For most of us, taking out a mortgage is the most important investment we might ever make. Yet, taken within the correct financial conditions you can succeed in minimizing your family's mortgage expenses.
Most mortgage loans that are proposed by banks have long-terms, which burden the future payer and heightens the level of uncertainty regarding mortgage loan payments.
However, there is an unbelievably wide choice of mortgages out there, although all may not be what they seem. Don't make the mistake of thinking interest rates are the "be all and end all" of the mortgage search.
We will try to discuss the different risk elements and offer tools to define the risks so as to make the loan-taking public better informed.
There are various ways of working out the interest rate on your mortgage. However, all tracks offered by the different banks are calculated according to an amortization table (amortization is the period, usually in a number of years that it takes to repay your mortgage in full).
There are three different amortization tables, as shown below:
1) The equal capital (decreasing) - The calculation system according to the equal capital amortization table will cause monthly payments to be equal while the total payment to the bank changes, and the repayment decreasing over the years.
2) The Spitzer amortization table - This repayment method is optimal. The monthly payment to the bank is affixed while the payment on account of the capital and interest change during the repayment period. A common mistake is believing that during the first years it is only or mostly the interest that is being paid.
3) The Bolit amortization table (Grace) - Using the Grace method payments aren't on the account of the capital but on the account of the interest. After a given period, repayment of the amount taken for the loan is made.
For very one of the three tables, it is possible to construct a mortgage loan track. We apply the loan elements to the tables that assemble the risk component.
There are many risks attached to the amortization tables: the linking risk - the rising consumer price index; the rising prime risk; the changing exchange rate risk; and the fluctuating interest rate risk.
Defining the risk means understanding how each component was caused and how using the right tools we should be able to neutralize it.
To understand how to hedge the risk we shall show a macro-economic survey:
The prime interest is the Bank of Israel's interest rate declared by its governor, in addition to a fixed gap of 1.5% percentage points.
In determining what the interest rate will be, the governor takes several monetary facts into consideration such as the amount of money in the market, the gap in interest rates between Israel and other big countries, the euro and dollar rates vs the shekel, investor expectations, private consumption and the inflation index, or consumer price index. As much as the difference of interest from month to month gets bigger, the prime interest will increase as to prevent high inflation in the market.
The prime interest rate influences the consumer price index - as much as the interest rate increases, more money will be transferred to savings on account of private consumption and the diminution of private consumption will decrease the rising price index rates.
Therefore, the prime interest influences and is influenced by the consumer price index and conversely the consumer price index influences and is influenced by the prime interest.
An additional factor that has to be considered is that payment according to the amortization table is composed of the loan amount, the term of the loan and the interest rate. The prime interest is the interest that is entered into the amortization table calculation equation and determines the monthly repayment, while when the loan is index-linked, the price index is taken and applied to the result.
Understanding the reciprocal influence as well as the calculation system between the different tracks will help greatly when hedging risks and dividing correctly the different mortgage loan options.
Based on the many studies that have dealt with the monetary issue of changing variables, the conclusion that can be drawn is that the most effective hedging of the interest and prime-linked tracks is distribution over a range of years.
According to findings, for a loan taken up to 10 years, it is suggested to take a fixed interest, index- linked rate, while for a longer period of time it is suggested to take a prime interest track. The impact of a longer amortization period, although it allows us to increase our borrowing power, provides for some significant long-term costs.
Further examples and explanations will be addressed in the next column.
Of course, the above are only suggestions as each individual's circumstances are different. Professional advisers should be consulted before making any decisions.
The author is an adviser in the Information Risk Management Department at KPMG Somekh Chaikin. The article is published under his responsibility only.