The interest rate represents the price we pay for borrowing money. The interest rate is therefore the first aspect to take into consideration to choose the mortgage that best suits our needs.
Based on the interest rate, the amount of the installment to be paid each month (or with a different frequency) is calculated.
The fundamental choice is between the fixed rate and the variable rate, but the banking practice has elaborated different intermediate types: the mixed rate, the possibility to periodically choose between fixed rate and variable rate, the variable rate with “cap” or “floor” , the variable rate at constant rate … there are many alternatives, so it is important to be clear about the consequences of our choice.
The interest rate is normally calculated by adding a parameter considered representative of the credit market at the time the rate is determined (and which therefore represents the cost incurred by the bank to obtain the money, or funding), to a “spread” which represents the profit margin of the bank lending the money.
The parameter is generally the same for all banks, usually the Euribor for variable rate mortgages, and the IRS (Interest Rate Swap) for fixed rate mortgages. The difference between the offers, therefore, is given by the “spread” applied by each bank, which can present substantial differences, and by the ancillary costs of the loan, which must not be neglected.
The comparison between the various loan offers is made easier by the obligation, established by law for all banks, to communicate to the customer the “Taeg” or “Isc”, which represents, in percentage terms, the actual cost of the loan, calculated taking into account, in addition to the nominal interest rate, also all the expenses to be incurred to obtain the loan.
The fixed rate
The fixed interest rate is agreed with the bank at the time of stipulation of the loan and remains unchanged for its entire duration. Consequently, the amount of the installments to be paid also always remains fixed.
If the cost of borrowing increases, those who have chosen the fixed rate have the advantage of maintaining a cheaper interest rate. Conversely, when the cost of money decreases, those who have a fixed-rate mortgage may find themselves paying a higher interest than that applied by the market at that time.
The fixed rate is normally determined based on the IRS (Interest Rate Swap) parameter plus the “spread”, ie the profit margin applied by the bank.
The IRS represents the rate at which the bank can conclude, at a certain time and for a certain duration, a contract to hedge the risk of changes in interest rates (swap) and therefore is an indicator of market expectations on the trend of medium to long-term interest rates. The bank guarantees itself against the risk of an increase in the interest rate by entering into hedging contracts with subjects acting for speculative purposes. The IRS is calculated for various durations (one year, two years, three years, and so on up to thirty years), which are used as a parameter to determine the fixed interest rate to be applied to mortgages with a corresponding duration.
When the IRS rate, for a certain duration, is close to the Euribor rate, it means that the market expects the rates to remain substantially unchanged over that period.
Normally the fixed interest rate is higher than the initial measure of the floating rate. The borrower, therefore, pays a little more in order not to run the risk of an increase in the rate, and therefore in the monthly payment.
The variable rate
The variable interest rate is recalculated periodically, usually every month (or every three months or six months), based on the variation of a reference parameter (for example the Euribor, which is the rate applied to loans between banks, or the ECB rate, i.e. the refinancing rate of the European Central Bank).
The amount of the installments to be paid also increases or decreases as the interest rate changes. Those who choose the variable rate assume the risk of its future increase, but could also benefit from a reduction. In short, the rate to be paid will always remain aligned with the market.
Usually the variable rate is, at the outset, lower than the fixed rate, so you may be tempted to choose it. It is important, however, to take into account the possibility of a rate increase, and therefore of the monthly payment, especially if the loan has a very long duration. In twenty or thirty years many things can change. We must therefore check the possibility of paying a “heavier” installment in the future than the initial one, to avoid having unpleasant surprises in the event of an increase in rates.
The Euribor rate
The Euribor (acronym for Euro Inter Bank Offered Rate, ie interbank offer rate in euro) is a reference rate, calculated every day, which represents the average interest rate of financial transactions in euro between the main European banks. It is the interest rate applied by banks when lending money to each other.
There is not a single Euribor rate. Interest rates are recorded for different periods, which vary between a week and a year. Normally the Euribor is increasing with the duration of the loan: the 1-year Euribor is greater than the 6-month Euribor, and this is greater than a 3-month Euribor. The rate is calculated on a 360 days per year basis. The calculation on a 365 day basis can be done with a proportion.
Euribor is often used as a basis for calculating interest on floating rate mortgages, especially on floating rate mortgages granted by banks.
We would like to remind you, however, that from 1 January 2009 all banks are obliged to offer customers the option of using the ECB rate as an indexing parameter as an alternative.
The interest rate of the European Central Bank (ECB)
The interest rate of the European Central Bank (ECB) is the so-called “refinancing rate”, and represents the interest rate that banks are required to pay when they take loan of money from the ECB.
Banking institutions use this opportunity when faced with periods of shortage of liquidity.
Interbank interest rates, such as the Euribor index, are normally sensitive to changes in the rate for ECB refinancing operations. For this reason, the ECB interest rate represents a tool for intervening on the market rate values.
The interest rate of the European Central Bank can be used as an indexing parameter for variable rate mortgage loans, as an alternative to the Euribor, which is usually used for this purpose.
Since 1 January 2009, all banks have been obliged to offer customers the possibility of using the ECB rate as an indexing parameter for variable rate mortgages.
The variable rate with a fixed installment
Some banks also offer a type of variable rate mortgage with a fixed installment, which combines the characteristics of the variable rate with the peace of mind of always keeping the amount of the monthly payment unchanged.
How is it possible that the installment remains fixed if the interest rate increases? In this type of contract, any increase in the interest rate involves an increase in the number of installments, and therefore an extension of the loan.
If the rates rise, instead of increasing the amount of the installment, new installments are added, so a mortgage that starts with an expected duration of fifteen years is extended to fifteen years and a month, fifteen years and two months and so on (usually up to to a predetermined maximum limit). In this way, the installment to be paid each month always remains unchanged.
Of course, if interest rates fall, the opposite happens: the number of installments decreases, and the duration of the loan is shortened.
The fixed rate variable rate mortgage therefore allows you to choose the variable rate without running the risk of not being able to pay an installment that has grown too much compared to our income.
Keep in mind that banks, for this type of mortgage, often apply a slightly higher spread than the pure variable rate mortgage.
“Cap” and “Floor”
There is also a type of variable rate mortgage that provides for a maximum ceiling on the interest that can be applied by the bank, technically defined as a “Cap”. If the loan agreement includes a “Cap” clause, the interest rate may increase, following changes in market rates, only up to a predetermined amount. For example, if a variable rate mortgage starts with an initial rate of 2.5% and contains a clause that sets the “Cap”, ie the maximum rate, at 5%, in the event of an increase in the reference parameter, the the overall interest rate applied to the loan will never exceed 5%. In this way the borrower is protected against an excessive increase in market rates which could cause an increase in the monthly payment up to an unsustainable amount.
Mortgages with the “Cap” have been particularly popular in the years characterized by increasing interest rates.
Normally the mortgage with the “Cap” clause is more expensive than the pure variable rate mortgage, because the banks apply a higher spread. This higher cost represents, for the borrower, a sort of consideration for the protection against the risk of an excessive increase in the installment.
In times of decreasing interest rates, we have also seen the appearance of another type of clause that limits the change in the mortgage rate, this time however to the advantage of the bank. This is the “Floor” clause (literally “floor”), which provides that the overall interest rate applied to the loan can never fall below a predetermined amount. In the presence of a “Floor” clause that sets a minimum at 3%, the rate applied to a variable rate mortgage can never fall below this value, even if the sum of the parameter and the contractually established spread gives a lower value .
Other types of rate
However, banks also offer other types of mortgages. Some contracts, for example, allow you to choose, at certain deadlines, whether to apply a fixed or variable rate. In this case, the borrower can decide, every three years or every five years, whether to apply the fixed rate or the variable rate to the next period.
However, we remind you that by choosing, at maturity, to apply the fixed rate, this is calculated based on the market trend at that time, and therefore can be very different from what could have been chosen when signing the loan.
The faculty of choice, therefore, must be exercised looking to the future, and must not be considered as a possibility to protect oneself against changes in interest rates that have already occurred.
Entry rate and fully operational rate
In any case, we must pay attention to the possible difference between the entry rate and fully operational rate. The entry rate applies only to the first installments of the mortgage, and is sometimes particularly convenient to attract customers.
What to consider is above all the rate at regime, which will accompany us for the entire duration of the loan.
The choice of the rate
The choice between the fixed rate and the variable rate is not easy, because no one can know for sure whether the rates will increase or decrease throughout the loan, which is often very long. However, there are some aspects that we can take into account when choosing.
When there is only one salary in the family, and the mortgage payment represents an important part of one’s income, it may be advisable to choose the fixed rate, because any increase in interest rates would make it difficult to pay the installments.
If, on the other hand, we choose a variable rate, in evaluating the overall weight that the mortgage payments will have on our family budget we must know that the amount of the installment may increase.
Those who believe they can also cope with a higher installment, or perhaps be able to pay off the loan early if this becomes too expensive, can choose the variable rate, which allows them to take advantage of any reductions in the reference rate.
It is also important to pay attention to the parameter chosen as a reference for the rate variation. Banks have always used the Euribor as a reference, but since 1 January 2009 the law allows customers to refer to the main refinancing rate of the European Central Bank for new mortgages intended for the purchase of their first home.
This solution allows for greater transparency of changes in the rate, which is fixed with an official provision (while the Euribor varies continuously according to market conditions), but its convenience must be assessed on a case-by-case basis.
The default rate
If the borrower does not pay the installments on time, a breach of the contract occurs, resulting in the application of a higher interest rate than that ordinarily agreed for the loan. This interest rate is called the default rate, and its amount is predetermined in the loan agreement.
The interest on arrears represents a sanction for the failure of the borrower to respect the commitments undertaken with the bank.
