Can’t decide between fixed or floating rate home loan?

It’s challenging time for homeowners in Singapore where a new generation has never seen mortgage rates go as high as over 4%.

It’s no wonder that many quickly jump for the cover of fixed rate mortgages for fear that their mortgage costs will continue to escalate out of control.  Fixed rate went as high as 4.50 per cent at one stage but has since moderated down to 3.75 to 3.88 per cent of late.  

With the latest banking crisis posing systematic risks to financial markets in the U.S., and the talk that Fed will likely pause, pivot and even cut rates earlier than expected, does fixed rate still make sense?

There are six factors to ponder before deciding on fixed versus floating rate home loans with the biggest being the interest rate cycle. So, let’s elaborate on that.

1. Where are we in the interest rate cycle? 

In a rapidly rising interest rate environment as what we have witnessed in the past year, selling fixed rate had been a compelling proposition for most bankers and brokers alike in the last 6 months.  Not for us.

We stopped recommending fixed rates, at least not for 2-year fixed, when it went above 2.75-3.00 per cent back in Q3 2022.  Our basis for that stems largely from looking at where we are now in the interest rate cycle.  Of course, it is still premature to say who will have the last laugh.

The biggest argument for fixed rate touted by banks and brokers alike has been that peace of mind which is highly-valued in turbulent times.  It is certainly comforting to know that you’ve hedged your cost of borrowing whilst watching rates continuing to ratchet up.  But as of all things in life, there’s a flip side to this which most in their moment of fear did not consider.  What’s the price to pay for this peace of mind should rates suddenly falter?

This is the value of working with veterans and established mortgage consultants who had brokered through cycles of changing interest rate regimes.  Hear the stories first-hand about how some homeowners who signed for fixed rates at 2.38 per cent in the last peak cycle of 2018-2019 regretted their decisions as they watched rates nosedived to sub-1% within the span of a year.  They overpaid by more than 1.50 per cent, which on a typical loan of $750,000, would translate into a sum of $11,250.

We’re not sure yet when rates will drop but certainly U.S. Fed will have to be more restraint from here.  As what goes up eventually must come down (that’s why it’s called a cycle), the question becomes how low can rate go to when it does drop at some point?   

If historical trend is some basis we can go by, then the interest cycle is telling us when Fed eventually cuts the fed funds rate by a full 1 percentage point (or more) like back in 2007, it will not come as a surprise to see 3-month compounded SORA crash all the way back to 1.50 per cent!  That is, even if inflation in the U.S. remains sticky at above the target 2 per cent level.  Inflation will eventually come down, typically six months into a recession.

So, if you sign for fixed rate today at close to 4 per cent, depending on when this happens, you might be overpaying by almost 2 per cent or $15,000 on a typical $750,000 outstanding loan balance.  What a price to pay for that peace of mind!

2. Duration risk for mortgages?

The failure of SVB is due to the duration risk mismatch between holding long duration treasuries which value has plunged drastically and the shorter duration deposits.

In a certain sense, there’s also duration risk for mortgages in the form a lock-in period.  That’s the biggest problem when it comes to deciding how long to commit to an interest rate structure.  You won’t want to be trapped with a high fixed rate for too long should the cycle turns down.

As this is an unusually fast and short cycle due to the pace of tightening, things can change quickly.  Inflation can also go back up if recession is avoided and Fed might need to continue to hike.  In such turbulent and uncertain times, ceteris paribus, the shorter the lock-in the better.

If historical trend is some basis we can go by, then the interest cycle is telling us when Fed eventually cuts the fed funds rate by a full 1 percentage point (or more) like back in 2007, it will not come as a surprise to see 3-month compounded SORA crash all the way back to 1.50 per cent!  

3. Investment vs. own-use property

Investors often want to have the flexibility to sell as you never know when that offer is going to materialize.  A floating rate home loan gives that flexibility along with the option to prepay a portion of the loan without penalty during the lock-in period.

Fixed rate mortgages attract a 1.50% penalty if you sell anytime during the lock-in period.  Having said that, nowadays there are certain fixed rate packages that come with waiver of such penalties due to sale.

Investment properties also come with a rental income which helps to partly service the varying monthly repayment of a floating rate mortgage.  Contrast that with own-stay properties where most will prefer to budget for a constant repayment amount every month.

4. Size of your outstanding loan

Our observation is that homeowners with smaller outstanding housing loans for example below $500,000 to $700,000 tend to opt for the comfort of a fixed rate mortgage, while those with much bigger mortgages tend to bet on floating rates.  Understandably, as every basis point difference in rate movement means a lot more in absolute dollars for bigger loans.

5. Personality and risk profile

Somewhat related to the preceding point, some people are more inclined to take bets while others prefer to take out all the guesswork.  For this latter group, peace of mind is highly  regarded as long as they determine that the monthly repayment is well within what they can afford to pay and commit for the period of the lock-in.

In that sense there can be no right or wrong when it comes to choosing fixed versus floating rate home loans.  I will just add – at what price does this peace of mind cost?  Which bring us back to point 1.

6. Stability of your income

It looks highly likely that it will take a recession, deep or shallow, to bring inflation down in the U.S.  The ensuing slowdown will hit global demand and economic growth.

If you do see headwinds in your industry with risks of redundancy, it might be better to quickly do a refinancing to a floating rate home loan that comes with a reasonably low spread (the mark-up above SORA) for the longest possible time.  It will be hard to refinance without an income and you won’t want to be caught out by a fixed rate which often reverts to a floating rate on a super-high spread at the end.

As this is an unusually fast and short cycle due to the pace of tightening, things can change quickly.  Inflation can also go back up if recession is avoided and Fed might need to continue to hike.  In such turbulent and uncertain times, ceteris paribus, the shorter the lock-in the better.

This month marks the anniversary of Fed’s first rate hike of 25 basis points back in March 2022.  The collapse of regional banks like SVB and Signature Bank is a canary in the coal mine for financial markets, after a monetary tightening cycle at unprecedented pace. Central banks will now pull out all stops to ensure no contagion effect leading to more bank failures.  Still, when financial conditions are this tight, something else might break somewhere.  Be warned.

A final word on the notion of interest rate staying “higher for longer”, which has been bandied around by many in the past year by economists, analysts and even politicians.  No one can say for sure how long more.  But there’s a big difference between “higher for longer” and “lower for longer” in the prior years.  In the latter case, there’s no pain or economic hardship.

Even in the epic 1980s inflation fight in the U.S. where inflation soared to 15% and fed funds exploded to over 20%, it only took months in 1980 not years for Fed to quickly halve the interest rate (see below).  Of course in that episode they cut too soon and inflation went back up triggering a second wave of hikes and a second recession that lasted even longer. Still, people missed the point now on the current inflation fight – headline CPI has fallen by a third from its peak of 9.1% in Jun 2022 to the latest 6% in Feb 2023.  It may be still too high for the Fed, but it is not getting worse. And the crisis is doing the Fed’s job for it. There’s no reason for the Fed to go much higher than where we are now.  Bottomline is we’re not going back to the 1980s Great Inflation era.

Need more advice?  We don’t just throw you a set of rates, or get different bankers to sell to you.  Not only do we help clients navigate through Singapore mortgage rates quick and fuss-free, we show you how best to position and profit from the interest rate cycle, be it for residential or commercial property loan. Work with us today and you’ll also be helping to support our social cause!

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Disclaimer: MortgageWise.sg endeavours to bring the best insights and knowledge in our expert domain of mortgage planning to the market.  Still, all viewpoints expressed in our blog remain as opinions of the writer, and shall not be constituted as financial advice.  We cannot be held responsible in any way for any financial losses arising from your mortgage decisions should you choose to rely on any of our viewpoints and opinions.