Mortgages and interest rates: the relationship with inflation

Elizabeth Smith

Inflation is today’s biggest concern for homebuyers taking out mortgages. Indeed, the cost of living is pushing the European Central Bank to continue raising official rates. With direct effects on the conditions applied to borrowers.

The ECB’s interest rates continue to rise in an attempt to counteract the still high inflation. And these increases also have an effect on the rates charged on mortgages. But how does this mechanism work?

What is happening?

Let us start with the current situation. In mid-June, the European Central Bank decided on the eighth consecutive increase of the reference rate by another 0.25 %. Thus bringing the official rate to 4 %. And further increases are also in plan for July.

The aim is to slow down the rise in inflation. If you increase the cost of money, individuals tend to save and spend less, the economy shrinks and so does inflation.

How interest rates work

Interest rates are the percentages that indicate how much it costs an individual or business to borrow money from a bank to buy a house, through a mortgage, or to purchase any other good or service.

Conversely, they also indicate how much the lender of the money earns. I.e. a saver opening a deposit in a bank or a bank financing a loan.

For example, if the rate is 4% per annum, this means that a lender who lends 100 euros will get 104 euros after one year.

Each currency has its own interest rate, called the official discount rate. The ECB regulates that of the euro. This is the interest rate that the Central Bank applies to the loans it grants to private banks. In fact, credit institutions exchange liquidity with each other all the time, to meet different needs and receive loans from the Central Bank.

Thus, interest rates are on the market which, although they deviate from the official rates set by the ECB, are nevertheless a derivation of them.

Changes in the ECB rate thus influence the rates that banks use to lend money to each other. The Euribor rate (Euro Inter Bank Offered Rate) is an important reference point.

What happens when rates rise?

The first consequence of a rise in central bank interest rates is an increase in the cost of applying for loans and mortgages. Banks use the official ECB rate as the main reference when they have to decide on the rate to apply in their trade with each other and in loans to private individuals.

If the rate is 4%, it is not convenient for a bank to offer a lower rate, because it would suffer a loss. But neither is it too high. Otherwise it will be beaten by competition from other banks. On the market, to take out a mortgage, you will therefore find rates more or less in line with the ECB rate.

Interest rates and mortgages

A mortgage is a contract involving two parties. The first, usually the bank, agrees to lend a certain amount of money. The second, the saver, agrees to repay the same amount of money disbursed, with the addition of certain predetermined interest.

The interest on the loan is paid back by the saver along with the capital disbursed by means of periodic payments, the instalments, over a period of time and according to an amortisation schedule predetermined at the time of the contract.

Types of mortgages

Mortgages are generally distinguished according to the type of interest rate applied. In the case of a fixed-rate mortgage, the interest rate remains constant throughout the life of the loan. Whereas if variable, the rate may change during the life of the contract.

A fixed rate is defined as a bank loan that, once chosen, does not vary the reference rate over time. Thus keeping the instalment constant regardless of the trend in the cost of money. The mortgage rate applied by the bank is calculated by adding the IRS (Interest Rate Swap) to the annual spread (the percentage that each specific bank decides to add as its own revenue).

The variable-rate mortgage, on the other hand, is a mortgage whose interest calculation changes over time in relation to changes in the cost of money. The variation follows that recorded by the Euribor. The rate applied to the mortgage instalments thus derives from the sum of Euribor plus the annual spread.

The higher the Euribor rises, as is happening, the higher the interest to be paid in the mortgage instalment. If Euribor is the variable component of the rate, the spread, on the other hand, will remain the same throughout the duration of the mortgage.

There is also the term ‘mixed rate mortgage’ when it is possible to change, at the terms and conditions laid down in the contract, the type of rate applied initially by choosing between a fixed rate and a variable rate.

There is also the ‘capped rate’, also called CAP. Which is a variable rate with a predetermined ceiling beyond which the interest rate can never rise, even if market rates were to exceed it.

Finally, the balanced rate is composed of a fixed-rate part and a variable-rate part. The composition between the two parts can derive from different mixes at the time of the contract.

Read also: The real estate crisis in Europe is getting closer: markets and banks on high alert

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