[Aldonssuljab] Why Did Loan Interest Rates Not Drop Despite the Base Rate Cut? ... Understanding Interest Rates Correctly

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Lee Chang-yong, Governor of the Bank of Korea, is holding a press conference on the Monetary Policy Committee's base rate decision at the Bank of Korea in Jung-gu, Seoul on the 11th. The Bank of Korea ended its monetary tightening stance, which began with a 0.25 percentage point increase in August 2021, and eased by lowering the rate by 0.25 percentage points, marking a shift toward easing for the first time in 3 years and 2 months. Photo by Joint Press Corps

Recently, the Bank of Korea made a surprise cut to the base interest rate on the 11th.

The Bank of Korea Monetary Policy Committee (MPC) decided to lower the base rate from the previous annual 3.5% by 0.25 percentage points to 3.25%.

This marks a shift from the monetary tightening stance that began in August 2021 to easing after 3 years and 2 months.

Accordingly, borrowers expected relief in loan interest burdens,

but it is known that feeling the effect of the rate cut is difficult.

During the rate hike period, interest seemed to be reflected immediately,

yet loan interest remains stubbornly unchanged despite the rate cut.

Is it just a feeling?

Let's take a look at how interest rates actually move and get reflected.

Bank of Korea lowered the base rate... but mortgage loan interest nears 7%?

As briefly mentioned earlier,

the Bank of Korea’s MPC decided on the 11th to set the base rate at 3.25% annually.

The people who most eagerly awaited the base rate cut were probably mortgage borrowers.

However, commercial banks’ mortgage loan rates far exceed the Bank of Korea’s base rate of 3.25%.

As of the 19th, the variable interest rates on mortgage loans (based on new contracts) at the five major commercial banks (KB Kookmin, Shinhan, Hana, Woori, NH Nonghyup) range from 4.57% to 6.67%.

KakaoBank’s 6-month variable mortgage loan rate ranges from 4.532% to 7.326%, with the upper bound breaking through 7%.

How are loan interest rates determined?

This raises the question:

If the base rate goes down, shouldn’t commercial banks’ rates be affected as well?

To clarify this, let’s first explain how loan interest rates are determined.

Banks set loan interest rates by adding a margin to a benchmark interest rate.

Then, various preferential interest rate conditions are applied to determine the final loan interest rate.

Generally, fixed-rate mortgages use the 5-year financial bond yield as the benchmark rate, while variable rates use the COFIX (Cost of Funds Index) published by the Korea Federation of Banks.

The margin usually varies depending on the borrower’s credit rating and the value of the collateral.

Additionally, preferential rates are set based on the borrower’s transaction history with the lending bank.

The COFIX rate represents the cost (interest rate) that eight domestic banks (KB Kookmin, Shinhan, Hana, Woori, NH Nonghyup, SC First, Industrial Bank of Korea, and Citibank Korea) incur to raise new funds through deposits and savings in a given month. Banks use this as the benchmark for variable-rate loans, including mortgages.

If COFIX falls, it means banks can secure funds at lower interest costs; if it rises, the opposite is true.

In fact, the COFIX rate, which influences loan interest rates, rose by 0.04 percentage points to 3.40% compared to the previous month’s 3.36% after four months, causing variable mortgage loan rates at commercial banks to rise accordingly.

This explanation got a bit long.

Benchmark rates like COFIX had already priced in expectations of rate cuts, but after the base rate was lowered, these benchmark rates actually rose, causing interest rates to move counter to the base rate cut.

Time lag with base rate cuts also matters

Another factor is the time lag between the Bank of Korea’s base rate adjustment and its reflection in loan benchmark rates.

Daily published rates such as CD rates or financial bond yields tend to reflect changes in the Bank of Korea’s base rate relatively quickly,

but monthly published COFIX rates based on new contracts, outstanding balances, or new outstanding balances can take over a month to reflect base rate changes.

Moreover, COFIX rates based on outstanding balances and new outstanding balances tend to have lower volatility compared to market rates, so even if the Bank of Korea’s base rate changes, it takes time for this effect to be fully reflected.

This is why changes in the Bank of Korea’s base rate are not immediately reflected in loan interest rates.

During rate cuts, which is better: variable or fixed interest rates?

So, during a rate cut period, which type of interest rate results in less interest burden: variable or fixed?

Loan interest rates come in three types: fixed rate, variable rate, and hybrid rate.

Fixed rates mean the agreed interest rate remains the same until maturity.

Variable rates change every 3, 6, or 12 months according to changes in the benchmark rate.

Lastly, hybrid rates combine fixed and variable rates, maintaining a fixed rate for a certain period before switching to variable.

Fixed rates are advantageous during rising rate periods, while variable rates are better during falling rate periods.

Investment strategies during rate cuts?

Typically, during rate cuts, abundant liquidity flows into stocks, real estate, and other assets, making them popular investment options.

However, this time is different.

Although rates have fallen, loan regulations have tightened, making fundraising more difficult than in usual rate cut periods.

So, you might be wondering which products to invest in.

Experts recommend bond investments during rate cuts.

Bonds have an inverse relationship with interest rates.

When rates fall, bond prices rise; when rates rise, bond prices fall.

Bonds can be divided into short-term and long-term.

During rate declines, long-term bonds with longer maturities are recommended.

Longer maturities usually carry risk premiums, resulting in higher yields.

You might also be curious about how to invest in bonds.

There are direct and indirect investment methods.

Direct investment involves buying bonds directly through financial institutions,

but the problem is the vast number of bonds with varying credit ratings and maturities, making it somewhat difficult for individuals to enter.

Unlike stocks, where individual investors can instantly check prices of individual stocks, bond prices are not as readily accessible.

For this reason, indirect investment is recommended.

Asset management companies create and manage bond funds.

You can join bond funds at banks or securities firms regardless of the amount.

Additionally, there is the option of equity-linked bonds (ELB), which guarantee principal and offer higher returns than deposits.

ELBs are products whose returns depend on specific indices or stock prices, with the biggest advantage being principal protection.

They mainly invest in stable government and public bonds and partially in risk assets.

ELBs are considered a 'safe haven' during rate cuts and are favored by conservative investors.

However, a caution is that early redemption may result in receiving less than the principal after fees.

Therefore, they are not recommended if you need funds in the near future.

They are suitable for long-term investors.

Also, although principal is guaranteed, ELBs are not covered by deposit insurance, so if the issuer goes bankrupt, you may not recover principal or returns even if the specified conditions are met.