Thursday, October 12, 2006
[RealEdge] BT Property Supplements : Borrowing smart
| Published October 12, 2006  | ||||||||||
| Borrowing smart As home loan interest rates rise, analysing the fine print can save you years of financial grief IN the last 12 months, one bank raised its home loan rate five times. Another increased its rate twice within two weeks. Should borrowers be running scared? The prognosis is mixed. For example, the three-month interbank interest rate - the rate at which banks trade with each other and an indicator of their cost of funds - doubled from 1.75 per cent in January 2005 to 3.5 per cent last month. However, much of that increase was in 2005. Since this January, the interbank rate has stabilised between 3.38 and 3.56 per cent. So in a sense, the banks have been kind in raising rates only recently. But what about the future? Many analysts think rates are not going to move much for the rest of the year. The US Federal Reserve, which sets the US Fed Funds rate which the Singapore rate roughly tracks, has indicated that there are likely to be no increases in their rate. That is, at least until the Dec 12 Federal Open Market Committee meeting. Beyond that, it is anybody's guess. The direction of interest rates should be a concern for most borrowers, of any income range. For the low-income borrower, any rate hike tends to hit spending directly. In the worst case, for someone borrowed to the hilt, maximising CPF resources and using a large portion of his salary for loan repayments, there is little room for error. Default becomes a real possibility. "Forget the free fridge, the free vacation, the possible deferment of interest, or the higher rates you get on deposits, until you have figured the deal on the core features.' For the higher-income borrower who in the last few years has made many speculative property purchases, higher interest rates could also hurt. He may need to liquidate the second home that he can no longer afford to hold, at a lower price. Rising property prices should normally be welcomed, but if a borrower has to force-sell his property, then the hit is doubly unkind, since he cannot take advantage of the property boom to maximise his gain. Complicating the question of interest rate direction is the proliferation of loan packages in the market, often as many as eight different ones from a single bank, making picking the right loan a Panadol moment for many prospective borrowers. Should the new property buyer try to get deals done earlier in case rates rise? Should the borrower refinance the loan to protect himself against increases? These are important questions. In fact, they are getting more important, given rising interest rates. For a borrower of $500,000, getting the right loan may save as much as $5,000 in just the first three years. In our experience, it is almost impossible to speculate on the direction of interest rates. Those who think they got it right often confuse skill with luck. A considerably better way to deal with interest rate uncertainty is to know oneself rather than try to know interest rates: Does one really have the time and discipline to refinance loans as interest rates change? In truth, we find that some borrowers are simply too busy to track interest rates other than at the start of the property purchase. One or two years out, they often find it too stressful to think about refinancing their loan. We call these people 'inertia' borrowers. For them, the best way might be to simply pay extra and go for higher fixed rates, given the long-term trend of rising rates. But not everyone is an inertia borrower. 'Beaver' borrowers are generally better off with floating rates. They can time the refinancing of their home loans, since they spend time tracking interest rates. The best starting point, in our experience, is to focus on the core features of the loan and ignore the peripheral ones. Forget the free fridge, the free vacation, the possible deferment of interest, or the higher rates you get on deposits, until you have figured the deal on the core features. The core features are those that directly impact your wallet, and they should include the following: Also, competition for loans may keep interest rates down. But when the macroeconomic environment dictates higher interest rates, all banks' rates will rise like boats on a rising tide. So it is prudent to look at the tides. Another bit of fine print: The borrower needs to know when the attractive first-year rate kicks in. The later the better, since some loans' first-year rates start the moment the borrower signs the letter of offer, and by the time the first disbursement is drawn down to pay the property developer, it is almost year two, with higher interest rates. Borrowers need to make calculated bets on whether the higher fixed rates justify the potential increase in interest rates on a variable loan mortgage. Given that professional economists have a hard time predicting interest rates, making such bets seems stacked against the home loan borrower. Here is where we think inertia borrowers should favour fixed rates and beaver borrowers, variable rates. But having considered these lock-in features, a borrower still has to weigh other factors, such as whether alternative loan packages are going to get better enough to refinance in the first place, and whether the interest rates during the lock-in period are variable and subject to increase. A refinancier who who does not have the time pressure of a new property buyer, should ask himself whether to refinance now or later, or at all. An important consideration is to calculate the costs and benefits, given the uncertainty in interest rates, the additional lock-in period that might come with refinancing and the legal fees. In addition, for those staying in HDB flats, there is the untested assumption that banks might be as lenient as the HDB when it comes to defaults. And since timing is flexible for the prospective refinancier, it is also important to see if waiting for new, better loan packages is the right move. In the last few months, many banks have introduced new packages. This renewed aggressiveness is due to several factors. First, the number of prospective borrowers continues to be small. With a small market, competitors try harder. Second, some bankers who work with dollarDEX tell us that the potential increase in property value makes banks more positive about home loans. So they are positioning themselves for an upsurge. But all this has to be considered in the context of the interest rate environment. Here, the news is not good. Rates appear more likely to go up than down, which led many local banks to increase their rates recently. However, many foreign banks have not followed suit. This is because interest rates on longer maturities have not moved up as much. Against this backdrop, you must also determine the cost of waiting, since until you refinanced, you are paying your current higher interest rates. What are some steps that smart borrowers might undertake? Get educated, since there are intricacies that borrowers need to be aware of. For instance, one dollarDEX client who asked us to help him refinance his loan was astonished when we told him that, beyond the penalty charges, he had to compensate his current bank for 'redeployment of funds on early repayment'. Get help from professional advisers who may also have greater bargaining power with banks. Buying a property is one of the most exciting rites of passage for many households. It can remain exciting, as long as one keeps an eye on financing. Otherwise, it can also be the beginning of years of grief. This article was contributed by dollarDEX Investments. dollarDEX is a wealth management firm that was recently ranked among the Global Top 30 for online finance by the Institutional Investor magazine. Details are at www.dollarDEX. | ||||||||||
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