Property 2006
Published March 30, 2006

Smart borrowing

Some important things to consider when taking out a home loan

DBS Bank recently introduced home loans that can fix interest rates for 10 years. In the last few months, several banks have also increased their board rates, the baseline rates on which home loan packages are pegged. And a couple of weeks ago, the US Federal Reserve got a new chairman in Ben Bernanke, whose stance on interest rates is still not well-known.

When the macroeconomic environment dictates higher interest rates, all the banks will need to raise rates, like boats on a rising tide. So it is prudent to look at the tide.

Should home loan borrowers worry about interest rate increases? Should they refinance their loans to protect themselves against these hikes? And should new property buyers try to get deals done earlier to beat the rate rise? These are important questions, 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.

The proliferation of loan packages in the market, often as many as eight variations from a single bank, makes picking the right loan a 'Panadol moment' for many prospective borrowers. The best starting point is to focus on the core features and ignore the distracting 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 out the deal on the core features. The core features are those that directly impact your wallet, and they should include the following:

Interest rates

Although this seems obvious, the case is considerably more complex once you look at the fine print. For example, some, such as HSBC's Smart Mortgage, have attractive rates only for certain minimum loan amounts.

Also, competition for loans may keep interest rates down. But when the macroeconomic environment dictates higher interest rates, all the banks will need to raise rates, like boats on a rising tide. So it is prudent to look at the tide. For example, the three-month interbank rate has more than doubled every year: 0.75 per cent in January 2004, 1.74 per cent in January 2005, and 3.38 per cent in January 2006. So it pays to take note of market rates given the magnitude of the changes.

Another bit of fine print: The borrower needs to know when the juicy first-year rate kicks in. The later, the better. Some first-year rates start the moment the borrower signs the letter of offer. By the time the first disbursement is drawn down to pay the property developer, it is almost year two, with its higher interest rates.

Fixed versus variable interest rates

The new DBS 10-year fixed rate mortgage charges a rate of 5.5 per cent for 10 years, compared with its one-year fixed rate mortgage which charges 3.5 per cent in the first year. Borrowers need to make a calculated bet on whether the higher fixed rates will work out better than a variable rate loan in the long run. Given that economists have a hard time predicting interest rates, making such bets seem ominously stacked against the home loan borrower.

Legal subsidy

This usually comes to several thousand dollars, not a small sum relative to most loan sizes. It is important to note this because some banks do not offer a subsidy. Others stipulate in the fine print that if you switch banks within a certain period, you have to pay back the legal subsidy.

Cost of lock-in

Many loan packages have clauses that make it hard for borrowers to refinance (that is, to switch banks) later. The usual clause is to lock in a borrower for three years, during which he can refinance only by paying a fee. Some borrowers are aghast to find that some banks impose the fee on the original loan quantum, not on the outstanding amount when they refinance. The lock-in period could start from the time the loan agreement is signed to as late as the first draw-down of funds.

Having considered these lock-in features, a borrower has to weigh other factors, such as whether alternative loan packages are attractive enough to refinance in the first place, and whether the interest rates during the lock-in period are variable and subject to increase.

The dollarDEX Index uses a fairly sophisticated way of calculating the costs of a loan, allowing a moderately successful way of comparing apples with apples. This can reveal the true cost of the loans. For example, the interest rate for HSBC's Smart Mortgage uses a different formula than that for usual home loans. So a 2 per cent interest rate for the Smart Mortgage loan is not the same as a 2 per cent rate from, say, UOB.

For those thinking of refinancing, the question is whether to refinance now or later, or at all. An important consideration is to weigh 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 loan defaults.

Since there is no time pressure, it is worth considering if waiting might promise better loan packages. 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 tell us that the potential increase in property value make banks feel more positive about home loans and they are positioning themselves for an upsurge.

Finally, all these factors have to be considered in the context of the general interest rate environment. Here, the news is not good. Interest rates appear more likely to go up than down, which led many local banks to raise 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 refinance, you are paying your current higher interest rates. The following are some steps that the smart borrower might undertake:

Get educated, since there are intricacies that borrowers need to know. For instance, one client thinking of refinancing his loan was astonished when we pointed out that, apart from the penalty, there was an additional charge to compensate the 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 can be an exciting rite of passage for households - 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, which was recently ranked among the Global Top 30 for online finance by the prestigious Institutional Investor magazine. Details at