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 a better deal if the loan (or other service) is arranged through a third party? Have you ever wondered how it is possible for financial advisers to work for free? Do inflation and the time value of money matter? If you’ve ever asked yourself these or similar questions, let’s try to find some sensible answers together. In this article, I’d like to give you an alternative view of credit. The basic principles have been discussed in part1.
Czech mortgage cheat sheet
Let’s discuss some important information that you should know. It will help you understand how your mortgage loan is paid off. If there is a possibility to pay off your mortgage loan earlier. What is the best way to get the most out of your mortgage. We will also try to answer some points that may seem counter-intuitive.
How is the mortgage repaid?
With an ordinary mortgage, you pay interest and principal together in a single monthly instalment. It’s important to realise that at the beginning, most of the instalment will go towards interest and a smaller part towards the principal.
Example mortgage loan:
- Loan CZK 5 000 000,-
- Interest rate 6.00 % p.a.
- Interest rate fixed for 7 years
- Duration 30 years
- First installment is 29 977,-
- Interest payment is 25 000,-
- Principal payment is 4 977,-
As you can see from the example above, for the next 7 years you will have known monthly instalments (after the fixed period the interest rate will change, so the monthly instalments may also change). And in this particular example, interest payment will be greater than principal payment until 223th month (about 18.6 years). The higher the interest rate, the later the principal payment will be a bigger part of the monthly instalment. In other words, based on the above example, after 7 years you will have paid off only CZK 518,031. And said even another way, if you decide to pay off this loan in full after 7 years, you will have to give the bank CZK 4 481 969,-. The rest of what you paid was interest (profit of the bank).
What are the current conditions for paying off a mortgage?
As of 22/04/2023 you will be able to pay 20% of the remaining principal each year without incurring any charges from the lending bank. You can also pay off the loan in full or in part at the end of the fixed term. Based on documents from the Czech National Bank, you can literally pay off the mortgage loan in full at any time (but there will be a small, reasonable fee from the lending bank). Please check with your bank in this case, as some of them may charge extra fees because they interpret the CNB’s regulation differently.
Please note that there is a strong lobby from banks to prevent this from happening, as in such a case they will be left with open IRS contracts that they signed to secure funding for your mortgage loan. It’s very likely that in the future banks will be able to charge you a significantly higher fee based on the interest rate difference between the day you cancel the contract and the day you signed it. Documents from CNB can be found at here and here.
How do mortgage loans, the time value of money and inflation fit together?
Little theory
Let’s think about it this way. You want to build a house. You need a place for it, you need materials, you need people to work on it (or do it yourself) and finally it will take some time to finish. The point here is that you can’t just wave a magic wand and a house will appear. It’s also important to understand that there is a finite amount of space you can build on. Simply put, it’s a scarce resource, and the less available it is, or the more people want it, the more expensive it gets.
On the other hand, money is really just an abstract concept. And there’s no limit to how much money you can create (theoretically, practically it’s limited by hyperinflation). Money is a tool to express the value of something in an easily measurable and divisible way. It’s a tool to facilitate the exchange of things of value.
Well, because assets like property, cars, etc. take time to build and there is a limit to how much you can build at any given time or on any given planet. They are rare and valuable. So if you create more money and you can’t immediately create more assets. The world will balance itself by increasing the price of existing assets and inflation (depreciation of the unit value of money) is created.
This means that as long as we keep putting more and more money into circulation, asset prices will rise. Of course, because the world economy is so huge, this happens with a lag as the new money spreads around the world. In other words, it matters whether you are the first or the last to have access to newly created money. If you are first, you buy at old (lower) prices, if you are last, you buy at new (higher) prices.
Another way of looking at it is this. If someone creates extra money and buys at old prices, they will be able to buy more of that rare, limited good or service. On the other hand, when the rest of the people finally make enough money to buy the same good or service. They realise it’s already more expensive and they can only buy less of it. It’s literally a transfer of wealth from the people who got new money last to the people who got new money first. It’s quite sophisticated and invisible to ordinary people.
How does it relate to the mortgage?
Remember we said that it matters who gets the newly created money first? Loans are actually one of the tools used by commercial banks to release more money into the economy. And if you are the one who takes out the loan, you are also the first to use it. And the more people do the same, the faster the effect of inflation and spreading through the economy is.
As a person with loan please meet your best friends inflation and the time value of money
Are we saying that having a loan can be beneficial to us thanks to inflation and the time value of money? Yes, we are! These two principles will help us to pay our loan more easily. How is this possible? Let’s try a simple experiment. Imagine you have bought a house or an apartment for CZK 1,000,000. To make things simple, the average inflation rate is 10% per year. This means that if you keep CZK 1,000,000 in cash at home in a safe. After a year you will still have CZK 1 000 000,-, but you will only be able to buy things worth CZK 900 000,-. In other words, the money has lost 10% of its value after one year. And we agreed to pay this loan in 10 yearly instalments of CZK 100 000,- each. To make it simple, no interest is paid to the lender.
Fortunately, you have bought a house or an apartment with the CZK 1,000,000 you borrowed. Let’s simplify this a little and imagine that we will pay annual instalments instead of monthly ones. We use this simplification to demonstrate the principle. Paying monthly instalments makes it better for the lender because he gets some money sooner along with the interest payment. We already know from our thought experiment that having money now is better than having money later.
Here is the magic. We have borrowed 1 million and bought a house or an apartment. We can say otherwise, we have bought an asset, this asset will be re-priced as inflation comes in (after some time). Because it is a scarce resource, there is a limited amount of it and it takes time to create. This is our first profit, because our asset becomes more valuable (it costs more money). At the same time, we were allowed to use a total of 1 million to buy this asset, so we used all the present value of money at once (we hit the sweet spot). But when we pay the bank back the first annual instalment of CZK 100,000. One year has passed, 10% inflation has taken effect and the lender really got CZK 100 000 in nominal (absolute) value. But its purchasing power one year later is only CZK 90 000.
On the other hand, in our case. Our house/flat has increased in value. We pay fixed instalments, the real value of which depreciates. It’s like magic. Of course, if something sounds too good, it usually is. That’s why there’s an interest rate and why the instalments are paid every month. And if the economic situation changes and interest rates rise, it can become much more difficult to pay off these loans. Please always be careful with loans as they can quickly become too much if not used wisely!
Why do banks sometimes offer better deals when you go through a financial adviser?
A little theory
As a rule of thumb, ask about services at the beginning of the month. Branch staff have a limited amount of discounts they can offer and this is usually reset at the beginning of the month. It’s a good rule to follow if you want to get a better price on car insurance, for example.
If you use the services of a financial advisor, how is it possible that he can offer you a better price (in some cases)? The answer to this question is quite simple. If this financial advisor does a significant part of the heavy lifting, it saves time of bank employees (and so they can work on something else and save costs). Another point is the fact that people are social creatures, in other words, if mortgage loans go through a single person, he is able to build good relationship with bank employees. Think about it, would you rather help a friend or a stranger?
A word of caution
A word of caution about financial advisers. Ask them questions to assess their expertize, get a reference on them from other people and reserve some time to learn at least the basics about mortgage loans. You may even want to shop around for offers from other banks to see if the financial advisior is really offering you value for money. Please bear in mind that with a mortgage loan you are usually making a commitment to pay it for another 20-30 years. Therefore, the few hours of extra time you spend thinking about it can save you a lot of money.
Types of financial advisors
There are two types of financial advisers. The first is where you’re paid by the company that has provided you with the service, it’s like a form of affiliate marketing. You have brought a new client to the company and so the company will compensate you for that. This also means that they can only offer services from companies that are in their portfolio (that they have a contract with). They can also refer you to other companies, but in this case they are doing it for free. In short, they are incentivised to provide you with certain services and so you will usually end up with the best of what is available (which may not be the best overall).
The second type of financial adviser is completely independent and you pay for their services out of your own pocket. It’s like hiring a lawyer. They are usually (check their references and results, of course) real experts in their field, so they are not afraid to charge for their services. Because people are quick to tell each other about the bad ones. This type of financial advisor is the best you can get if you want the best possible level of service.
Of course, nothing is black and white. You can find amazing advisers in the first group and terrible ones in the second. That is why you should always double check, ask questions and get references from their previous clients. Let me ask you an interesting question: are financial advisers really paid by the company providing the service and not by you? Do you think that the company saves so much on the salary of the employee (as part of the work is done by the financial advisor) that it can pay the financial advisor, offer you better conditions and stay in the business for a long time?
Is there really a proverbial ‘free lunch’ inside economy?
If something seems too good to be true, it usually is. If you want to know who usually pays for everything and who should invest time and money in themselves to become wiser. I’m going to dare to tell you a little bit about how you can see the person who should do it. Please go and stand in front of the mirror and that person will appear. Yes, you are the person who should care most about your own future and take action!
Who is really going to pay it all?
In most cases, you will pay everything. It’s just nicely hidden over a long period of time so you have no chance of noticing. There is nothing really wrong with it, because you are using someone else’s service and that person/company is going to take your money in exchange. What’s a bit sneaky about it is the fact that it’s well hidden and spread out over time, so it doesn’t cause you a lot of pain and you just stay in it until it’s too late to fix it. Because pain (Pain can be just a bad feeling. We are talking about pain in general. It’s not just physical) is a very powerful motivator and it can wake you up to take action. Let’s go through an example to see how it works in reality.
Mortgage loan
Mortgage loans have a limited period when the interest rate is fixed. After this period, the bank will offer you a different interest rate. If you do not have the luxury of having enough money to pay off mortgage loan immediately. You will have to accept an offer, be it from your current bank or another one. Hopefully it’s already clear who’s in a position of power here (the lender). And that is exactly how you are going to pay it all back over a long period of 20-30 years and also provide a hefty sum over and above that.
Life insurance with investment
These products are designed to extract from you during the first 5-10 years a payment for investment services. Only a small part is actually paid into the investment. There is also a period until which you can’t cancel it. If you cancel it, the financial adviser has to return the money he got for providing you with this insurance. Again, the product is cleverly designed to extract money from you over a long period of time. If you cancel within the first 5-10 years. You have already paid all the fees up front, so who cares. Actually, you should care because investing is about time and amount of money working within the market.
Pension insurance
Do you think that pension insurance has been left out of the desire to make a lot of money and take it from people? If so, you are sadly mistaken. I have to admit that the conditions and support from the government make it a reasonable investment vehicle for very conservative people. And it’s definitely better to invest in it than not. Because one day we will all be old and having a little extra money never hurts. The fees are usually around 1% of the invested amount of money + they will take 15% of any appreciation of your money.
What is important to realise is that, given the size of these pension funds, they usually have to buy some index or ETF (exchange traded fund) fund. Which is really a no-brainer, there is not much added value in that. Because you can also buy an ETF that charges you 0.1% of the money you invest. As usual, nothing is black and white, but on average they make a lot of money thanks to your lack of knowledge (that you can do the same).
How much does 1% in case of investment matter?
Let’s say your parents were financially wise and saved CZK 1,000,000 for you. You have just graduated from university and at the age of 25 you are just jumping into the wild world of work/entrepreneurship. If the laws in the Czech Republic don’t change too much and you want to retire at the official age of 65. You have a lot of fun ahead of you, spreading over the next 40 years of your life. For the sake of simplicity, we will play with these two assumptions:
- You have invested 1 milion from your parents and use it to fund your retirement with the following conditions
- You have chosen a third party fund with an average return of 5% per year
- You have invested all this money into an ETF that tracks the whole market with an average return of 6% year
Now let’s calculate how 40 years and a 1% difference in the average rate of return can change the resulting sum of money that awaits you after the long, sometimes sad, sometimes amazing, bumpy road through your 40 productive years before you reach the retirement age of 65.
- Compounded total value of your investment at the end is:
- At 5% after 40 years with an initial investment of 1 million CZK – a total of 5 457 532,- CZK
- At 6% after 40 years with an initial investment of 1 million CZK – total 7 657 436,- CZK
- The difference is CZK 2 199 904.
As we can see, 1% over a long enough period of time really does matter and works wonders for us. It’s no coincidence that Einstein said: “Compound interest is the most powerful force in the universe”. Or in other words, exponential growth, which is very unnatural for us humans to imagine. And so we make this very painful mistake of not realising how important 1% is over a long period of time.
Are there any other perks?
Yes, there is a cult of home ownership in the Czech Republic. It is seen as a great achievement and brings with it pride and social status. Of course, this is also reflected in government incentives. You can apply for tax relief on the interest paid on a mortgage loan. There is an upper limit of CZK 150,000 by which you can reduce your tax base (as of 23.04.2023 it is 15%). In other words, the maximum you can get back from the government is 150 000 * 0.15 = CZK 22 500.
It’s always better to own than to rent accommodation
This is a very dangerous myth to accept and base your decisions on. The world isn’t just black and white, it’s many shades of grey. Your decisions should always be based on thinking, asking others for help and forming your own opinions about things. And of course, over time and by making mistakes, you will build up your own wisdom. For example, as of 23/04/2023, due to very high interest rates of the Czech National Bank, mortgage loans are much more expensive compared to just renting. At the moment it usually makes no sense to buy a house/flat, but rather to rent it and wait for the time when interest rates go down.
Summary
As has been mentioned several times in this article. Whether or not something is good for you in many cases depends on your current situation, what you want to achieve and how it fits into your long term plans. If there is one single most important thing you should take away from this article. Hopefuly, it will encourage you to think your way out of difficult situations, don’t be afraid to ask other people for help and learn from your own mistakes. Let me end this article with the words of the famous writer Mark Twain.
Twenty years from now you will be more disappointed by the things you didn’t do than by the ones you did do. So throw off the bowlines. Sail away from the safe harbor. Catch the trade winds in your sails. Explore. Dream. Discover.
Mark Twain