Welcome to the “new normal”. We have social distancing, remote working – and rock-bottom interest rates. As of Sep 30, 2020, the 1-month and 3-month SIBOR rates stand at 0.25% and 0.41%, respectively.
The reason is the US Federal Reserve (Fed), which slashed the target range for its benchmark federal funds rate to 0—0.25% in response to the COVID-19 pandemic. Since MAS does not directly influence interest rates, SIBOR’s moves are generally highly correlated to this rate.
Since the substantial fall in SIBOR in February, there has been a steep drop in floating mortgage rates in, spurring a wave of refinancing. This is not a critique – in fact, it is the smart thing to do in a low interest rate environment.
But the question is, how long can these low interest rates last? And more importantly, what happens to your mortgage when rates go up? Those are the questions this article will tackle. To begin, we must first understand why the Fed (and other central banks) lower interest rates in response to a recession.
Central Banks, Interest Rates, and the Economy 101
One of the key roles of central banks is to regulate monetary policy to influence the economy. And one of the main “weapons” at their disposal is interest rates. While this does not apply in Singapore (the MAS uses the exchange rate instead), we are the exception, not the rule.
By lowering interest rates, borrowing costs are brought down, which stimulates consumption. Remember that consumption is a key part of the GDP equation. Conversely, it may raise interest rates to cool down an overheated economy, where inflation is deemed to be above healthy levels. The bank thus increases borrowing costs to tamper consumption, encourage savings (which reduces the money supply), and bring down price levels.
Inflation is an important metric here. You see, most central banks have a target inflation range. When inflation trends beyond that range, that’s when interest rates are often raised. But if inflation remains below that target, central banks know they have room to drop interest rates to encourage consumption.
Inflation is thus a big aspect of when interest rates are projected to rise again.
When Will the Fed Raise Interest Rates Again?
For the longest time, the Fed has had a target inflation of 2%. Since the pandemic, U.S. inflation rates have fallen to below 1.5% and has shown little signs of recovering. Further, the Fed recently shocked markets with a major policy shift. In September 2020, it announced that it will now let inflation run above the 2% target until maximum employment could be achieved. Subsequently, the Fed also announced that it expects to keep rates unchanged until at least 2023.
In a nutshell, what this means is for Singapore SIBOR home loans – low interest rates may persist for some time. In fact, inflation in the U.S. is expected to only average 1.3% in 2020, 1.5% in 2021, and 1.7% in 2022.
This is good news for Singaporeans with home loans. Based on the current economic trajectory, it is not unreasonable to expect that floating-rate SIBOR home loans will remain at highly attractive levels for another two years or more.
Note: Although SIBOR may soon be replaced by SORA as the benchmark for floating-rate loans, they have generally displayed similar trajectories. For example, from the beginning of 2020 till October, the 1-month SIBOR fell by 1.5%, from 1.75% to 0.25%. The SORA decreased from 1.68% to 0.08% over the same period.
But there is something that could disrupt this trajectory – the discovery of a safe and effective vaccine for COVID-19. While this would hasten the global economic recovery (an indisputably good thing), it would also mean a quicker recovery in inflation and employment levels, and thus a higher likelihood of interest rate increases.
Again, this would be a positive thing. But it would also result in higher mortgage instalments – a situation that has happened less than two years ago.
Remembering the 2018 Interest Rate Increase
After the Global Financial Crisis, the Fed kept interest rates low for years. Then beginning 2017 it gradually began to raise them again (before halting this policy in 2019). But in that period, the 1-month and 3-month SIBOR rate increased from 0.71% and 0.94%, respectively, at the beginning of 2017 to 1.89% and 2.00% in June 2019.
Consequently, Singaporeans with floating rate home loans saw their monthly instalments increase. News outlets like the South China Morning Post ran stories profiling new homeowners who ran into financial difficulties as a result.
Fortunately, they were eventually saved from such increased payments by the Fed’s policy reversal in 2019 and the subsequent pandemic. But if those events had not happened, many could have faced even greater troubles.
There are two main lessons we can take away from this.
Lesson #1: Always Be Prepared (Build in a Buffer)
Yes, mortgage rates are at all-time lows, which means your mortgage payments likely are too (and if they’re not, you should consider refinancing). But when it comes to your personal budgeting, it might be best for you to work in an additional buffer to account for potential rate increases.
What rate should you use? We recommend assuming your mortgage interest rate is 3.5%. Anecdotally, that is the rate we have heard that bank officers use when assessing applications. And that is also the rate we set for our Mortgage Affordability Calculator.
So, even though 3.5% might be as much as double the interest rate you are paying now, it is still worth budgeting around that rate. Sure, it might crimp your lifestyle a little. But wouldn’t you rather have the peace of mind of knowing that you can comfortably handle any interest rate increases?
Lesson #2: Look for Ways to Make the Most of the Situation
The second lesson is to see if you can take full advantage of the extended low interest rate environment. For instance, if you have the financial means, you might want to consider prepaying your mortgage (assuming there are no prepayment penalties and you don’t have any other higher-interest debt, of course) or even refinancing at a shorter tenure.
Of course, this requires additional cash outflows, so it will not be the best option for everybody. Many may prefer to refinance and extend their tenure to conserve cash flow instead. But for those with the capacity in their budget to do so, this could save them tens of thousands of dollars in interest costs over the long run.
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This article was written by Ian Lee, an ex-banker turned financial writer who hopes to use his financial background and writing skills to help raise people’s financial literacy levels – a necessity in our modern world”