In order to favor the choice of the type of loan most suited to the needs of its customers, as is well known, in recent years banks have begun to propose solutions that go beyond the eternal dilemma between fixed and variable rates. Thus other forms of mortgage were born, with a mixed rate or variable with a constant cap or installment .
These solutions are proposed by highlighting the opportunity to grasp the typical advantages of both the variable rate (savings and opportunities to be seized in the event of falling rates) and the fixed (security in the event of market turbulence and rising rates). But it is always advisable to carefully evaluate the negative aspects of these types of loans, sometimes not exactly immediately recognizable.
As we all know, the “classic” variable rate mortgage has the characteristic of having an interest that can increase or decrease over time (generally the reference index in this sense is the Euribor ) and, consequently, an installment that can become more or less expensive.
So how is it possible that a variable rate mortgage can have a constant installment ?
The answer is basically simple: an increase or decrease in the interest rate will result in an increase in the duration of the loan.
Mortgages of this type therefore guarantee that the amount of the installment remains constant over time, but also provide for the possibility that the duration may change and that, in particular, the loan may extend beyond the originally scheduled expiry. In general, banks set a limit on the total duration of the loan, for example 5 years beyond the initial maturity. And if at the end of the maximum period set by the contract there was still a part of the loan to be extinguished? There are generally two solutions offered by banks: the balance in a single payment by the customer or, alternatively, the opening of a new loan.
Another interesting aspect is related to the “cost” of this solution compared to that of a traditional mortgage.
As is known, the interest rate of a variable rate mortgage is given by the sum of two components, the Euribor and the spread : the latter is applied by the bank during the stipulation and is constant for the entire duration of the loan. The value of the spread for variable rate mortgages with constant installments is generally higher than the traditional one.
When we are dealing with complex formulas or, in any case, different from the classic ones, it is always good to consider that, if on one hand the advantages are clear and widely communicated by the banking institutions, the same cannot always be said about the disadvantages or the risks connected to this type of solutions.
The advantages as we said are obvious:
Among the disadvantages we have already highlighted one, namely the greater value of the spread that banks generally apply compared to a normal variable rate mortgage. But perhaps the most important aspect to take into account is the particular mechanism of operation of this type of mortgage in the event that there is a significant increase in rates.
To understand well all the implications (and risks) of the variable mortgage with constant installment, we need to know how the mortgage repayment plan works, or the projection of how our installments will be and above all the ratio between principal and interest.
The figure shows a possible amortization plan for a loan of 100,000 euros over 10 years and a rate of 3%. As can be seen in the first installments, the interest rate is higher than the subsequent ones, and will tend to zero towards the end of the loan
In the event that the rates should increase, if ours were a constant rate mortgage , the interest rate would increase and that capital would decrease, with the result that at the end of the 10 years there would still remain a capital quota to be extinguished.
If the increase in rates were considerable and took place at the beginning of our amortization period, we would find ourselves paying a much higher share of interest and much lower capital. In particularly unfavorable market conditions we could even find ourselves, at the end of the 10 years, to have extinguished a reduced share of capital: our installments would have served in large part only to pay interest, increased by the increase in rates. If instead we had had a classic variable rate mortgage, the installment would have increased, but in the meantime we would have also extinguished the principal amount.
In general, the variable rate mortgage is chosen because it is feared that it will not be able to sustain a higher installment in the years to come, so it is perhaps taken into consideration by families who do not have the certainty, or even the possibility, of increasing their income. in the future. Precisely for this reason, however, we must also consider the possibility of still having a substantial residual credit at the end of the loan, and it would not be pleasant to have to repay it in a single payment. It is therefore necessary to have clarity from the bank on this point and on the possible solutions, before venturing into hasty choices.
The constant installment can prove to be a fair solution to your problems if the increase in rates remains low and translates into a few more installments to be paid at the end of the period. Conversely, if the increase in rates were much more significant, it could prove to be a dangerous boomerang, both for the family budget and from a strictly financial point of view. And what will happen to rates in the long run is not predictable a priori …