In our last column we discussed how to deal with mortgage loan risks. We will now review the different mortgage loan plans available to consumers.
The fixed-rate mortgage
A fixed-rate mortgage is a loan in which the interest rate and hence periodic payments, handling the principal and interest on the loan, remain the same throughout the term of the loan, as opposed to loans where the interest rate may adjust.
All fixed-rate mortgages have an interest rate tied to an index. To apply an index on a rate means that the interest rate will equal the index plus a margin basis. This is the interest rate for the life of the loan. For example, if you've received an interest rate of 4% and the index margin is 2%, you will have a fixed- rate mortgage calculated at 6%.
Its riskless characteristics promise certainty, but under certain market conditions it may not be the optimal choice.
The disadvantage is that early pay-off of the entire loan amount will incur a penalty. Also, it is usually more expensive than adjustable rate mortgages since lenders require higher rates for longer-term fixed-rate loans because they bear the interest-rate risk (risking that the rate will go up while they are receiving lower interest income than they otherwise would have had).
The graduated payment mortgage
A graduated payment mortgage is a loan with low, initial monthly payments that gradually increase according to a predetermined percentage over a specified time frame. These plans are mostly geared towards first-time home buyers or young couples who do not have the resources to afford high monthly home mortgage payments but can realistically expect to do better financially in the future.
Even though the amounts of payments are drawn out and scheduled, it requires borrowers to predict their future earnings potential and how much they will be able to pay in the future, which may be tricky. Borrowers could overestimate their future earning potential and not be able to keep up with the increased monthly payments. Also, even if the graduated payment mortgage lets borrowers save at the present time by paying low monthly amounts, the overall expense of a graduated payment mortgage loan is higher than that of conventional mortgages.
The adjustable-rate mortgage
In an adjustable-rate mortgage, the interest rate is generally fixed for a period of time, after which it will periodically (annually or monthly) adjust up or down to some market index. Consequently, payments made by the borrower may change over time with the changing interest rate. According to the Bank of Israel's Commissioner, the lender has no possible control over the change in interest.
The fact that an adjustable-rate mortgage has a lower starting interest rate does not indicate what the future cost of borrowing will be (when rates change). The borrower benefits if the interest rate falls and loses out if interest rates rise. Adjustable-rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain.
The adjustable rate mortgage might offer the ability to repay the capital early without penalty, which is an advantage to anyone who expects to receive a certain amount of money in the near future and will be able to pay off part of or the entire loan.
Some studies have shown that the majority of borrowers with-adjustable rate mortgages save money in the long-term, but that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs. In each case, a choice would need to be made based upon the loan term, the current interest rate and the likelihood that the rate will increase or decrease during the life of the loan.
Lately, many banks have started to offer a new mortgage loan course with a non-linked fixed rate for the entire loan term. The monthly payment is fixed and is independent from the prime rate, the dollar exchange rate or any other market index. This course is optimal for people who want a fixed monthly payment for the entire loan term. Its main disadvantage is the extra percentage added to the fixed rate as the lender must bear all risks.
What are the different interest rate types?
The prime rate
One of the basic lending interest rates is the prime rate, which is speculating against the Bank of Israel raising or lowering the prime rate. The prime rate is often used in calculating mortgage rates specified as the prime rate plus/minus a fixed value. For example, if the bank offers an interest rate of prime minus 0.7 percentage points and the prime rate stands at 5%, your rate will be calculated at 4.3%. This way, the interest rate is not index-linked and enables repayment on account of the capital without penalty.
The dollar-linked rate
During the entire interest period, the interest rate will be linked to the dollar's exchange rate fluctuation, which is also linked to the rounded "LIBOR" (London inter-bank offered rate) interest rate plus percentages added by the bank. The interest will be calculated periodically by the bank as of the date of the beginning of every interest period. In addition, the dollar-linked interest rate will usually be lower than the fixed interest rate (in shekels) but the main risk is the chance taken if the dollar exchange rate leaps. It is proven to be worthwhile mainly concerning rented properties as the rent is usually paid in dollars - even if the dollar's exchange rate decreases in value so will the interest rate on the loan so there will be no gap between the income from the rent and the payment on the mortgage loan.
Combining different interest rate types offers a possibility of flexibility when choosing a mortgage-loan plan. Many are concerned and prefer the riskless fixed-rate mortgage when, in fact, it is sometimes worthwhile to consider other plans in view of the exchange rate fluctuation or decrease in interest rate. In order to encourage usage of different plans, there is an option of choosing a certain course for a fixed period with an option to change the course. Opting for a combined course requires profound understanding and analysis of the expected income, future payments and of market tendencies.
The borrower's income is an important factor when considering the different mortgage loan courses. If the income is index-linked, it is logical to choose an index-linked interest rate. However, if the income is in foreign currency such as the dollar, a dollar-linked loan should be considered. In fact, the dollar-linked course is very common among foreign residents but very few Israelis opt for it.
The repayment capability is one of the main issues to consider before taking a mortgage loan especially when defining the loan term. The customary rule is that the monthly payment can reach up to a third of a family's net income. A higher installment may drag difficulty in payments, assuming there are no alternative incomes.
The banks offer a large range of options; enabling postponement of payment on the account of the capital, a diminished payment on account of the capital at the beginning of the loan term and increase in payments along the way. Here, as well, the income flow of the borrower is an important fact.
The author is an adviser in the Information Risk Management Department at KPMG Somekh Chaikin. The article is published under his responsibility only.