Why A Lock-In Clause Is Not Always Bad For Home Loan
A home loan is the first thing a homebuyer needs to consider when buying a property. There are only rare fortunate few who can afford to buy without having to take a housing loan.
With many HDB upgraders in the market this year, some will be taking bank loans for the first time.
Housing Loan Can Be Very Complex
A housing loan offered by banks is quite different from the simpler HDB concessionary loan you may have been used to before. Bank loan packages are quite varied and have different terms and conditions. Some basic variations are:
- Fixed rates with lock-in
- Floating rates with lock-in
- Floating rates with no lock-in (generally for buildings under construction or BUC, referring to non-T.O.P projects)
For our discussion here, we will focus only on the lock-in clause, which is misunderstood by many first-time bank home loan borrowers.
What Is A Lock-In Clause In A Home Loan?
Many bank housing loan packages come with a lock-in clause of two to three years; very rarely, you may see some with a lock-in that’s as long as five years.
In addition, you should know that any fixed-rate home loan is by default “locked-in”, for the duration of the fixed rate (typically two to three, sometimes up to five years).
Penalty That Comes With Lock-In
The concept of the lock-in is simple:
If you attempt to refinance your home loan (i.e. switch to another, cheaper bank) within the lock-in period, you will be charged a penalty of 1.5 per cent of the undisbursed loan amount.
For example, if you have $500,000 outstanding on the home loan, you would end up paying 1.5 per cent of $500,000 ($7,500). This penalty is how the bank makes up for the interest it would lose on the loan you take. Due to the harshness of the lock-in penalty, it is almost never worth incurring it just to refinance.
This condition also applies if you attempt to pay off the whole loan during the lock-in period (e.g. when you try to pay off the remaining loan all at once, following the sale of your house). However, there are some exceptions to this, as I’ll explain below.
The Main Worries Regarding Lock-In Clause For Housing Loan
Bank home loans can fluctuate with the interest environment and economy; whereas HDB loans at 2.6 per cent hardly change. As such, many bank loan users will be on the lookout for cheaper rates – you can minimise the interest you pay by switching to a lower rate loan when the time is appropriate.
(Ps. If you’re confused by how a bank home loan affects your property asset, do contact me. I can help to clarify the important details, especially if you’re a recent upgrader who has only dealt with HDB loan before).
Worry #1: Interest Rates Rise During Lock-In Period
The main worry is that should the interest rates rise, and with a lock-in, you will be stuck with the higher rates. This will be true for the case of a housing loan package that is based on floating rates, which is based on a fixed percentage plus usually SIBOR rate. SIBOR rates can change over time.
Currently, with the major Covid 19 crisis at hand, fixed rates with lock-in can be as low as 1.68 per cent and floating rates as low as 1.36%.
Floating rate loan package is the preferred choice now because it is likely interest rates will stay low in the next one to two years. But do be aware of the potential risk in the event the world recovers fast from the Covid 19 crisis.
(Ps. Finding you the cheapest loan is not the role of your property agent; it is best handled by a mortgage broker. And they usually don’t charge you anything. So do look for one).
Worry #2: Sell Your Property During The Lock-In Period
The second fear is that, if you need to sell your house during the lock-in period, you will incur the penalty. 1.5 per cent of the undisbursed loan amount can be very painful.
But A Lock-In Clause In A Home Loan Is Not Always Bad
This may sound crazy, but a lock-in can actually be a good thing.
Housing Loan With Lock-In Enjoys Lower Interest
The first reason is that housing loans with a lock-in tend to be slightly cheaper. The bank will compensate you by lowering their spread (their charges) slightly. You might find your loan rate lower by 0.2 to 0.3 per cent.
(I know that doesn’t sound like a lot – but given the sheer size of home loans, and the effect of compounding, small changes can accumulate to significant sums).
Here is an example for a home loan with lock-in and no lock-in:
Note: For this example, we are using a sample bank loan package by a particular bank, which is available at the time of writing. Available loan packages and rates change on a monthly basis.
Example of a Home Loan With No Lock-In
Loan amount: $1 million
Duration: 25 years (300 months)
Interest with no lock-in: 2.03 per cent per annum
Monthly Payment: $4,253.16
Total Payments: $1,275,949.14
Total Interest Paid: $275,949.14
Example of a Home Loan with Lock-In
Now, let’s look at an alternative package from the same bank, which also has lock-in. The loan amount and duration are the same, but the loan interest rate is only 1.7 per cent with either 2 or 3 years lock in:
Monthly Payment: $4,094.02
Total Payments: $1,228,204.57
Total Interest Paid: $228,204.57
Slightly Lower Interest Rate Big Savings
So you can see that, with a slight “tweak” of just 0.33 percentage points, it comes to saving about $159.14 per month. If you maintain the loan at the same rate over the whole course, the difference in interest payment will amount to $47,744.57.
This extra interest is yet one more cost that eats into your gains and negatively impacts your net rental yield.
(Important to note: unlike our hypothetical example, interest rates fluctuate so you will not have the same rate throughout your entire loan tenure. I am using this to illustrate that, all things being equal, the differences in the interest rate can impact your bottom line. Hence, it sometimes justifies accepting the lock-in clause for a lower rate).
For Singaporeans who don’t intend to refinance, especially when the current interest rate is so low, a lock-in period of two or three years is not a key restraint. In fact, most home loans are cheap for three years and then jump on the fourth. So you would be getting a lower rate, with no real penalty.
Housing Loan With Lock-In May Have Waiver of Penalty Due To Sale of Property
The second reason is that today, some banks provide a waiver for “redemption of loan due to sale”. This means that, if you are paying off the loan as a consequence of selling your property, you won’t be hit by the penalty. This incentive mitigates one of the main fears of a bank loan with lock-in.
Lock-In When The Rates Are Very Low
A final consideration is an environment with rising interest rates. While rates are low right now (mainly due to factors like the US-China trade war, Covid-19 flu, Brexit, etc.), do note that home loan rates have been abnormally low for over ten years.
Bank loans now are as low as 1.68 per cent to two per cent per annum, cheaper than even HDB loan rates (2.6 per cent). Can’t imagine how much lower it can get. So it’s good to lock in these low rates while you can.
Opt For Lock-In When Interest Rate is Very Low Now
For reference, the “normal” interest rate for home loans in Singapore used to be around four per cent. This was before the Global Financial Crisis that sent rates plummeting in 2008.
As such, there’s likely to be a time when interest rates start climbing again. Before the US-China trade war, mortgage rates did go up in tandem with US Central Bank rates. With the current Covid-19 pandemic, we are seeing unprecedented low-interest rates. Interest rates will not stay so low forever.
When interest rates do go up, why would a lock-in be a problem? Surely you’re not going to refinance into more expensive loan than you have! Also bear in mind, after the lock-in period, you will likely need to do a refinancing. By then, your future decision will be based on the situations when the time comes.
In building wealth through property, a fundamental principle is keeping your costs low.
A high interest rate eats into your capital gains, and lowers your net rental yield (like me on Facebook, for further updates on how to maximise your property gains). It may not make sense to forego a good loan offer with a low rate, for a lock-in clause that may ultimately be irrelevant.
Update: Falling Interest Rates Due To the Covid 19 Pandemic
Following the United Stated Federal Reserve (the Fed)’s cut in interest rates to near zero, and the escalating Covid 19 pandemic, bank interest rates are falling to an unprecedented low level. Low rates help to keep the economy going in rough times.
We are seeing a knock-on effect. The anticipated protraction of the pandemic will mean interest rates will be kept low for quite some time. Hence, it’s worth considering floating, SIBOR-pegged home loans at the moment.
Right now, rates can be as low as 1.15 to 1.24 per cent per annum with a lock-in package (drop me a message if you’re looking for a home loan right now, and want to save money). Don’t wait too long however, as banks will eventually raise their spread when SIBOR falls steeply.
Danny Han has been a licensed real estate agent since 2005.
The insights and knowledge he shares are the results of years of experience in helping many of his clients in their Property Wealth Planning.
Do feel free to drop him a Whatsapp message for a non-obligatory discussion if you are planning to grow your property wealth.