The variable rate mortgage is, together with the fixed rate loan , the best known and applied solution in the panorama of banking institutions.
Its main characteristic is obviously that of having an interest, and therefore an installment, potentially variable for the entire duration of the loan.
But what are the advantages and risks associated with this solution? How does it work in detail? This is what we will try to explain, even using some practical examples.
How the variable rate mortgage works
Like any type of mortgage, even the variable rate loan will have an installment to be paid periodically (generally every month) which will depend, in addition to the amount requested and the duration, on the interest rate. The latter, for variable-rate mortgages, is almost always given by the sum of two components:
– Euribor (or alternatively, as we shall see, the ECB rate ), which varies over time
– the spread applied by the bank, fixed and defined when the loan is subscribed.
The Euribor is an index defined as the average of the rates applied in exchanges between the main European banks. In practice it reflects the cost of money used by banks in exchanges between them. Its value can vary over time, and also have a negative sign. There are different types of Euribor based on duration, 1 month (Euribor 1m), 3 months ( Euribor 3m ), etc.
The spread instead is a fixed value that is a specific part of the bank’s offer. It often reflects the policy of that particular institution and the market situation: if in fact a bank wants to acquire many customers on mortgages it can decide to make very aggressive policies by reducing the spread, or vice versa raising it if it has no particular objectives in this regard.
Therefore the Euribor and the spread are the two components of the rate that will be applied, the first fixed and the other variable, which respectively reflect the trend of the cost of money and the strategies of the banks
Also read: Euribor forecasts
The variable rate: a practical example
Suppose you want to open a mortgage so defined:
- Amount: 100,000 euros
- Duration: 20 years
- Rate: variable
Let’s assume that the 3m Euribor has a value of 0.5% and that the spread applied by the bank is 1.0%.
The rate applied at the start will therefore be equal to:
- Euribor 3m 0.5% + spread 1.0% = 1.5%.
The monthly starting rate will be around 480 euros : if the 3 Euribor remains constant over time, this would be the installment to be paid for the entire duration of the loan.
In reality, however, Euribor 3m could increase or decrease, or, over the years, do both in different periods: 20 years are not few.
Let us suppose, therefore, that after 5 years Euribor 3m has risen by one point, from 0.5% to 1.5%. The overall interest rate will have become:
- Euribor 3m 1.5% + spread 1.0% = 2.5%
and, consequently, the installment will be increased, but by how much?
Let us say immediately that based on the formulas adopted by the banks there may be differences, the issue is very complex to be analyzed here. To get an idea under certain circumstances the installment could become around 520 euros , with an increase of 8%. But with other calculation criteria the amount could be higher, but then decrease thereafter.
From what has been said it is easy to understand how the functioning mechanism of a variable rate mortgage can be extremely complex if you look at the details, and having an idea of how your own installment could evolve is very important for a correct evaluation of the risk.
Is the Euribor or the ECB rate better?
Going a little further, in reality there are different indexing solutions for variable rate mortgages on the market.
First of all, as we have seen, there are different types of Euribor , at 1, 3, 6 and 12 months. In addition, some banking institutions also allow indexing at the ECB rate , or the official rate defined by the European Central Bank. But what are the main differences, and what should be chosen?
- First of all it is worth pointing out that the choice of the type of Euribor (for example between 1 or 3 months) has nothing to do with the frequency of the repayment installment of our mortgage (in fact there are alternative forms of repayment to the monthly repayment, for example half-yearly or annual).
- The ECB rate is generally more stable than the Euribor : the latter is recognized daily, while the ECB rate is changed at most a few times in a year based on the decisions of the European Central Bank.
- Similarly, the Euribor 1m is subject to a greater fluctuation compared to Euribor 3m or to the “other Euribor”, and generally has lower values.
What you should choose is a topic that is often debated and it is probably not possible to give general rules. Also because the spread applied by the bank can also be significantly different, for example that applied in the event of indexing to the ECB rate is generally higher.
It is therefore advisable not to make a choice a priori on the type of indexing of the loan, but to evaluate the individual proposals of the banking institutions also considering the spread applied.