I was writing this article half way when I heard that UOB has introduced the 50 years mortage[Link]. At the current low interest rate of 1.7% for housing loan, an outstanding loan of $1M can be serviced with just $2.4K a month for 50 years.
"Homeowner Edward Ti, 28, said he would certainly take up a 50-year loan for an investment property. 'I would take a 50-year loan if interest rates are low. I would think that it is more efficient to use the money saved from the monthly mortgages to do something else.'" - Straits Times article.[Link]
If you can easily service a 20 year mortgage, stretching it to 50 years is not a bad idea under the current low interest rate environment. However, if you're depending on the low rates for affordable instalments, you are asking for trouble. If interest rate rises, say from 1.7% to 5%, your home mortgage payment will balloon from $2.4K a month to $4.5K a month. If you're doing what Edward Ti is doing, you have to be prepared in case interest rates move up. For a businessman with $4M-5M in the bank, instead of paying for a $1M condo in full, he may still want to take out a mortgage because he wants to keep cash for his business that earns a higher return. For a professional risk taker like a businessman, 1.7% interest is very cheap money and should interest rates go up, he can pay down the loan because he has sufficient cash in the bank to do so. The people who should take up these 50 year loans are people who don't really need these loans. The people who shouldn't take up these loans are the ones who need to stretch their mortgages to achieve affordability. The low interest rates and longer term mortgages (20 years and above) are a partial cause of the housing bubbles in US, Spain and Ireland. In Japan at the height of the housing bubble in 1989, banks were lobbying for 100 year 2-generation loans. 50 year mortgages can easily lead to trouble for those who are counting on low interest rates for affordable instalments. The interest rates we are seeing are artificially low.
Just to give a historical perspective, here is how US 10 year treasury interest rates has changed over time. Unless there are local factors, interest rates around the world follow the sane trend.
Just 13 years ago, interest rates on housing loans were 5%. You go back further to 30 years ago, housing loans were 10-15%.. As interest rates trended down, debt levels around the world went up - people borrowed to buy homes, businesses borrowed to expand, govts borrowed to fund deficis and consumers borrowed to spend.
A month ago, an alarm I set on my computer calender rang. My fixed interest mortgage loan which I refinanced 3 years ago was about to expire. I called up the bank to check what would happen. If I do nothing, the interest rate on the loan will be 3.6% floating rate based on a markup of the prime rate (the lowest interest rates the bank charges its best customers). I told them I wanted to refinance. The bank officer told me the outstanding loan was too small (5 figures) and the remain tenure was too short.- I either pay up in full or live with the 3.6% interest rate. I told the bank officer, I was very unhappy the bank was no longer interested in keeping me as a customer and told her to talk to her manager to see if something can be done. A few days later, she called up and told me the best offer they can give me is a fixed rate of 2% for the remaining period of the loan and I had to pay $200 for the refinancing. I was still unhappy because I knew that banks were offering deals closer to 1.5% for larger loans but she was quite clear it was a "take it or leave it" deal. The last time I refinanced my loan 3 years ago, I was already to pay it back in full either with my savings or CPF funds. The reason why I didn't do it was the low interest rates for mortgage loans. At 2%, I can keep my CPF funds in CPF at an interest of 2.5% and still make 0.5% more by paying off the loan in instalments from my CPF. - so there is no logical reason not to take up the 2% fixed rate offered by the bank.....except maybe something goes wrong in the next few years and the withdrawal rule for CPF changes.
There are other reasons to do this even if interest rates are slightly higher, say 3%. When you use cash to pay down your housing loan, it is very hard to get the cash out again easily. You have to sell your home or take out a mortgage on your fully paid home - the legal fees, admin fees etc makes it expensive to do so. Facebook billionaire, Zuckerberg, who is in a different league altogether bought a US$5.9M home when he got married recently. Given he has hundreds of millions in cash, you would think that it is pocket change for him to just buy it with cash. His wealth can change by much more than $5.9M in 10 minutes when Facebook stock price changes, Why trouble himself with a minuscule $5.9M mortgage from the bank? Well interest rates are so low, even Zuckerberg took out a mortgage loan - for a billionaire like him with near zero chance of default, the bank offered him 1.05% mortgage loan deal [Zuckerberg's Mortgage Rate is Now 1.05%]. A 1.05% interest is below the inflation rate of 2+% in the US and economist call this a negative real interest. Even Zuckerberg couldn't resist taking up a mortgage loan at this low interest rates.
When I first took up my mortgage loan, things were quite different. A 5% interest rate for a mortgage was considered a good deal and it was not uncommon for people to pay 6% for their mortgage loans. The first thing I did when I bought my home was to empty all my CPF money to pay down the loan as fast as possible because it didn't make any sense to keep money in the CPF at 2.5% when the bank was charging an interest of 5%. for mortgages.
Singapore's inflation rate rose to 5.4%[Singapore's inflation rises to 5.4% in April], fixed deposit accounts in DBS are paying 0.125%[DBS Fixed Deposit Rates] and a 1% interest is considered a great deal [OCBC's fixed deposit deals]. Basically what has happened for savers is the buying power of their money has declined 4-5% due to inflation last year due to low interest rates. If nothing changes, their money will keep eroding. The negative real interest rates is supposed to encourage you to spend or bring forward your spending. If you want want to expand your business, you might as well do it now instead of later because prices are expected to rise due to inflation. Keeping money in the bank is not risk free - your money is eroded by inflation when the interest you're paid is below the inflation rate, there are periods in history during which savers are completely wipe out by high inflation. While there are people who keep savings in bank out of habit not realising the risk, there are legitimate reasons for keeping some money in the bank as savings. You might want keep the savings to buffer against unexpected events - job loss, emergencies etc. For the risk averse, the negative real interest rate situation is a conundrum because a positive return can only be achieved by taking risk otherwise your money gets eroded by inflation i.e. there is no way to avoid risk for the risk averse!
"In other words, the money that is sitting in your bank account, with its near-zero nominal rates, is shrinking day by day. Even worse, this situation of negative real interest rates could well continue for the coming one to two years.
With the US economy not quite out of the danger zone and the eurozone struggling to ringfence its mountain of sovereign debt, monetary policy is likely to stay very loose. Indeed, the US Federal Reserve — which has kept the federal funds rate near zero since the global financial crisis — has said it would keep rates “exceptionally low” until late 2014, as it sees economic weakness persisting until that time." - Sunita Sue Leng, The Edge[Link]
Negative real interests rates can persist for quite sometime so what can a person do about this? If you're living in America, you can purchase something known as TIPS (Treasury Inflation Protected Securities) with part of your money to insulate one part of your wealth against inflation. In Singapore, however, your options are limited. Overcoming the negative real interest rates cannot be done without taking risk. If you buy property, at the current levels which some consider a bubble, you may see heavy losses when property prices fall. Same for stocks. Some investors have gravitated towards high-dividend paying blue chip stocks - this again carries risk of losses should the stock price go down.
The artificially low interest rate environment and negative real interest rates can lead to devastating consequences if one is not careful. Take the example of property. A speculator looks at the current 1.5% home loans and goes out to buy a $1M, The property can fetch a rent of roughly $3500 a month giving a nominal yield of 3.6%. He figures all he needs to make money is to overcome $15,000 interest every year. He goes and take a 50 year loan. Happily pockets $1,000+ extra he collects in rent over and above his instalment payments. When the real interest rates normalises to positive, the home loan rates will be 5%, he very quickly finds himself in an unhappy situation with money flowing out of his pocket. He now tries to unload the property and there are probably thousands like him and that will pressure property prices downwards.
A very recent example is India which saw negative real interest rates, the Indan govt pushed up interest rates to fight inflation and Indian stocks and property plunged[After Mumbai flats, land prices too nosedive].
Inflation has remained moderate only because the global economy is weak - central banks have printed trillions without runaway inflation occurring as feared by many economists. However, we have seen rising inflation even as the global economy muddles along. There is a real risk of inflation [Quasi-fiscal policies pose inflationary risks, warns IMF paper] even as global growth remains anemic. When central banks shift to contain inflation, interest rates can rise and those who over-leveraged and assumed interest rates remain low will find themselves in trouble.
Property prices in Singapore has risen much more than median income in recent years. This rise is fueled by large foreign influx as well as the expansion of level of housing debt in Singapore. Buyers are persuaded by low interest rates and long loan tenure (now 50 years) to take up a large debt. The long the current situation persists, the more painful the deleveraging becomes when interest rates goes up. For those who want to avoid the pain, avoid the risk of taking too large a loan and don't be seduced by the artificially and historically low interest rates. Plan your finances based on more reasonable assumptions of where interest rates will be several years from now and avoid those super long 35-50 year tenures unless you have more efficient use for the money you already have in the bank.