May 31, 2019

Interest Rate of a Fixed-Rate Mortgage

We hear more and more often talk about spreads : but it is not always clear to everyone what its meaning is . And, above all, sometimes it can escape the reason why it has become so important to the point of conditioning the economic choices and political destinies of an entire nation.

To fully understand the meaning of the spread and its reasons is therefore an important first step in order to assess whether there really are any imposing clouds on the horizon for our economy and to understand whether, behind the countless statements of politicians in this period, there are always serious reasons or the usual attempts to exploit the fears and anxieties of public opinion

The meaning of the term spread

The term spread in Italian can be translated as differential, and therefore has the meaning of a “difference”, or of a “gap” between two quantities or values.

For example, the term spread can be used to define the interest rate of a fixed-rate mortgage, given by the sum of an indicator, the Eurirs and, indeed, a spread applied by the bank, a differential which is added to obtain the final value of the interest rate

Read also: Worried about spread and Euribor?

The literal meaning of the BTP / Bund spread….

The literal meaning of the BTP / Bund spread….

In the context to which we are referring, the spread has the meaning of difference between the interest values relating to Italian and German government bonds. We are talking about the famous spread between German BTPs and Bunds, or the differential between the yields guaranteed by the 10-year Italian BTP and the equivalent German government bond..

The significance of the BTP / Bund spread for the Italian economy….

But why is the BTP / Bund spread able to influence our country’s economic policy decisions so much? And why when the values ​​of this indicator move upwards does a climate of deep nervousness take over the destinies of our economy?

Government bonds in general, as we know, are issued by states to finance or re-finance their public debt. And, this is also a known fact, Italy is certainly one of the countries most burdened by debt and is therefore very subject to disturbances on this matter. In fact, every creditor must be remunerated, and this happens thanks to the interests that the various BOTs, BTPs, CTZs etc. guarantee investors. The greater the benefit to the investor (the interest rate), the greater the costs for the state.

To understand the significance and importance of the spread we must consider that the value of the interest rate of government bonds, and therefore of the ten-year Btp, depends on many factors, but a very important one is the trust in the stability of the state that issues the title itself. Moreover it is quite logical: if we have to lend money to someone who is not very reliable, we will ask for a higher remuneration (and therefore a greater interest) because we will assume a higher risk.

The spread therefore has the meaning of “trust” in economic stability in comparison with a “benchmark”, a reliable reference: in this case the German solidity. If the spread increases, it means that the market trusts less than before in the solidity of our economy, in comparison with Germany

… and the meaning of the BTP / bund spread for public accounts

... and the meaning of the BTP / bund spread for public accounts

Finally, we need to consider the significance of the spread for public accounts . In general, if the interests of government bonds increase, the cost that the state must bear to finance its public debt will increase. The BTP / Bund spread tells us how much of these additional costs derive from the specificity of our condition, from the lesser trust that markets have in our solvency than in Germany.

The extent of the spread

In this period we hear phrases like this: the BTP / Bund spread has exceeded 300 basis points. But what is the meaning of base point with reference to the spread?

A base point consists of a differential equal to the value of 0.01 in the interest rate between the BTP and the Bund.

Let’s take a practical example: if the Italian 10-year BTP had an interest rate of 5% and the German Bund a rate of 1%, the spread would be 400 basis points.

So the threshold of 300 basis points is equivalent to a difference in interest rates of 3 percentage points (for example from 4% to 1%).

So we now have several more elements to understand how important certain phenomena are for the stability of the Italian economy and public finances. If the spread increased by 10 basis points in 6 months, probably no one would be too alert. If, as happened during the crisis of a few years ago, the spread increases by a few hundred points in a very short time, the impact can be very strong, both for the risk of being considered not as reliable debtors by investors, and for the impact on public accounts of the major interests needed to finance our substantial public debt.

written by Adrienne Fehr - Posted in Mortgage