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Friday, January 15, 2010

Is it time to hedge mortgage bets?

Star Property 
Nov 26, 2009

For many, a mortgage – which is simply paid every month and then forgotten about – is their largest financial commitment. Consumers have the option to choose either the fixed or floating rate mortgage.
In the constantly-evolving finance market, it is always important to understand the potential future consequences of decisions made today. This way, educated decisions can be made in response to the economic climate as and when it changes.
Most home loans will normally fall into one of two broad categories: the fixed rate or floating rate mortgage. There may be countless different packages with many differing features, but they still fall under these two categories.

Fixed rate loans
Fixed rate mortgages do exactly what they suggest; the interest rate is fixed, which means that monthly payments are fixed as well.
In Malaysia, insurance institutions offer these loans. For most of them, the interest rate is fixed for the entire mortgage term. Therefore, a borrower is not only protected from any interest rate fluctuations in the open market, but he also knows exactly what his monthly installment is for the entire lifetime of the loan.
However, most lenders will tie the borrower to the product for a set period (usually around 5 years) by way of a penalty. Hence, if the decision is made to redeem the mortgage within the first 5 years, a penalty is imposed. It is generally calculated with a formula that takes into account the remaining term of the loan and the amount repaid.
The downside is that if interest rates in the open market fall, there is no benefit since the rate is locked.
Floating rate loans
Floating rate mortgages are a variable loan that typically tracks the BLR (base lending rate). It can either track higher or lower than the base rate. Most, if not all floating rate loans are currently tracking below the BLR, roughly in the region of BLR -1.8%.
In most cases, the loan will continue to track at the same margin for the entire loan term (although some banks may attract new business by offering an extremely low floating rate, which increases after the first few years).
Floating rate mortgages can also be pegged against the 3 month KLIBOR (the Kuala Lumpur Inter-Bank Offered Rate), which is the interest rate banks use when lending each other. However, this method is relatively unusual.
Floating rate mortgages can be influenced by changes in the economy: roughly speaking, if demand increases resulting in an upward inflationary pressure, monetary policy dictates that the BLR increases. This may mean the borrower’s monthly payments will significantly increase. On a positive note, interest rates could fall too and the borrower will pay lower monthly installments.
At present, the fixed rate interests are just under 5% while floating rates are around the 3.8% mark. So the golden question is whether to fix or float?

To fix or to float?
There are numerous factors to take into account when deciding which type of mortgage to go for. At first glance, the floating rate package seems much better because a difference of more than 1% will certainly have a large impact on monthly payments. There is obviously a significant difference in price, but it is worth remembering that the BLR is at an all time low.
Market watchers believe that the BLR rates could increase and this means that opting for a floating rate could be more of a gamble instead.
Secondly, the risk-to-reward ratio should be taken into consideration. Irrespective of economic conditions, it is obvious that a 3.8% floating rate can only fall by a maximum of 3.8%, while there is no limit to its increase. If however, the BLR is at 9%, then the potential reward for taking a floating rate is much greater as it could fall much further. However at present, it is at the all time low of 5.55%.
Also, a mortgage commitment is not just for a few months. On average, it is around 3-5 years. So, while floating rates are especially cheap at the moment, it is difficult foresee that the fixed interest rate will fall below 5%.
Even if the BLR stays low for the next 5 years, and therefore (with future hindsight) the fixed rates of today are undesirable in comparison to current floating rates, the peace of mind one gets from a fixed rate should be enough to prevent the average risk-averse borrower from worrying about what they could have “gained” if they settled for a floating rate mortgage.

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