Elements of the Loan: The Interest Rate
The interest rate is a fundamental element of the loan in that, in addition to being fundamental for determining the amount of the installment to be paid, it is the parameter that is generally used to define the category to which a mortgage belongs.
In fact, it is generally distinguished between:
- fixed rate mortgages ;
- variable rate mortgages ;
- variable rate mortgages with Cap ;
- mixed rate mortgages ;
- variable rate and constant installment mortgages.
Before analyzing them on a case-by-case basis, however, let’s see what the interest rate is and what its function is.
The interest rate
In a loan agreement, one of the two parties, the lender (which is generally a banking institution) pays the other (the borrower) a sum. Obviously for this service, a fee is requested, and in fact, the sum that will be returned will be higher than the one paid.
The measure of how much will be the higher value paid is given on its own by the interest rate , even if to be precise the rate applied does not only serve to remunerate the bank for its performance: as known the value of money can decrease in time and the extent of this phenomenon is given by inflation.
Hence the interest rate also has a component that serves to offset the lower value that the same amount of money, given in the year in which the loan is granted, will take on in subsequent years when it will be repaid.
Different types of rates that can characterize a mortgage
FIXED RATE MORTGAGE
The interest rate is constant for the entire duration and assumes a value determined in the start-up phase of the loan. Consequently, the installment will also be constant, allowing the borrower to be sure of knowing what will be the exact amount to be paid for the entire duration of the loan.
By contrast, the bank will generally apply a higher value than a variable rate (at least at the outset). We can say that, in a sense, tranquility is the certainty of the installment have a cost.
MORTGAGE RATE VARIABLE
The rate, in this case, is linked to a financial index (generally the Euribor) and may vary over time. The value assumed by the rate will be given by the reference index plus a fixed amount, the spread. In general, if inflation also increases the variable rate will tend to rise, while it will fall if inflation were to decrease. This exposes the borrower to the risk of seeing the installment rise (but it can also give the opportunity to bring it down)
MORTGAGE VARIABLE RATE WITH THE CAP
They are similar to variable rate mortgages, only, in this case, a maximum value is defined beyond which the interest rate cannot rise. This reduces the risks associated with strong inflation increases, but generally also involves an increase in the spread applied by the bank (and therefore a higher starting interest rate). So the principle of the first returns, namely that tranquility has a cost.
They are mortgages that allow you to change between fixed and variable interest rates over the life of the mortgage. Attention, however, that the moments and the ways in which this change is made possible are predefined and reported in the contract.
MORTGAGE WITH VARIABLE RATE AND CONSTANT INSTALLATION
How is it possible then to have both the variable rate and the constant installment? The answer is: making the duration of the loan variable. In these less used forms of mortgage, the installment is kept constant and, if the interest rate rises (or falls), the duration will increase (or decrease).
But beware that, even if at first sight this type of mortgage seems to guarantee greater peace of mind given the security of a constant installment, it may actually hide pitfalls in the event that rates rise significantly: the borrower could find himself paying an installment made of practically only interest, making the extinction of the debt more and more remote.
THE COUNCIL OF Miss Banko
In summary, therefore, the different types of mortgage have advantages and disadvantages and therefore the choice must be made with caution and taking into account both their own inclinations and the market situation (and trends).
It is important, however, to emphasize that the “classic” forms (fixed or variable rate) have the advantage of being basically more transparent while the others, which apparently seem to capture the needs (and therefore the expectations) of the bank’s client, can hide some pitfalls and need an extremely accurate evaluation of the mechanisms that govern them.
If you want to consider sophisticated tools, then you need to be aware of the need to have to go deeper into the analysis.