Last Updated 1 year by Lukas
Have you ever wondered whether it is bad to take out a mortgage (or loan)? Have you ever wondered how it is possible for a bank to offer you better conditions if the loan (or other service) is done through a third party? Have you ever wondered how it is possible that financial advisors can work for free? Do inflation and the time value of money matter at all? If you’ve ever asked yourself these or similar questions, let’s try to find reasonable answers together. In this article, I’d like to give you an alternative view of credit.
First things first, what is good to know before you start the article?
What is ‘Time Value of money’?
What is ‘Inflation’?
How ‘Inflation / deflation’ changes perception of loans?
What is ‘Interest rate swap’?
Let’s get rolling with knowledge of basic concepts
We now have a basic understanding of important concepts such as inflation, the time value of money and what an interest rate swap is, or we can say swap in general. In other words, inflation is the depreciation of money caused by putting more money into circulation. Time value of money refers to something called risk-free interest rate (usually government bonds) which helps us decide if it’s better to have money now or later (present value / future value). And finally, we understand that there is a contract available where two companies can swap conditions/benefits between themselves. In the case of an interest rate swap, they swap interest payments.
Mortgage loans for ordinary people in the Czech Republic
90% of mortgage loans available in the Czech Republic are either ‘standard’, where you pay interest together with principal in monthly payments over a long period of time (15-30 years). Usually you will be offered either a fixed interest rate for a certain period of time (3-7 years is the most common period) or you can choose a so-called ‘floating’ interest rate. In this case, your interest rate is calculated on the basis of the Czech National Bank rate + some margin above the rate charged by the lending bank. In exchange for the money, you’ll have to provide some collateral, which is usually the house/flat you want to buy. However, it can also be any other property you own that meets the bank’s requirements for collateral.
The second most common type of mortgage is ‘refinancing’, which is simply taking your loan to another bank, usually one that offers better terms. There is fierce competition between banks for customers who want to refinance. That’s because you already have a long (3-7 years) history of regular payments and all the hard work has already been done when you applied for the original mortgage. Financial checks, valuation of your property.
The last most common type of mortgage loan is the so-called ‘American mortgage loan’. Normally, a mortgage loan is a loan with the specific purpose of buying/modernising accommodation. It can’t be used (at least not in full) to buy a car, for example. That’s where this last type is different. You put your own house as collateral, get money from the bank and you can buy whatever you want, for example a car. Of course, the bank will charge less favourable interest rates and you will not be able to take advantage of tax breaks (depending on the country).
How can we compare mortgage loans in between themselves?
What can we do to compare two loans? For example, we can use the interest rate, but unfortunately lenders are aware that people compare loans using this metric. And so they have adapted by charging extra fees and keeping the main interest rate low. This can give the impression that the loan is amazing when in reality you will pay a lot of money for it.
In order to fight this new financial trick, the regulators created a rule to indicate a new characteristic of loans (besides the interest rate) and it’s called APR (Annual Payment Rate). The APR takes into account the interest rate + all the fees you will pay to get the loan and translates them into a ‘real’ interest rate per year. If you want to compare two loans, make sure you use the APR rather than just the interest rate. Remember that regulation is always a little behind the latest inventions to make things look better than they are, so double check, ask questions and check the terms before signing anything!
How does mortgage loan work?
Step 1
You have chosen your dream house, you have saved some money and now you would like to buy a new house. So you go to the bank / ask your financial advisor to arrange a mortgage loan. What will happen?
At the beginning this bank will check your creditworthiness (How responsible you are with money and is there any history of missing regular payments, among other checks). After that, the lender (in our case the bank) will also check that you’re complying with the rules of the local financial regulator (in the case of a mortgage loan in the Czech Republic, it’s the Czech National Bank).
Currently (21/04/2023) the general rules in the Czech Republic are 80% LTV (Loan To Value), which means you have to pay 20% down payment from your own money. In other words, if a house/flat costs CZK 1 000 000,-, you have to pay 200 000,- from your own savings.
DTI 8.5x (This is the maximum multiplier of your annual income to the value of the loan). For example, if you earn CZK 1,000,000 per year, you can borrow a maximum of CZK 8,500,000.
And finally DSTI 45% (It is maximum percentage how much ALL loan instalments can take monthly from your salary). For example, if you earn CZK 100 000,- each month, it means that you can pay a maximum of CZK 45 000,- for all (including existing) loans together in a given month.
With current interest rates announced by the Czech National Bank at around 7%, these requirements, combined with high property prices, make mortgage loans unavailable to the majority of people living in the Czech Republic.
Step 2
You have chosen a bank and an offer that you like best. Now the bank has to secure funding for your mortgage. It’s unlikely that it will cover the long-term loan (mortgage) with short-term deposits from customers. Simply put, deposits can be withdrawn from the bank at any time by the bank’s customers. Alternatively, the bank can have some time bound deposits or ideally it will use an interest rate swap (IRS). In other words, the bank itself will secure money in the interbank money market. Of course, the bank will borrow this money at more favourable conditions than those provided in your mortgage loan contract.
The difference between the interest rate the bank is expected to pay on the IRS (or any other money the bank decided to use for covering the mortgage loan) and the interest rate of your mortgage loan contract is the bank’s income. The general idea is that the bank itself is borrowing money to provide you with a mortgage loan. Of course, it has to meet regulatory requirements, so there is some limit to how much it can lend to other people.
Currently, according to the CNB’s regulatory statement, it is possible to pay off a mortgage loan in full at almost any time (even during the fixation period). Of course, for the bank this means that your contract has ended and theirs is still active (the bank also borrowed money to cover your mortgage loan). Of course, in the case of big banks, it’s usually easy to use this money to cover other mortgage loans. Articles from CNB can be found at here and here.
Prices of the most frequently used IRS for mortgage loans (source: Patria.cz)
- 3Y – as of 22/04/2023 it’s 5,5%
- 5Y – as of 22/04/2023 it’s 4,95%
- 7Y – as of 22/04/2023 it’s 4,65%
- 10Y – as of 22/04/2023 it’s 4,55%
Step 3
You have signed a contract. The terms of the mortgage loan have been agreed. Now the bank will make an entry in the Czech Property Register about the security right it has over your new house/flat. After you have also signed the contract for the purchase of the new house/flat, you will provide the bank with the expected instalment of money from your own sources and hand these documents over to the bank. The bank will transfer the mortgage money to the seller’s account according to your request and that’s it.
Summary
You are now the happy new owner of a house/flat, congratulations! The only thing to remember is to pay your monthly instalments as agreed with your bank. Please bear in mind that these instalments may change when your fixation period ends. According to the current regulations (as of 22/04/2023), you can (without penalty) pay 20% of your loan principal each year (even during the fixation period). If there is a re-fixation (end of your fixation period and you are provided with a new interest rate proposal), you can pay off part of the full mortgage loan. We will discuss these details in next article.