Is fixed rate home purchase loan the best for new residential property purchase, or should you opt for a floating rate? This is a question a lot of new buyers have to contend with
If you’re planning on a new home purchase, or on refinancing your current one, or on taking out a second mortgage, you will have to decide between a fixed-rate and a floating rate mortgage. Most floating rate home loans have a variable interest rate, usually based on the Singapore Interbank Offered Rate (SIBOR) or Singapore Swap Offer Rate (SOR).
Is fixed rate home purchase loan the best for a new residential property buy?
As the name implies, fixed-rate mortgages are home loans with an interest rate (and payment) that remains the same over time. With this fixed rate home purchase loan, you pay the same amount every month for the entire life of the loan, generally 1 to 5 years. There are currently no lenders that offer a perpetual fixed rate for the entire loan tenure.
For fixed rate home purchase loan, in the beginning the portion of your monthly payment going toward interest will be high, and the portion going toward principal payment will be low. The interest portion of the monthly payment tapers off over the term and the principal portion rises to compensate, but the total payment amount does not vary.
Payments over the total term of a floating rate mortgage for your new home purchase will vary by design.
The interest rate usually starts off low (thus the attraction), but it can later rise. If you opt for a floating rate, you will pay a fixed interest rate for a predetermined time period (usually three years or less), followed by periodic rate adjustments for the remainder of your loan’s term.
This rate is normally a set number of points over a widely published rate, such as the Singapore Interbank Offered Rate, or Sibor. If that rate rises (or falls), so do your monthly payments.
There are many types of floating rate structures. They are:
- Pegged to bank’s internal board rate. (i.e. Board Rate – Discount)
- Pegged to Sibor Rate. (i.e. Sibor + 1%)
- Pegged to SOR Rate. (i.e. SOR + 1%)
- Pegged to Fixed Home Rate (FHR)
- FHR12 – based on 12 months fixed deposit rates (i.e. FHR12 + 1%)
- FHR18 – based on 18 months fixed deposit rates (i.e. FHR18 + 1%)
- Pegged to Fixed Deposit Mortgage Rate (FDMR)
- FDMR36 – based on 36 months fixed deposit rates (i.e. FDMR36 + 1%)
- Pegged to Cost of Funds. (i.e. COF + 1%)
It is almost certain many more types of floating rate packages will be created in the future.
The benefit of fixed rate home purchase loan is that are no surprises.
Your initial payment on the home equals your final payment. For many borrowers, this provides peace of mind in an unpredictable economy. It also is a good strategy for new home purchase when rates are low but likely to rise.
On the flip side, the interest rate on fixed rate home purchase loan is typically higher than an floating rate’s initial interest rate. If you expect to move or trade up in a few years, this means you will pay more than necessary for a short-term investment — money that you could have invested elsewhere or saved. You also would pay more over the long term if interest rates stayed low for an extended period or fell; though in the latter case, you could refinance.
A fixed rate home purchase loan is almost always more expensive than a floating rate package.
As banks are unsure of the future interest rate environment, they will need to enter into hedging contracts, which incur a fee, to guarantee you the future rates. It’s like buying an insurance policy against interest rates going crazy.
For example, if the current borrowing cost of the bank is 1.5%. The bank may then decide to create a fixed rate package that is 2% fixed for 3 years.
However, the bank does not know what will happen in year 2 and year 3. What if the cost of borrowing for the bank rises to 3% for year 2 and 3?
This would mean that the bank’s profit would be: –
- Year 1 = 2% – 1.5% (cost of funds) = 0.5%
- Year 2 = 2% – 3% (cost of funds) = -1%
- Year 3 = 2% – 3% (cost of funds) = -1%
- Total over 3 years = -1.5%
A bank is unlikely to create a product that has a risk of losing money. So banks typically pay a fee to go into a hedging contract.
The bank will buy a hedging product that would guarantee them 2% for year 2 and year 3 and maybe pay a fee of maybe 0.3% to do so. It is similar to insurance.
Hence the bank’s profit would be: –
- Year 1 = 2% – 1.5% (cost of funds) = 0.5%
- Year 2 = 2% – 1.5% Cost of funds + 0.3% Hedging cost = 0.2%
- Year 3 = 2% – 1.5% Cost of funds + 0.3% Hedging cost = 0.2%
- Total (over 3 years) = 0.9%
A guaranteed profit for each mortgage loan product is probably more important for the bank than the potential to make more money, but also open to the possibility to lose money.
Choosing between a fixed rate home purchase loan and floating rate for your new home residential property buy should be a consideration of a few factors:
- current rates
- your personal investment horizon
- the state of the economy
- future rate hike risk
- how long you plan to own your home
- closing costs
- your qualification for each type of loan
More recently, banks have started launching a new SORA-based home loan referencing the 3-month Compounded Singapore Overnight Rate Average (SORA) published by the Monetary Authority of Singapore (MAS). The interest rates for this types of loans were based on a simple average of the daily SORA rates in the preceding 90 calendar days.
If all these loan jargons seem like alien language to you, you should speak to a home loan specialist. A home loan specialist will be able to simplify the technical terms for you and help you compare mortgages so that you get the best home loan. The services of home loan specialists are free, so new home buyers have nothing to lose and everything to gain by engaging them.