Monday, November 29

Fixed or variable rate mortgage?



In this article I want to address the importance of correctly choosing the economic conditions of a mortgage loan that, due to its amount, is usually one of the most important investments in our life.

Most people have or will end up applying for a home purchase loan. Unless you have enough liquidity to be able to pay it in cash, you will be interested in knowing what is best for your pocket.

The main destination of a mortgage loan is usually the purchase of a property (home, premises, warehouses, …). For the ordinary citizen, it is usually the purchase of his house. The word mortgage loan refers to the fact that the home has a burden and it responds in the event of insolvency. That is, if you cannot pay the loan, the lender (usually the bank) can keep it to collect the debt.

Suppose we find the perfect house for us and want to buy it. We have made the visit to the property and it has convinced us. The price is 200,000 euros. Later, we go to our bank and the first thing it tells us is: “How much savings are you going to contribute on the purchase price?” Currently, it is around 20%, in our example it would amount to 40,000 euros. Second, you request all the necessary documentation for the study of the loan. At those moments our head begins to fume, drawing numbers of whether or not I will be able to assume the purchase and our manager tells us: “Are you going to want a mortgage, at a fixed or variable rate?”

The first thing we should know, before deciding, is how the interest rate on a loan is composed:

On the one hand we have the interest rate to which the loan refers. Currently the most common is the Euribor. It is the interest rate applied to operations between European banks, that is, banks lend money to each other at an average interest rate (Euribor) and this rate is what they will apply to our mortgage loan.

On the other hand, we have the differential that the entity applies to us. A “fixed” percentage that our bank charges us. Although it is initially fixed, it can be reduced according to the products contracted with each bank. For example, if at the time of signing the mortgage loan the reference Euribor is at 3% and we have a differential of 1%, the interest applied to our loan will be 4%. Now, normally, mortgage loans review the Euribor interest rate periodically (semi-annually, annually …). Therefore, if at the time of the review the Euribor has decreased to 2% and we maintain the differential of 1%, we will pay 3%.

This last part is important for the decision making between fixed or variable interest rate. If we look back, our recent history shows us the evolution of interest rates in recent years. In the midst of the real estate boom, the average Euribor for 2008 amounted to 4.5% and in January 2020 it was negative, specifically -0.25%. To give more clarity to the facts, let’s look at an example of how this affects a mortgage loan of 160,000 euros over 30 years in both cases. In 2008 our monthly loan installment at an applied interest rate of 5.5% (Euribor of 4.5% + 1% bank spread) was 908 euros, but in 2020 the applied interest rate has decreased to 0 , 75% (Euribor -0.25% + 1%) so our quota is 496 euros. The difference in fee from one period to another is 412 euros. Important, right?

However, if our choice was a fixed interest rate, it implies that throughout the life of the loan we will maintain a constant fee. Let’s give an example that the interest rate offered by the financial institution is 2.30%, which would imply a constant installment of 615 euros during the term of the loan (for the same 160,000 euros over 30 years).

So what interest rate do I choose? Unfortunately, there is no clear answer to this question, but we can give some clues so that each one makes the best decision. It is important to understand the economic situation, since it will affect the interest offered, and the time horizon of the loan (the term). Since the 2008 crisis, the reference interest rate -Euribor- has been reduced in order to reactivate consumption (thus making loans cheaper). As the economic recovery has been slow, the Euribor has been falling. We end 2019 with good economic prospects, but in 2020 the damn bug puts us back in the starting box. Therefore, the Euribor is not expected to rise in the short and medium term. Faced with this situation, we might think that a variable interest rate is more convenient for us, but it is key to set the time horizon: How long will I apply for the loan? If we talk about 15 years, it seems logical that with the information that we have today we would opt for a variable interest rate, but if the term is 30 years (the most common) and, given that fixed interest rates are literally on the ground , we can think that maintaining a fixed fee will avoid surprises in the future.

Conclusion: this situation is usually one-off in a person’s life, but it can cause significant financial expenses between one choice or another. For this reason, it is very important to receive professional advice adapted to personal and financial circumstances to make the best possible decision.


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