The lowdown on home loans

Investing 2006
Published November 8, 2006

The lowdown on home loans

Watch those 'special' interest rates and be wary of teasers and extra features, says dollarDEX INVESTMENTS

WHEN a client came to see us for advice, he was saddled with a home loan that had promised to pay him the same high interest rate on his deposits as on his home loan. This would have been the dream of a businessman, whose deposits can continue to be liquid for any new opportunity. But for our client, the loan turned out to have several problems.

First, he is a salaried worker and has little use for the additional liquidity. If anything, he tries to lock up his cash so he won't spend it on vacations and other luxuries that he fancies once in a while.

Second, he could have simply put his cash in a fixed deposit that could have earned a higher rate than the one linked to his home loan. Worse, the bank has just lowered the maximum amount of cash that can be put into the interest-offsetting deposit account. What was a businessman's ideal home loan turned out to be our client's doom.

The past year has seen at least one new home loan launched a month. With such an embarrassment of choices, how does one find the most suitable home loan?

Start with the basics

We begin with an unconventional answer: look at basics such as interest rates, whether these are fixed or variable and how long the lock-up period is (during which you have to pay a penalty for refinancing at another bank). The conventional advice - often provided by banks keen to interest you in their special package - is: don't look at the basics like loan rates as the most important criteria.

In our experience, this almost always leads to a bad outcome. Banks often add features to the basic home loan to differentiate their package. But there is one underlying theme in this exercise: it almost always comes in the form of higher rates.

This is only to be expected, since one can't get something for nothing. The cynic might even say that banks are adding these features to mask what are fundamentally bad loan rates. In any case, the result is clear: the loan that is pitched as 'most suited for you' is inevitably one that comes with a higher interest rate. But is this additional feature worth the higher rate?

The question is hard to answer because borrowers often do not have other loan rates with which to make comparisons. Even when they can make a comparison, most borrowers over-estimate the worth of the special features. We have never come across a borrower who says: 'I've been so lucky to pay a bit more to get this extra flexibility!' Instead, the standard refrain is (after some unprintable exclamation): 'This extra feature is simply not worth the higher interest I have been paying.'

So we advocate this rule of thumb: Start with the basics. To make it easier, we compile an index that allows borrowers to compare the basics. Naturally, the index considers loan rates. But it also imputes the costs and benefits of fixed and variable rates, the duration of the lock-up period, the size of the penalty, and the legal subsidy.

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On today's dollarDEX Index, packages from three banks - Standard Chartered, HSBC and Maybank - rank high (see table).

Back to basics is a rule that would suit most people. But for the few who have additional requirements - such as the experienced stock picker who has lots of cash but needs it to be liquid - other considerations can matter. The question you have to ask is: are they worth the higher loan rates?

Then, and only then, check the extra features

After considering the basics, look at the extra features that differentiate the top loan packages.

Interest-offsetting. As mentioned earlier, many banks today have interest-offset loans in which one's deposits earn interest rates as high as those on the loan amounts. Citibank, Standard Chartered and a few others offer these. They suit those who need liquidity, such as business people. In effect, an interest-offsetting loan converts a businessman's borrowing against his business to borrowing against his property, which is cheaper.

Nevertheless, details matter. For example, if the bank modifies the terms of the loan, such as reducing the maximum one can put towards the deposit account, then the benefit of interest-offsetting would be smaller than anticipated. An important alternative many borrowers do not consider is a DIY (do-it-yourself) interest-offset. Such a DIY product can be created by putting the cash in treasury bonds. It could also be created by borrowing against the property when a cash crunch actually materialises.

The key is to find out how much one can get from bonds or has to pay when borrowing against property, and compare this against the interest-offsetting loan.

Increasing interest rates. Some banks offer fixed loan rates that rise over time, usually over the first three years since few loans have fixed rates for periods longer than that. The low rates in the earlier years are usually teasers. Indeed, UOB's First Zero loan has a zero rate in the first year. Maybank's Choice Instalment is a particularly flexible loan. It allows the borrower to vary the repayment amount, as long as it is within some specified range. For example, by repaying less now, one effectively lowers the loan rate this year, in return for a higher rate in the future.

These increasing-rate loans are rarely attractive. They are only attractive if a borrower knows that he is going to terminate or refinance the loan before the teaser rates expire, and the termination or refinancing penalty is small enough not to overwhelm the benefit of the teaser rates.

For a borrower with a property under development that is paid progressively, the early teaser rates are illusory. This is because these low rates apply during the early years when the principal amount is small. In the later years when the full principal amount is drawn down, the higher rates kick in.

Flexible duration. Some banks allow you to adjust the duration of the loan. For example, DBS's Managed Mortgage allows the borrower to allocate the principal among four different durations. Another way to adjust the duration is indirect. For example, the Maybank Choice Instalment mentioned earlier offers this feature. Instead of using the feature to keep the duration fixed and vary the loan rate, the borrower can vary the repayment amount. By repaying more, he shortens the loan duration.

Flexible duration loans are best suited to those whose income streams are predictable, or those who want the loan repayment to be predictable. For example, the DBS loan might be suitable for someone who has a higher income now than later, when the borrower will retire. The Maybank loan might be suitable for someone who wants to have a constant repayment amount, even if the loan rate varies year by year.

Flexibility has its costs. People have a tendency to procrastinate. This is why, for example, some subscribe to health clubs: having spent the money, they feel obligated to exercise. It is also why many sign up for forced savings schemes like regular savings plans in unit trusts. Similarly, fixed repayments could be a feature some borrowers want. Flexibility entices borrowers to defer repayment, and lengthens loan durations.

Fixed versus variable loan rates. In the current climate of generally rising interest rates, fixed rates have a cost. For example, the DBS 10-year fixed rate mortgage charges 5.5 per cent for the 10 years, compared with its one-year fixed rate mortgage that charges 3.5 per cent the first year.

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 economists have a hard time predicting interest rates, making such bets seems stacked against the borrower.

A considerably better, albeit unorthodox, way to deal with interest rate uncertainty is to know oneself rather than try to forecast interest rates: does one have the time and resolution to refinance loans as interest rates change?

We find that some borrowers are simply too busy to track interest rates after they first get their loan. One or two years out, they often either forget it or find it too troublesome to think about refinancing their loan. One has to shop around, make some calculations and keep up on macroeconomic conditions, none of which are entertaining except for the most money-minded. These are the 'inertia borrowers'.

For inertia borrowers, we suggest that the best option is 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. The 'beaver borrower' is generally better off with floating rates, since there seems to be some zig-zag even among pundits on the rate direction. Beaver borrowers can time the refinancing of their home loans, since they spend time tracking interest rates.

Whether inertia or beaver, borrowers go through the initiation of a first-time home borrower. At this stage, both have to do their homework - understanding loan features and interest rates, even though they may choose different types of loans. Here is where we think inertia borrowers should favour fixed rates and beaver borrowers, variable rates.

What next?

Given all these complications, what are some steps that smart borrowers might undertake?


- Get educated, since there are intricacies that borrowers need to know. For instance, one client who asked us to help him refinance his loan was astonished when we told him that beyond the penalty charge, there was an additional charge to compensate his current bank for 'redeployment of funds on early repayment'.


- Get help from professional advisers who may have greater bargaining power with banks. Buying a property is one of the most exciting rites of passage for many households. Just keep a careful eye on financing. Otherwise, it can also be the beginning of years of grief.

This article was contributed by wealth management firm dollarDEX (www.dollarDEX.com)