Just the other day, I received a notice from my insurance provider notifying me that the interest rate credited to my prepayment facility will be revised downwards in response to the low interest rate environment.
This is in stark contrast to the United States Federal Reserve’s approach just two years ago which saw four rate increases after bumper economic growth. However, this is no surprise with the global economy taking a strong blow from the unexpected COVID-19 pandemic. In fact, the Fed recently announced that interest rates will be around zero for at least a few years to help spur the economy.
While not great for my premiums, the policymakers’ rationale is simple. When central banks lower their lending rates, commercial banks tend to follow suit. Borrowers may now be more open to start new business ventures that create jobs, as well as more goods and services. For savers, they may find it more worthwhile to put their money elsewhere, such as investing it, or simply, spend it while interest rates for fixed deposits are low. While borrowers and savers tend to respond differently in a low interest rate environment, both help propel the economy.
The Fed’s announcement also affects Singapore. Interest rate movements in the US will influence the Singapore Interbank Offered Rate (SIBOR). In the last year, SIBOR had dropped from a high of 1.9% in June 2019 to 0.25% in June 2020. The Singapore Long Term Interest Rates have also dropped from an average of 1.8% in 2019 to 0.8% in 2020.
While this may seem like good news for consumers, the benefit will be disproportionate as there is a differential impact on who can and will take advantage of it. Those who are better off have time on their side. They can make use of low interest rates to start new ventures. The needy, who may struggle with day-to-day expenses, may not have time to look at other investments. In addition, they may have a poorer credit history that discounts them from the benefits of low interest loans.
Recognising the early-warning signs
Historically, you will see consumers purchase durable goods such as houses and cars when the interest rates are low. In Singapore, we have seen massive mortgage refinancing, or the switching of one home loan package to a cheaper one, during periods of lower rates. These happened, for instance, in 2015, 2017 and 2019. The trend with the current drop is no different.
What then can go wrong? A lot, apparently.
History reminds us of the US subprime mortgage crisis that occurred around 10 years ago. Home prices were high in 2006, but dropped sharply after that. When mortgages were reset at higher interest rates, there was a huge number of defaults. The long-lasting consequences included a deep recession of the US economy that did not recover until years later.
From a consumer’s perspective, they may be over exuberant when it comes to spending because interest rates are low. Many people believe they can take on more small business debt and credit card debt just to feel like they are getting a deal and saving money.
This short sightedness will be of grave concern when the COVID-19 situation starts to improve. When the pandemic recedes, central banks will once again raise rates to combat inflation and SIBOR will rise. Think of it as equilibrium. When the economic situation improves in the very far future and prices of goods and services soar, interest rates will be increased to discourage borrowing and bring things back to a more controlled level.
For borrowers who have taken on a loan during the low interest rate period, their mortgages and repayment rates will go up for existing and new loans. They need to think ahead and consider whether they can afford the repayment pegged to a higher interest rate in the future.
If we want to avoid a high number of defaults in payments in future, banks and regulators have to play their part. The banks, which have information on borrowers’ debt to income ratio, will be the first to notice warning signs if this ratio becomes too high when interest rates increase in the future.
For the banks, low interest rates will negatively impact the interest and fee income they receive. Practically speaking, they should not let this loss of revenue push them to offer bigger loans to make up for the shortfall.
To keep them in check, regulators do need to analyse the historical data and step in to prevent history from repeating.