In this post, I will share with you about the system of mortgages. On how mortgages works and why would the bank want to provide mortgages. I will move on to talk about Fixed Rate Mortgage (FRM) and Variable Rate Mortgage (VRM). I will talk about how the secondary mortgage market come about which led to the development of an alternative mortgage market.
How does mortgage come about?
Many a time, when we are going to purchase a home to stay we do not have enough cash to fully pay the home. Does this mean that everyone is going to be homeless? We would find additional sources of funding. One place we can go to is the bank. It is similar to getting a business loan.
Where does the bank get its money?
Banks get their money from savers/depositors. When people save their money in the bank, the bank uses the money to conduct loans. The loans conducted could have interest rates that are high or low depending on the loan. However, the interest rates for the loans will usually be above the interest rate that the banks need to pay back to the savers. The difference in this interest rates allows the bank to profit. To get a loan the bank will require two things.
- Interest to be paid by the borrower.
- Banks need to have a collateral to grant you the loan.
In the case of a mortgage loan, the bank will use your property as a collateral. The bank will be able to take a position of your property if you do not repay your loans. This could lead to a foreclosure of your property.
Fixed Mortgage Rate(FRM)
A FRM is a mortgage that has a similar interest rate throughout the whole loan term. The borrower will have a fixed amount to repay to the bank monthly. This fixed payment includes both the interest repayable and the principal payment as well. The break down of the payment for interest and principal payments is calculated like this. For example, for easy illustration purposes, a mortgage loan with full amortization of 1Million with 10% interest p.a. for 30 years.
Using a financial calculator you can calculate the monthly repayment by inputting PV = $1000,000, FV = $0, I/Y = 10%/12 (based on payment period 1), N = 30x12 = 360, calculate PMT = $8775.72
- The monthly repayment will be $8775.72
- To calculate the interest payment. Take 10%/12 to find monthly interest.
- Multiply monthly interest by the loan amount. 0.83333% x $1mil = $8333.33
- First monthly interest would be $8333.33
- Take monthly payable minus interest payment to find out principal payment.
- $8775.72 – $8333.33 = $422.39 (Principal payment)
- Only the principal payment will reduce the total amount of loan payable, the interest will not.
- Total loan left would be $1mil – $422.39 = $999,557.61
- Repeat the steps to calculate the interest on the remaining loan all the way to 30 years.
- You can check out the interest and principal payment here http://www.amortization-calc.com/
If you notice the interest payment would decrease over time as more loans are being repaid by the principal payment. While the principal payment would increase over time.
What is the risk of FRM?
FRM bears more risk to the lender instead of the borrower. The borrower will not have to change his monthly payment even if the market interest rate rises. The banks will have to increase their interest payment on the short terms deposit while the interest collected from FRM is still the same. Therefore, the number of profit decreases. Even if the interest rate goes down, the lender cannot fully enjoy the benefits as borrowers will tend to refinance to get a lower interest rate.
Therefore, many countries are not able to provide long-term FRM as it is not beneficial to them. For example, it is not available in Singapore, UK and Canada. However, there are still FRM in countries and they are sustainable due to the secondary mortgage market.
Introduction of ‘adjustable’ rate mortgages(ARM)
With only FRM, banks stand to lose out when interest rate changes. Therefore, they are not willing to provide a long-term FRM. With ARM, they will not be worried if there are huge changes in the interest rates. It aims to share the risk of the borrower and lender. Banks usually lure borrowers by giving a lower interest rate compared to FRM. ARM interest rates for borrowers are not fixed, they change monthly and so monthly payments also differ.
Singapore mortgages come in two packages. Firstly, ‘fixed’ mortgage and secondly, floating mortgage. ‘Fixed’ mortgage may sound misleading, it is actually fixed for a short period of 1-3 years. After the fixed period, it would convert to a floating mortgage.
Lock-in Period Of Loans
Lock-in means that you will not be able to prepay the loan within that lock-in period or face a lock-in penalty. Different banks have different lock-in period and lock-in penalty.
Where Does Bank Reference Interest Rates?
There are three common ways that banks determine their interest rates.
- Singapore Interbank Offered Rates(SIBOR)
- Singapore Swap Offer Rate(SOR)
- Bank’s Board Rate
SIBOR – This is the rate that banks lend money to each other which is determined by the Associations of Banks in Singapore. The rate changes every day based on market conditions. 1-month SIBOR rate gets reviewed monthly and 3-month SIBOR rate gets reviewed quarterly. You can check the SIBOR rates here.
SOR – This is the rate of borrowing USD instead of Singapore dollars. After borrowing USD, it will be swapped to SGD to be used. This method is more volatile as it is dependant on USD interest rate and exchange rates. You can check the SOR rates here.
Bank’s Board Rate – This rate is determined by the bank and they are able to change the rate anytime. The banks will have to notify customers 30 days in advance when they want to revise the interest rates. This method is less transparent and not advisable.
Interest Rates (Loan to value <=80%)
|Year 1||1.75% Fixed|
|Year 2||1.75% Fixed|
|Year 3||1M SIBOR + 0.60%|
|Year 4 & Onwards||1M SIBOR + 0.60%|
|Penalty Period||2 Years|
|Legal Subsidy (For Refinancing only)||0.4% of loan amount, capped at S$1,800 (Private Residential Home Loan) / S$1,500 (HDB Home Loan)|
Fixed Mortgage Interest Rates For UOB.
In Singapore, there is hardly any long-term fixed mortgage. The only mortgage close to it is the HDB concessionary loan which is pegged at 0.1% above the CPF interest rate of 2.5% since July 1999. Mortgage rates are at an all-time low and are starting to increase. With a lower rate, it means that your payments are lesser which would result in a higher yield. For investors, the mortgage rates can have a huge impact on their returns. This is because these loans are taken over a long period of time and a slight difference can have a big impact. This aspect will be covered in my other post of Time Value of Money.