interest rate projections will rise from 1.375% in 2017 to 2.125% in 2018, 2.6875% in 2019 before finally peaking at 3.0625% in 2020. Having said that, do note that these are just projections by individual US Fed governors. The actual interest rates may differ from the projections depending on how strong the economy is in the coming years.
|Fig. 1: US Fed Dot Plot|
Given the rise in interest rates over the next 3 years, it makes sense to fix the interest rates for 3 years. However, on the other hand, a 3-year fixed interest rate package is naturally more expensive than a 2-year package, since banks bear the risks of interest rates rising rapidly. Using the bank that we chose as an example, the interest rates for a 2-year and 3-year package are as follows:
|Year 3||15M FD+1.43%||1.68%|
|Afterwards||15M FD+1.43%||15M FD+1.55%|
As shown above, not only is the fixed portion of the interest rates higher, the margin for the floating portion of the interest rates is also higher (note: not all loan packages are as such). For a $650,000 loan over a 25-year tenure, we will end up paying $11,867 more in total interest if we were to select the 3-year loan package. That is equivalent to an extra interest of 1.83% on the $650,000 loan. For the 2-year loan package to be more expensive than the 3-year loan package, the 15-month Fixed Deposit (15M FD) rate, which is currently 0.25%, has to reach close to 2.0%.
We decided on the 2-year loan package. In the event interest rates continue to rise, we can choose to re-finance and fix the interest rates when the lock-in period expires. If conditions permit at that time, we might also choose to pay down some of the loan.
Step 3: Peg to Which Base Interest Rate
As discussed above, we selected a loan package that is pegged to the fixed deposit rates. Fixed deposit rates are actually board rates set by individual banks and are therefore less transparent compared to SIBOR and SOR, which are set collectively by a group of banks. The conventional wisdom is that if banks were to raise their fixed deposit rates to earn more interest on the loans, they would also have to pay more interest on the fixed deposits. Hence, banks are less likely to raise fixed deposit interest rates. However, the reality is that 98% of local banks' deposits have maturity of less than 1 year. Raising the interest rates on fixed deposits of more than 1 year maturity will not hurt them. See Behind Fixed Deposit Home Loan Rates for more info.
On the other hand, although SIBOR and SOR are more transparent, they are more volatile compared to fixed deposit rates. The shorter the SIBOR/ SOR tenure (i.e. 1-month vs 3-month SIBOR/ SOR), the more volatile the rates are. Also, between SIBOR and SOR, SOR is affected by the USD/SGD exchange rate and therefore fluctuates more than SIBOR. See Why Singapore Interest Rates Might Rise Faster than Expected for more info.
Comparing between the transparency of SIBOR/ SOR loan packages and the stability of fixed deposit loan packages, we went for stability as they provide greater visibility on the amount we have to pay every month, which helps us in planning other expenses.
There is a large variety of housing loan packages. It can get overwhelming at times, especially since you have to decide on a loan package quickly after you sign the option to purchase the property. Choosing the right loan package can save you some money and offer greater visibility in later years.
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