Variable vs. Fixed Interest Rates
SMB’s Tip: There is no right or wrong answer. Take a view on interest rates, own it and bite the bullet.
Real estate investors who need financing will inevitably be faced with the decision to choose between a variable or fixed interest rate. No one can predict the future direction of interest rates, not even us. Keep abreast of current economic news and political events by reading the paper, business magazines and publications, refer to the link on our website for recommended web sites, watch the news and discuss with anyone whether in the finance industry or not to develop your own view of the market.
A fixed rate of interest protects against an increase in rates while a variable rate allows the borrower to benefit from falling rates. A fixed rate of interest does not mean lower risk. It simply provides the borrower with peace of mind because his or her rate will not change. In other words, there is less volatility.
Low vs. High Interest Rate Environment
SMB’s Tip: What goes up, must come down and what comes down, must go up.
Buying property is a long term investment yet we calculate affordability based on our current financial situation. If interest rates are low on a relative basis, they can and probably will increase over time. These cycles can last for months, even years giving the novice investor the impression that he or she can easily afford to carry the mortgage or even add more property to the portfolio. Understand that rates may climb and hedge yourself against rising interest rates by diligently paying off debt during low interest rate cycles; when rates climb to 5%, 6%, 7% and above, you will be happy you did.
Choosing the Right Interest Rate Benchmark
SMB’s Tip: Understand the characteristics of each benchmark/reference rate to choose the right one for you.
The Board Rate represents each bank’s own cost of funds plus a healthy profit margin. When applying the Board Rate in a mortgage, banks will generally provide a discount making the rate more attractive. The Board Rate is often criticized for its lack of transparency as it does not necessarily move in tandem with market interest rates. However, banks generally seek to maintain stability in their board rates and some pride themselves in being successful at doing so. Compared to the SIBOR and Swap Offer Rates which change on a daily basis, Board Rates are less volatile changing only every few months or even less often.
SIBOR stands for the Singapore Interbank Offered Rate and is the rate of interest at which banks borrow funds from one another, in marketable size, in the Singapore interbank market. SIBOR moves in tandem with market conditions thereby providing transparency to consumers. The SIBOR rate was only recently introduced as a real estate lending benchmark and is set daily by the Singapore Association of Banks.
The Swap Offer Rate, otherwise referred to as SOR, is a published reference rate for short term interest rates in Singapore. It represents a bank’s cost of funds for commercial lending. Like SIBOR, it moves in tandem with market conditions thereby providing transparency to consumers. SOR has a tendency to be more volatile and price higher than SIBOR though this is not always the case.
Cash Flow Management: Interest Only Repayment
SMB’s Tip: Tread carefully with Interest Only Repayment. Like medication, it should only be prescribed by your doctor.
The standard mortgage is structured such that monthly payments include both interest and principal. Therefore the outstanding mortgage reduces over time; from a bank’s perspective, this translates to lower risk.
With interest only servicing, a borrower only pays interest to the bank. There is no monthly repayment of principal and therefore the loan outstanding remains the same. The advantage of paying only interest is that monthly mortgage payments are significantly lower than if principal were included which is good for cash flow management. Interest only servicing may be used selectively by the sophisticated investor and is common tool used to increase return on equity.
Because there is no repayment of principal, the bank’s risk remains the same (assuming property prices are constant) which is why banks sometimes charge a premium for interest only repayment. In fact a borrower is also exposing himself to the risk that if interest rates rise, his mortgage payment will increase and he will end up paying more in interest. Because there is no reduction in principal, there is no mitigation against rising interest rates.
Cash Flow Management: Adjusting the Tenor
SMB’s Tip: The tenor is one of the levers available in cash flow management.
By increasing or decreasing the tenor, you can adjust the size of your monthly mortgage payment. As an example, a home owner seeking to lower his or her payment may seek approval for the maximum allowed tenor based on his or her age. Beware: While this helps preserve cash, it also translates to higher interest costs over the life of the mortgage because it takes longer to pay off the property.
SMB’s Tip: Begin buying property early in life to benefit from longer loan tenors.
Buying property early in life gives you maximum flexibility to either quickly pay off your property or to capitalize on longer approved tenors so as to minimize your mortgage payment. The older you get, the shorter the approved tenor and the higher your monthly mortgage payment will be. Banks determine the tenor of a mortgage by subtracting the mortgagor’s or debtor’s age from a maximum cap of 65 or 70 years where the maximum tenor is 35 years. This essentially means that a mortgage will be fully paid by the time the individual reaches the maximum cap (assuming of course that interest rates don’t shoot sky high). There are exceptions and some banks have been known to grant special approve for tenor’s exceeding 35 years.
SMB’s Tip: A term loan granted in conjunction with a standard mortgage is an excellent source of inexpensive financing.
If you need financing, consider taking out a term loan against your property instead of credit card or personal loans. The rates are generally more competitive. However, carefully consider leveraging up on an existing mortgage. It might sound like a good idea today, but could become a significant burden down the road.
SMB’s Tip: Think twice about applying for an overdraft facility. Consider drawing down on a term loan instead.
Banks often include a section in their mortgage applications to request a separate overdraft facility secured against the property. This line of credit functions as a back stop to cover short term cash requirements. However, due to its higher cost, an overdraft should be repaid as soon as possible. Once an overdraft becomes a “permanent” outstanding facility, it will have been more prudent to set up a term loan instead.
SMB’s Tip: Make a conscience goal to pay down your mortgage to accumulate equity.
Although some like to think of an investment in real estate as low risk especially for residential properties meant to be the buyer’s home, it is probably the greatest amount of leverage anyone will ever carry in their lives. As a property appreciates in value, it can give a false sense of wealth and security. Don’t be fooled. Being wealthy is having no mortgage at all.
Purchase/Market Price vs. Bank Valuation
SMB’s Tip: Always cross check the price you are willing to pay for a property against a bank’s valuation to avoid unexpectedly having to increase the size of the down payment.
Just because a property has been transacted at a certain price does not mean that a bank will come to the same conclusion. In fact, the difference can be quite large. In markets characterised by rapidly increasing property prices, bank valuations typically lag actual transaction amounts. In a deflationary environment, bank valuers may seek to stay ahead of the curve by cutting their valuations to account for further potential price declines. An example illustrates the point: If you have purchased a property for $500,000 and are seeking 80% financing, you would need a maximum of $100,000 for the down payment and you would expect the bank to finance the remaining $400,000; however, if your bank only confirms a valuation of $450,000, the loan size would only be $360,000 (80% of $450,000) which means the down payment would have to be $140,000 to make up the difference to $500,000.