The concept is now new as some banks in the market do offer such loan structure on requests. Most bankers will refer to it as combo loan. DBS calls it “Managed Mortgage” with its latest offering of a 3-year fixed rate at 1.88% p.a. – half the loan is fixed, the other half must be on one of its floating rate packages.
Lately we have been getting more enquiries on Managed Mortgage, not surprising as the market is still relatively unfamiliar with such a loan structure. Does it make sense? In the current ambivalent situation of rate hike versus no rate hike, the latest proposition by DBS do carry some merits. Let us take a look.
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Traditionally the question to ask has always been and still is – should we go fixed or floating? Of course such a question is premised on one not looking to sell the property within the next 12 or 24 months as fixed rate home loan comes with a lock-in period (penalty on full redemption of the loan).
The reasons for wanting to fix the mortgage interest is obvious – general outlook on interest rate is for it to head upwards when US Fed finally architects a lift out after almost a decade of ultra-low rate accommodative monetary policy. However fixed rate often begot the need to always refinance home loan every two to three years once the fixed rate term ends hence incurring hefty transaction costs which erodes the interest savings from refinancing in the first place. This is especially true for smaller loans. Remember even when banks offer a legal fee subsidy they always come with a clawback period of 3 years and if one is on a 2-year fixed rate that means one needs to pay back the legal subsidy in full if one refinances out in the 3rd year (when the rate becomes floating on a higher spread). In this blog we have been forewarning on this issue for a while now that this is how banks will earn back from homeowners who take a 2-year fixed rate.
The new Managed Mortgage for DBS home loan, or for that matter any other bank which offers a combo loan, serves to fulfil the twin objective of locking in some kind of fixed interest rate for a certain period of time while ensuring even when the fixed term ends, the overall interest will still be low enough to justify staying put. For this concept to make sense, the fixed rate term needs to be sufficiently long so that one could aim to then make a big lump sum repayment at the end of the fixed period. DBS would do even better if they offer a 4-5 years fixed term at a slightly higher rate instead of a 3-year fixed rate of 1.88% p.a.in my opinion.
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DBS “MANAGED MORTGAGE”
50% of the loan to be on Fixed:
Year 1 to 3 : 1.88% p.a. (Fixed)
Year 4 on : FHR18 (0.50) + 1.80 = 2.30% p.a.
50% of the loan to be on Floating:
Year 1 to end : FHR18 (0.50) + 1.25 = 1.75% p.a. (with Mortgage Insurance)
Most would agree that even after Fed’s 1strate hike (which will be more symbolic in nature), the subsequent interest rate increases will be at a very subdued pace as the central bank would err on the side of caution lest it derails economic recovery. If we assume just a 0.50% increase per annum for the next three years, the effect of having half the loan on fixed rate 1.88% will be as follows (on a typical loan of $700,000):
1. For Those With Contrarian View That Interest May Not Rise
Based on a typical loan size of $700,000 in the illustration above, we see there are 3 groups of homeowners who will benefit most from Managed Mortgage:
Notwithstanding the majority view that interest is poised to rise in 2016, there continues to be those who believe otherwise. In the post-Great Recession era it is very hard for anyone to say with certainty how events will unfold. Just look at the unexpected oil crash last October or the sudden devaluation of Chinese yuan after many years of denial by Chinese government.
In the example above, there is not much difference in terms of the monthly repayment for a loan to be completely on floating versus one that is on Managed Mortgage at the current rates in Year 1. The extra $12 per month or $144 in a year is like a hedge or insurance premium one pays against sudden rate hikes.
For those who believe that there is no reason for US Fed to hike rates given the anaemic inflation that will persist in US for many more years to come due to changing demographics and the strengthening dollar, not to mention the contrarian actions of monetary easing taken by almost the rest of the Central banks in the world (EU, Japan and now China), they may want to go on floating rate with a constant spread that does not increase after first three years. However if one is not 100% sure and especially if the loan quantum is substantial, then it might be a good idea to take up an “insurance” by fixing 50% of the loan as you can see should interest continues to climb in Year 2 and 3 at 0.50% p.a. the savings start to kick in. By Year 3, one would have saved approximately $1700 in one year. Remember it is not just savings from monthly cash flow perspective, there is also savings from principal reducing effect as when interest rises, more and more of your monthly repayment goes towards interest rather than principal reduction.
2. For Those With Intention To Pay Off Half The Loan In 3 Years
By Year 4, when the fixed rate term ends notice how the overall interest (3.53%) jumps ahead and surpasses that of the 100% floating package (3.25%). This is due to the higher spread when the fixed rate ends and reverts to floating. By this time one should be ready to pay off the entire fixed portion of the loan or at least a big part of that. If one is unable to do that then Managed Mortgage may not make so much sense. Such a homeowner might want to go fixed for the entire loan from the outset since there is a need to refinance the loan after three years in any case.
However in life there is no perfect solution. Going fixed for 3 years for entire loan attracts a higher premium or interest rate currently at 1.98% p.a. We have already covered this topic not too long ago in this blog where in fact we argue that it makes good sense to go fixed for longer than 3 years which is premised on our interest rate outlook.
Managed Mortgage, in our view, is for those with a dovish interest rate outlookbut yet wants a hedge against the wrong bet. In fact if one has a dovish view, but is unable to pay off 50% of the loan after 3 years, we think it is better for such a homeowner to take Managed Mortgage from DBS but to go on an even lower spread in the first 3 years for the floating portion, ie. FHR18 + 1.05 or 1.55%. This low spread of 1.05 goes up to 1.80 from year 4 onwards but that is also when one can refinance the entire loan as the fixed rate term ends at same time.
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3. For Those With Intention To Do Partial Repayment Every Year
Then there is the final group of homeowners who do receive big bonuses every year and will like to progressively pay down the loan over time right from the beginning, but who still like to enjoy the savings of a fixed rate mortgage. Hence Managed Mortgage allows them this flexibility unlike the other option of an interest-offset account touted by some banks – one still cannot lock down fixed rate for interest offset.
After three years when the fixed rate term ends, one will just need to shop around for the next best combo loan available in the market to continue the practice of locking down fixed rate for 50% of the loan, while slowly making repayments to the other 50%. In fact some other banks we know will even allow one to vary this split and the fixed portion need not be just 50%. Speak to us today to find out more.
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