Loans: When is it beneficial to change the interest rate from floating to fixed?

The answer depends mostly on how close it is to expiration. Important factors are the rate of rise in interest rates, the margins on new loans and how much risk a borrower can bear.

Since July, the ECB has raised interest rates by three percentage points, putting corresponding upward pressure on the benchmark floating rate, the euribor.

Most floating rate mortgages are based on the 3-month euribor, which is currently at 2.60%, when before the ECB’s moves it was negative (-0.55%). The margin added to the euribor varies between 0.70 of the unit and 2.80 percentage points, with the average value being around 1.61 units, and depending on the Eurozone member country in which the European citizen lives and requests a loan. Therefore, one factor in the comparison between floating and fixed rate is the new margin or credit profile pricing that the bank will now give, compared to before.

The crucial question is whether and when it is beneficial to convert the floating interest rate into a fixed one

The decision should be made after analyzing the characteristics of each loan separately. As a general rule, at this stage, converting from floating to fixed is not or will not be a significant benefit if the borrower does not expect the rate to rise by more than 1 percentage point (plus) or if it is in the middle or the end of the loan maturity.

In fact, the last parameter, i.e. how much a loan has matured and how much time is left until it expires, is probably the most decisive for any decision. This is because mortgages are interest-bearing. That is, at the beginning of the loan, the largest part of the installment results from the interest (interest rate on the balance) and the smallest part from the repayment of the principal. As the loan nears its end, the interest is the smallest part of the installment. Thus, the installment mainly repays capital and is to a small extent affected by the amount of the interest rate from which the interest is derived.

In addition, the points that the borrower must take into account are the following:

  • Fixed rates are generally set at higher levels than the new floating rates as they ‘lock in’ risk. Today’s levels are not representative as volatility has risen sharply. The distance between floating and fixed will move between 1 and 2.5 units.
  • The floating interest rates follow the euribor and the fixed interest rates the yield of the government bonds of the Eurozone member country where the borrower lives. The euribor today follows the deposit rate (2.5%) of the ECB due to the high liquidity from the pandemic measures. As liquidity decreases, so will the main funding rate, which is currently higher at 3%.

Real case example

We can see this with the following example, which is a real case. A borrower, 5 years ago had received a housing loan of €100,000 for 20 years with a variable interest rate of 1.94%. The installment was €503 per month. At the beginning, €162 was interest and €341 was capital. After 5 years, with an approximately constant interest rate, the balance of the loan had fallen to €74,000.

With the rise of the interest rate to 5.1%, the installment is close to €500 because the balance had fallen. At this level he pays around €30 more each month than if he had a fixed rate loan. If it converts from floating to fixed, then it will move to a rate of 4.4%-4.5% for the remaining 15 years. Converting the floating to fixed for 15 years (from the original 20, after 5 years have passed for the remaining €74,000) will result in a monthly installment of €562. That is almost €60 higher than what he is paying now with the variable rate mortgage (which has reached 5.10%). On the other hand, it ensures a fixed amount from today and for the next 15 years. And this is another feature that the borrower should take into account. That is, how much risk it can withstand.

However, if the previous loan was 5 years before it expired, then the calculations would be different. The interest on the monthly installment of €503 was €38. The balance of the loan would be €23,000. In this case, the euribor should be significantly increased to affect the interest part of the total installment, since the capital is now being repaid. If it proceeds with a conversion, then this will at best be done with a fixed interest rate of 4% for the remaining 5 years, it will lead to an installment of €423, with the interest part rising to €77.

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