The mortgage is a type of medium-long term loan, which is usually requested when we want to buy a house. This is a secured loan, where a mortgage is established on the house. But how does it work? In short, the bank lends us money and we will have to pay it back in installments that include interest that we pay to the bank. But what is the difference between fixed and variable interest rates? And between TAN and APR? But above all: how much can we ask for a mortgage? And what does its duration depend on? And what are the strategies for saving money?
In this article we see how a mortgage works in simple words, so as to have all the tools to avoid making the most common mistakes.
What is a mortgage and how does interest work
First of all, what is a mortgage, it is a type of loan that has two fundamental characteristics: it is of medium/long duration – from a minimum of 5 years to a maximum of generally 30, in some cases even 40 years – and of a high amount, usually not less than 50,000 euros and in the order of hundreds of thousands of euros.
And in fact, when do we usually apply for a mortgage? When we want to buy a house or renovate it. And since it involves a lot of money lent, the bank protects itself with a guarantee to be sure of being reimbursed, which in the vast majority of cases is the property itself. That is, if we fail to repay the mortgage, the house we bought becomes the bank’s property. But let’s go step by step.
As we said, the person who grants the mortgage – who is called the lender, i.e. the bank – lends money to the borrower – who is us. And how do we return them then? Through installments that we will pay to the bank usually monthly, or quarterly or semi-annually, for the entire duration of the mortgage. Clearly, in order to make a profit, in exchange for the loan, the bank also asks us for interest, that is, a percentage of the loaned portion, and therefore the installments are made up of two parts: one is the principal portion, that is, that small piece of debt that we are repaying, while the other is the interest portion. And what is the interest calculated on? On the part of the loan that we still have to repay.
To give an example, if we have requested a mortgage of 100,000 euros with an annual interest rate of 3% and we have already repaid 20,000, we have 80,000 euros left to repay, so the interest rate of our monthly payment will be 3% of 80,000, 2400, divided by 12 months, i.e. €200 of interest.
Now, there are two main types of interest: fixed rate, that is, when the percentage of interest we pay in each individual installment is always the same for the entire duration of the mortgage, and variable rate, in which the rate varies over time depending on the market, which can fluctuate. Then there is a third type of interest which is the mixed one, which alternates a fixed rate with a variable rate.
And how are these rates established? Through European reference rates: Eurirs for the fixed rate and Euribor for the European rate. If these indicators vary, the interest rates applied by banks also vary. The profit margin established by the bank, which is called the spread, must then be added to the reference rates.
For example, if the Eurirs is at 3.2% and our bank has a spread of 0.8%, our fixed rate will be 3.2% + 0.8% = 4%.
Yes but, what is the difference between fixed and variable? That is, which is the most advantageous? It depends on the situations: the fixed rate is initially higher than a variable rate, but it gives us more security, because we always know exactly how much our installment will be, because it does not take into account market fluctuations that could cause rates to rise. On the other hand, however, rates could also fall, thus making us pay less interest! Conversely, the variable rate has the advantage of being initially lower and could decrease over time, but also increase, making us pay more. In short, depending on our financial situation, how much we can afford to risk and how long our mortgage will last, one choice is more advantageous than the other.
Ok, that’s the big picture of a mortgage. But: how do we establish how much we will be lent, how much interest we will have to pay and how long the mortgage will last?
How the amount and duration of the loan is established
The first thing to know is that most banks usually finance up to a maximum of 80% of the value of the property we want to buy. There are banks that also grant 100%, but these are special cases, for example in the case of the purchase of the first home for young people under 36 years of age. And be careful, to evaluate the value of the property, not only is the price at which we paid for the house taken into account, but the bank also carries out a further evaluation of the property, i.e. an appraisal. If with the appraisal, the bank assesses that the house is worth less than the purchase price, 80% will be calculated on the appraisal. Clearly, sums lower than 80% can also be requested, but it must be kept in mind that the remaining 20% - or more in the case of mortgages with a lower percentage – must be paid immediately as a down payment.
Let’s take a practical example. If the house we want costs 150,000 euros, but the bank’s appraisal values it at 140,000, we will be granted a maximum of 112,000 euros, i.e. 80% of 140k, not 150k. The remaining 38,000, however, we must pay immediately.
The second important thing is that – to ensure that we are able to pay the installments for the entire duration of the mortgage – the amount of a single installment must not exceed ⅓ of our monthly salary, therefore approximately 30%. For this reason, before establishing the value of the installments, the bank carries out an analysis of our income, i.e. the last three pay slips are requested, how much was earned in the previous year, what your family situation is (if you have dependent children, for example), if you have other loans in progress and if you have a fixed-term or indefinite employment contract or are VAT registered. In the case of a fixed-term contract, for example, it is essential to demonstrate that you have sufficient family capital or a guarantor capable of paying for us in the event that we lose our job.
Let’s therefore imagine having a salary of 2000 euros per month and take the previous example again. This means that the maximum installment granted to us is 30% of 2000, i.e. 600 euros per month, which includes principal + interest. And let’s imagine that the bank has offered us a fixed rate of 4% per year.
Now, how long will our mortgage last? The bank, based on our salary of 2000 euros and therefore on the maximum fee of €600, tells us that if we want a loan of 112,000 euros, the mortgage will have a minimum duration of 25 years, i.e. 300 months, so as to have an installment of €591. This is a complex calculation, there is special software to do it. What we must keep in mind is that the longer a mortgage is, the more interest we will have to pay, being monthly and annual interest. So: more years = more interest. While fewer years means less interest, but the installment must necessarily increase, because we have to pay off the mortgage in less time! In our case, under the age of 25 the installment should be greater than 600 euros, but we cannot afford it given our salary. While if we chose a 30-year mortgage, the installment would be less than 591 euros per month, but we would have to pay more interest.
Returning to our example, at this point we can calculate how much we will repay in total with the installments for a loan of 112,000 euros, with installments of 591 euros, a fixed rate of 4% and a duration of 25 years, i.e. 300 months. We just need to do 591*300=177300. That is, in 25 years, we will have returned 112,000 euros plus 177,300-112,000=65,300 in interest. So more than 50% interest.
What is the difference between TAN and APR?
Up to now we have only considered the costs due to the installments, i.e. the annual interest rate, called TAN i.e. (Nominal Annual Rate). But when we set up a mortgage there are a series of additional costs, such as the cost of the initial technical appraisal, compulsory fire and explosion insurance, optional life insurance, taxes, the expenses the bank incurs to offer us the mortgage and another series of costs. For this reason, there is a fundamental indicator that shows us how much we will actually pay to the bank, in addition to the installments: it is the APR, i.e. Global Effective Annual Rate.
In our case, for example, by adding all the additional costs, the bank tells us that the TAN is 4%, while the APR is 4.5% and this means that we will not only repay the approximately 177 thousand in installments, but also another approximately 9,000 in additional costs. We must also always consider that we are talking about the expenses we will have with the bank, but there are others, such as the notary for example.
We understood how installments work and how long a mortgage lasts. But I imagine you’re wondering: what happens if we can no longer pay the installments?
What happens if we don’t pay the installments?
First of all it must be said that there are cases in which we can request the suspension of the mortgage for up to 18 months if we find ourselves in difficulty, for example if we lose our job and our mortgage does not exceed a certain value. In this case, the law protects us.
However, in the case of unjustified late payments, there are different scenarios depending on the severity of the situation. When we are late with the payment of an instalment, the bank applies additional interest, called late payment interest. Clearly, the consequences vary depending on the number of days of delay. If it is only for a few days, the late payment is sufficient. But if the delay persists and we become seriously delinquent, the bank may decide to terminate the contract. And here two scenarios open up: in the first, we are asked to immediately pay the part of the fee that we still owe to the bank. But if we are not able to cover this expense, the second scenario opens up: if we do not pay the installments for more than 18 months, our house is put up for auction and the proceeds of the sale go to the bank to repay the loan. It is the so-called foreclosure. However, this is the worst possible scenario.
Speaking instead of slightly more positive things, at this point the question remains: what are the measures we can take to save on a mortgage?
How to save on your mortgage?
The first fundamental piece of advice is to always consult more than one bank before deciding on the right plan for us. When a bank evaluates our request, it is required to issue us a document containing all the information relating to our mortgage: how much we will pay each month, how much interest we pay each month and what the additional costs will be. It is the so-called PIES, Standardized European Information Prospectus. Here, the advice is to have multiple PIES to compare, so as to make the right choice.
Another piece of advice is to continue to evaluate whether there are banks that offer convenient mortgages, even when we have already taken out our mortgage and are already paying it. This is because if we find a more convenient offer than ours, it is possible to change bank, this is the so-called subrogation or portability. And how does it work? The new bank pays the remaining debt to the previous bank, and at that point we will pay the mortgage to the new bank, with the new conditions. And all this without penalties or additional costs thanks to the Bersani Law of 2007.
The last possible advice is that of early repayment, that is, when we repay all the debt in advance, if we have the possibility. In this way, we will pay less interest, because let’s remember that interest is paid on the residual debt, so the shorter a mortgage is, the less interest we pay. This operation, like subrogation, also does not provide penalties or additional costs thanks to the Bersani Law.
