Finding middle ground between fixed and floating rate packages
By Paul Ho
/ iCompareLoan.com |
There are two categories of mortgage loans in general— floating rate or fixed rate. Banks seldom offer very long tenures for fixed rate mortgage loans. Such home loans are typically fixed for a certain period of time, ranging from one year to five years, and they revert to floating rates after that.
Banks face a challenge of offering fixed or floating rate packages. The latter are best for a bank as it can simply mark up its cost of funds, typically Sibor (Singapore interbank offered rate), SOR (Singapore swap offer rate), or cost of funds or internal reference and, most recently, pegging to fixed deposit (FD) rates.
Floating rates transfer the interest rate risks to the borrower. For example, if a bank charges Sibor + 1%, it can be assured of earning the spread of 1%, while the borrower takes on the risk of interest rate fluctuation via Sibor.
Fixed rates are more costly for the bank as they are priced higher and therefore, are harder to sell. Is there a middle ground between fixed and floating rate packages?
Why fixed rates are more expensive
Fixed rate packages are almost always more expensive than floating rate packages. As banks are unsure of the future interest rate, they will need to enter into hedging contracts, which incur a fee, to guarantee borrowers the future rates. It is like buying an insurance policy against interest rates going crazy.
For example, if the current borrowing cost of the bank is 1.5%, it may decide to create a fixed rate package that is 2%, fixed for three years. However, it does not know what will happen in the second and third years. What if the cost of borrowing were to rise to 3% by then?
This would mean 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 three years = -1.5%
A bank is unlikely to create a product that has a risk of losing money. So, it would typically pay a fee to go into a hedging contract. The bank will buy a hedging product that would guarantee it 2% for years two and three, and maybe pay a fee of about 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 three 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 it also open to the possibility of losing money.
Birth of innovative DBS FHR and OCBC FDMR packages
There are many types of floating rate structures, and they are:
• Pegged to the bank’s internal board rate (that is, board rate minus discount)
• Pegged to Sibor rate (Sibor + 1%)
• Pegged to SOR rate (SOR + 1%)
• Pegged to cost of funds (COF + 1%)
• Pegged to fixed home rate
FHR12 based on 12-month FD rate (FHR12 + 1%)
FHR18 based on 18-month FD rate (FHR18 + 1%)
• Pegged to FD mortgage rate
FDMR36 based on 36-month FD rate (FDMR36 + 1%)
Borrowers want the stability of fixed rates and cheaper floating rates— an almost impossible combination.
Credit should be given to DBS’ product team for creating the FHR package, which addresses the risks of rising interest rates, yet is able to provide the lower cost of floating rates. OCBC soon followed with the FDMR. These two products come close to “cheap and stable”, depending on a few conditions which we will explain later.
DBS’ FHR was pegged to its 12-month FD rate, and later versions are pegged to the 18-month rate. OCBC’s FDMR is pegged to its 36-month FD rate.
The historical trend of DBS’ FHR12/24 and FHR18
From January to September 2008, DBS’ FHR was lower than Sibor. But when Sibor was on an uptrend between January and February 2016, FHR lagged it. This meant lower costs for the borrower if he had taken an FHR home loan package.
However, DBS has also been adjusting the spread, so borrowers should look at the FHR + Spread% to figure out whether the rate is worth it.
Chart 1
Source: DBS
The historical trend of OCBC’s FDMR
OCBC followed suit with a mortgage loan package pegged to its 36-monthFD rate. It is important to know the historical trend of the FDMR36 as it has a direct bearing on the overall package interest rate.
As we can see, the FDMR36 stayed flat from October 2005 to April 2015, giving depositors very little interest. When the general interest rate environment is rising (Sibor going up), FD rates tend to lag in going up. When Sibor is dropping, FD rates lag in going down as well.
Hence, there is some advantage in taking FHR or FDMR packages when interest rates are rising, as they tend to lag the rise in Sibor. However, if the interest rate environment is dropping, it is better to take Sibor- or SOR-based packages as FHR and FDMR tend to lag in reducing their rates.
Chart 2
Source: OCBC
The historical three-, six- and 12-month FD trends
From Chart 3, we see that between the three- and six-month FDs, there is a gap of 0.1%. Between the six- and 12-month FDs, there is a 0.15% to 0.2% gap.
The 12-month FD rate is about 0.35%. The difference between the 24-month and 12-month FD is perhaps +0.2% (that is, 24-month FD should be around 0.35% + 0.2% ~ 0.55%). The difference between the 36-month and 12-month FD is perhaps +0.4%, hence an estimated relative fair value is 0.35% + 0.4% = 0.75%. This gives you an idea of how much these different-duration FD rates are likely to be priced.
However, it is uncertain how the Monetary Authority of Singapore (MAS) calculates these average FDs from 12 banks. Are they based on deposit-volume-weighted FD rates or simply based on published rates averages.
Chart 3
Source: MAS
What banks typically offer for their FDs
A look at OCBC’s website, as at Feb 29, showed the following FD rates:
• 12 months — 0.25% (Promotion: 12 months from $20,000 to $999,000 — 1.7%)
• 18 months — 0.5%
• 24 months — 0.55%
• 36 months — 0.65%
It seems that DBS offers better rates for its 24-month FDs — 1% — than OCBC’s36-month rate — 0.65%. A look at UOB’s website reveals that it pays almost similar FD rates as DBS and OCBC. However, Maybank pays higher interest rates than those three banks. Maybank’s website, as at Feb 13, indicated a 2% interest rate for its 24-monthFD. Meanwhile, CIMB pays 1.95% (for deposits of $20,000 and above) for its 24-month FDs whereas OCBC’s 36-month rate ($5,000 to $20,000) is 0.65%.
In short, depositors in OCBC, DBS, UOB are underpaid by more than 1% in FD rates.
When depositors finally realise that there is a big difference whether they deposit with DBS, OCBC, Maybank or CIMB, local banks may have to raise rates or lose their FD funds to other banks that pay much higher interests.
A few reasons explain the differences:
• Brand premium (people knowingly and willingly accepting less)
• Fear, ignorance and inefficient market (people do not know they have a choice and are fearful of new encounters)
• Convenience (people knowingly and willingly accept less because it is convenient)
However, these reasons are dominant factors that may need further study.
It is possible that depositors at the local banks will continue to accept a much lower FD interest rate. Hence, mortgage loan borrowers pegged to FHR and FDMR structures may have good savings when the interest rate trends gradually upwards.
Is the FDMR or FHR safe?
Depositors in Singapore are very loyal and risk-averse. Many have the mistaken belief that its banks are safer than foreign banks in the city state.
In Singapore, depositors’ funds are insured up to $50,000. What this means is that if you deposit between $5,000 and $50,000, even if a foreign bank were to go bankrupt, you would not lose your deposit.
All qualifying full banks and finance companies are members of the Deposit Insurance scheme, except those exempted by MAS.
Paul Ho is chief mortgage consultant of iCompareLoan. He can be contacted at paul@icompareloan.com.
This article appeared in The Edge Property Pullout, Issue 718 (March 7, 2016) of The Edge Singapore.
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