Those who have taken a home loan may be familiar with its two forms – the fixed rate and floating rates, which its market managed variants are typically based on the Singapore Interbank Offered Rate (“SIBOR”). So, what will the introduction of the Singapore Overnight Rate (“SORA”) mean for you, and will this make loans cheaper for homeowners in our current property booming climate? In this article, we will cover a few of these matters to demystify these changes.
Why do we need interest rate benchmark?
Interest rate benchmark determines the amount of interest payable for many financial products. Banks use this benchmark and apply a “spread”. Such benchmark is useful for effectively valuing debt products.
In a floating rate loan such as a SIBOR/SORA loan, the agreed interest rate to pay on a loan is benchmarked according to the SIBOR/SORA reference plus the spread. The cost of the loan goes up if the benchmark rate increases, and the cost of the loan goes down if the benchmark rate falls. i.e.: 1M or 3M (benchmark rate) + (Spread in xx%) = Effective Rate.
Example: 1M + 0.9% (Spread) = 1.018% (Effective Rate)
Ideally, the benchmark rate should be one that is regularly updated and publicly accessible to promote transparency. These benchmark rates represent the rates at which banks lend and borrow, and hence how easy it is for banks to access money and consequently, how readily these banks are able to offer loans and other financial products.
What is SIBOR?
SIBOR is the average rate that Singapore banks forecast that they can borrow money from each other. Simply put, it is the forecasted interest rate on interbank lending. This is determined by the 20 member banks within the Association of Banks in Singapore (ABS) who report their interest rates daily.
Breaking it down into a concept of supply and demand, all else being equal, a larger supply of money lowers market interest rates, making it less expensive for consumers to borrow. When governments engage in expansionary monetary policy, the quantity of money within an economy is increased. This results in a lower cost of borrowing as reflected in falling interest rates.
In home mortgages, the 1-month SIBOR and 3-month SIBOR are the most common, expressed as “1M” and “3M”. This determines how often the interest rate on your home loan changes, and hence the effective monthly interest rate on your loan. A 1M SIBOR loan revises its rates every month, while a 3M SIBOR loan revises its rates every 3 months.
So why the difference? Forgoing all other fees in obtaining a home loan, in a falling interest-rate environment, more borrowers may opt for 1M SIBOR loans to take advantage of the constantly falling interest rates, so that the effective interest paid on the home loan is reduced. However, this would expose you to greater volatility in a rising interest rate scenario. SIBOR has references to US Federal Reserve Interest Rates. It is due for discontinuance and MAS has released of replacement by SORA.
What is SOR?
Similar to SIBOR, the Swap Offer Rate “SOR” is another benchmark for interest rates in Singapore. An interest rate swap is an agreement between two parties to exchange on stream of interest payments for another over a stipulated period.
Since SOR-based home loans were discontinued in 2017, we will keep this explanation simple. SOR is a currency swap – a derivative which contains interest rate forwards for USD and SGD forwards in its calculation. In this calculation, London Interbank offer Rate (LIBOR) rates were used as a component, which caused concern in the recent LIBOR fraud and extensive rigging by banks. This called into question the effectiveness of such rates, and as a result, LIBOR will be discontinued by the end of 2021.
What is SORA?
According to the Steering Committee for SOR and SIBOR Transition to SORA (SC-STS), banks will cease issuing SIBOR-linked mortgages by the end of September. While this does have an impact on home loans, Singapore’s derivative market depends on such benchmarks as well. While this previously depended on SOR as a component for computing derivative prices, this subjected these financial products to the volatility of SOR.
Hence, the introduction of SORA – a volume-weighted average of borrowing transactions in the unsecured overnight interbank market. Doing so would remove the dependence on USD interest rates and LIBOR rates, thereby increasing transparency and reducing the risk for banks which have SOR-tied products on their books.
Since SORA is based on interbank transactions like SIBOR, it offers better visibility on interest rates and thus, your mortgage loan instalments. Given similar volatility to SIBOR, SORA products can now be easily compared to other home loans in the market, which ultimately benefit the borrower, in making long-term decisions.
SORA is often identified as backward looking, as it is based on overnight transacted rate, with it being opposed to SIBOR which is based on future estimate of lending rates.
Unlike SIBOR, SORA’s computation will not incorporate term and credit risk. Hence, SORA rates will typically be lower than SIBOR.
With SORA being backward-looking rate, eliminating the usual spikes and dips you often see in SIBOR movements, hence resulting in a smoother curve in SORA. Such rate will fill in a sweet spot between a volatile SIBOR rate and a premium fixed rate.
Furthermore, since banks now take on lesser risk for derivatives and other financial products, technically speaking, the cost of debt is lower than a riskier product. As banks and financial institutions continue to adapt their benchmark rates, we will begin to see greater efficiency in the market.
What will this mean for me when getting a home loan?
There is no certainty to whether the effective cost of borrowing for SORA-pegged loans will be cheaper than SIBOR loans. Once again, the interest rate paid on your loan will also take into consideration the spread which the bank chooses to impose.
Furthermore, it is always important to look into totality within the package that respective banks have to offer, so as to make sure that it is catered to your financial plan and needs.
To determine what home loan suits your needs best, a comparison with a mortgage expert have to be made between various floating rates, be it SIBOR and SORA, Board, Fixed Deposit or Fixed rate loans.
While SIBOR and SORA may introduce more volatility than the stability of Fixed rate, they do offer benefits in the form on lower monthly payments when interest rates do fall. This could be useful if you are considering financing your mortgage in a low interest-rate environment, although it presents a slightly higher interest rate risk to the borrower when interest rates move upwards.
Nonetheless, these movements are unlikely to come out of the blue if you spend the time understanding the macro-economic environment. Alternatively, while fixed deposit rates are determined by board rates set by the bank and are considered more stable, we are unable to predict any changes subjected by uniquely manipulated baskets determined by the bank, and it being lack of transparency.
All rates are also subject to a spread set by the bank, and we would encourage you to take this into consideration when making your comparisons across banks. Speak to us about how these changes will affect your current situation!