The general consensus and all the nuances coming from Fed officials now suggest that interest rate is likely to come down, soon but perhaps not by too much.

So, what’s the impact on mortgage costs should interest go south?  How big deal is that?  That may be the question that lingers in the minds of some homeowners?

After all, we heard of stories where some borrowers found themselves stuck with a high 3.88 per cent fixed rate signed in a hurry just barely a year ago with fixed rates plummeting since by more than 120 basis points (1.2 per cent) and is currently hovering at 2.85 to 2.88 per cent.

Just how important is the feature of a free conversion after 12 months, or the flexibility to be able to convert to another lower-rate package about a year into another 2-year lock-in period?

To answer this question, let’s look at a typical loan of $700,000 with 25 years of remaining tenure.  The heuristic we use at MortgageWise, when we compare packages for clients, is for every 0.1 per cent difference in rate, the absolute amount of interest saved in a year is simply the numbers before the three zeros.  For example, on a $700,000 loan, if we ignore the three zeros behind, that amount saved will be $700 in a year.  Likewise, on a $1 million loan, the interest savings for 0.1 per cent will be $1,000 in a year.

Since the market is now pricing in the likelihood of two rate cuts of 0.25 per cent each this year, and if we also assume for simplicity sake that mortgage rates will come down exactly by 0.5 per cent when that happens, then the absolute amount saved on a $700,000 loan will be 5x $700 = $3,500 in a year.  Obviously if your outstanding mortgage loan is much bigger like $1.5 million, the savings on a similar 0.5 per cent drop in rates is significantly greater, i.e. 5x $1,500 = $7,500!  And so on.

For the majority of clients with typical loans of $700,000, it might still be hard to gauge how meaningful is this savings of $3,500 which is probably close to a month of mortgage repayment.  So, you save paying one month with eleven months of mortgage repayment instead of twelve, but is that significant enough for you to put in some time and effort to do a mortgage refinance to another bank?

That depends on how much you value your time and each dollar saved.  Perhaps the best way I could illustrate the impact of such a savings is to measure it based on what we know many clients did in the past two years – doing partial repayment.

Given the exorbitant interest rates which had ballooned three times to over 4 per cent at one stage, it’s hardly surprising that homeowners in Singapore were actively deleveraging in 2022 to 2023 by redeploying all their fixed deposit savings and idle funds in the banks to the paying down of their outstanding mortgage loans.  For example, we had seen clients who refinanced a loan of $1.5 million with us two years ago but when we contact them for a review now, their outstanding loan had been reduced to $500,000!

No doubt not everyone has the means to partial prepay a million dollar of debt to avoid incurring high interests, still we estimate most customers will be doing some small amounts of repayment whilst refinancing their mortgage, typically in the range of $100,000 to $200,000.

At the current lowest interest rate of 2.88 per cent, every $100,000 prepaid means you would’ve saved yourself $2,880 in a year.  Hence, a ball park estimate of a 0.50 per cent drop in interest rate would equate roughly to the effect of interest savings from prepaying about $3,500 / $2,880 x $100,000 = $120,000.  Likewise, should interest drop much faster than what everyone thought and fixed rates go to 1.88 per cent within a year, it’s equivalent to you prepaying about $240,000 of debt.  That’s shaving off about one-third of an outstanding loan of $700,000.

To make it easier to grasp, just look at the percentage drop in headline interest rate.  A 1 per cent drop in interest rate from 3.88 last year to 2.88 per cent this year “shaves off” only about 25 per cent (1 over 3.88) of the outstanding loan; but the same 1 per cent drop in interest rate from 2.88 per cent, should it go to 1.88 per cent, would shave off 35 per cent (1 over 2.88) or close to 40% of your outstanding mortgage loan!

In other words, as the headline interest rate goes lower, every 0.50 per cent drop in rate has greater impact to your overall mortgage costs compared to when you start off at a much higher level of interest last year.  This also means the optionality of an any sort of exit after 12 months into a 2-year commitment period should be valued enough more now.

To conclude, if you know the effect of being able to switch out to a lower interest rate can be as impactful as you draining your cash reserves to do a lump sum repayment, you may want to twice before passing up their free conversion optionality too easily.

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Disclaimer: MortgageWise Pte Ltd is not in the business of providing financial advice nor are we licensed or regulated by MAS under the Financial Advisory Act (FAA) in Singapore. All information presented are opinions and any representations given, whether by way of example, illustration or otherwise, are purely portfolio allocation advice and not recommendations or inducements to buy, sell or hold any particular investment product or class of investment product.  All opinions are generic in nature and are not tailored to the particular circumstances of any reader.  Seek advice from a qualified financial advisor before making any investment decision.

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