How rate cuts can change your home loan picture

With fixed mortgage rates today markedly lower at 3 per cent, as opposed to floating rates hovering mostly above 4 per cent, one would think it is a no-brainer to go for the cheaper loan.

The complication comes from an outlook that is pointing to interest rates coming down from the second half of 2024. US Federal Reserve chair Jerome Powell had said, following the last month’s Federal Open Market Committee (FOMC) meeting last month: “Almost everyone in the committee is in favour of moving rates down this year.” He went on to push back against the idea of a first rate cut in the next meeting in March, but certainly the market is now pricing in cuts to begin either in May or June.

Fixed mortgage rates fell significantly at the start of 2024, compared to the start of 2023, from 4 per cent down to 3 per cent. No one can be certain that they will not fall by a further 100 basis points to 2 per cent by the start of 2025, after the Fed starts dialling back its hikes from the middle of this year. The extent of cuts is determined by how fast the Fed moves, which is in turn dependent on whether we get to a soft or hard landing in the US.

Even if the drop is halved this time to 2.5 per cent, that is 0.5 per cent, which translates to a dollar sum savings of S$3,500 in a year for a typical mortgage of S$700,000 – much more if your loan is substantial.

Two options

Anyone looking at a new home loan package today is unlikely to opt for floating rates still in excess of 4 per cent. The question becomes: Do you take the lowest nominal fixed-rate number out there – which would be for a two-year fixed rate package that comes with two-year commitment period (lock-in), or do you go for a marginally higher fixed rate that comes with an option to reprice or convert 12 months into a two-year lock-in period?

Going for the second option lets you switch to a floating rate if interest rates drop more quickly than expected and mortgages are repriced. This means you won’t be stuck with a high 3.1 per cent fixed rate, for example, until mid-2026.

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How do you decide between the two options? Studying the interest rate cycle can tell us quite a few things.

Against analysts’ predictions, forecasts and the narratives of the day, which can swing from month to month – for instance, a Fed pivot in November last year became a Fed pushback now – the cycle continues to behave like a cycle. This means that what goes up always comes down, after having stayed at the top for brief periods, and it can come down just as fast as it goes up.

Some people will counter that with the four most dangerous words (to me) in finance: “This time is different.”

Let me remind you that it was just a few months ago that the narrative was that rates would stay “higher for longer”. As it turned out, inflation is not different and is indeed “transitory”, but that transitory period lasted two years and inflation is now coming down.

Of course, we could still end up being wrong. So, the best course of action advocated by our firm would be to go for the lowest fixed rate with the shortest commitment period, and keep that optionality of a review after 12 months. This could make the biggest difference between saving S$700 (0.1 per cent) or S$7,000 (1 per cent) on a typical S$700,000 mortgage over one year.

There is a problem with this approach, though. As recently as in October and November 2023, banks pulled out all stops to get market share by offering, for example, the lowest fixed rate, a one-year lock-in, lowest thereafter floating spreads after fixed ends, free conversion during the two-year lock-in period, and even enhanced cash rebates for refinancing with extra S$500. Unlike during brief spells like that, options at the moment are limited.

It seems like when the year crossed over to 2024, banks stopped dishing out rates below 3 per cent. You would have thought banks would seize the window before the Fed cuts rates and SORA dips in the second half of the year, to cater to that sweet spot of “lowest fixed rate with optionality”, to rake in the biggest market share in 2024, leading to higher margins later as cost of funds subsides.

Two factors to consider

I would also advise against becoming fixated on that small difference in fixed rate packages – between one that comes with a strict two-year lock and one that comes with an optionality after a year.

Consider two factors: First, how big is this gap? If it is merely 0.1 per cent, perhaps overlook that and keep that optionality to reprice after 12 months.

If it is bigger than 0.1 per cent, then it depends on what perspective you take. If you are one of those lucky ones who has been largely shielded from the high mortgage rates of the last two years, having locked down a fixed rate at below 1.5 per cent in 2022, you can adopt a “blended” cost of funds perspective by pursuing a strict two-year lock with the absolute lowest fixed rate today. That means your average interest cost over a four-year period will be near 2 per cent, a remarkable feat in a period of record-smashing Fed tightening rate cycle.

However, if you have been paying through your nose in the last few years, be very careful that you do not get stuck again the other way around – and be forced to serve out a high rate while watching the interest rate cascade due to a recession or some unexpected exogenous event. We live in an uncertain world.

The writer is executive director of MortgageWise.sg