Mortgage: how is your rate calculated?

You’ve just received a letter from your bank telling you that the interest rate on your variable-rate mortgage is going to be reviewed. Whether it goes up or down, you knew this could happen. While myLIFE can’t stop mortgage rates from evolving, we can try to explain the reasons for this change and how it might play out.

Since the beginning of summer 2022, and after years of little movement, the European Central Bank (ECB) has significantly changed its policy, with a substantial rise in interest rates. Faced with this situation, private individuals have been wondering about the impact this may have on their savings – and even more so on their loans. On the ground, banks are also adjusting their rates regularly, due both to the global economic environment and the ECB’s various announcements.

Based on what criteria?

Determining the rate on a mortgage isn’t easy. Many elements come into play, such as the overall economic environment, the personal circumstances of the borrower, the purpose of the loan, or the situation of the lender. In concrete terms, there are four major parameters to consider.

• • The refinancing cost, i.e. the rate at which your bank itself can borrow money from other financial institutions. This is very closely linked to the ECB’s key refinancing rate, as we’ll see later.
  • The risk assessment performed by the bank to evaluate the quality of the borrower. The future is uncertain and some client profiles are at greater risk of insolvency than others. The longer the term of the loan, the greater the risk for the bank.
  • The bank’s operating costs and profit margin. While banks want to serve their clients well, they also want to earn money to support their business and its growth.
  • The competition. Banks take into account the market in which they operate and the rates charged by competitors. The more competitive the market, the more the bank’s profit margin tends to decrease.

The longer the term of the loan, the greater the risk for the bank.

The refinancing cost

The refinancing cost is by far the most important element considered in setting the rate of your loan and it depends mainly on the ECB’s decisions regarding its key interest rates. The key interest rates are a powerful tool for directing the European economy and the ECB regularly adjusts them as the economic situation requires.

To stimulate an economic recovery, the ECB typically lowers rates in combination with other measures to increase the amount of money flowing through the economy. Lower rates reduce the cost of borrowing, thereby encouraging investment, and also reduce the return on savings, which encourages individuals to consume or invest their savings. Conversely, the ECB may raise rates to combat excessive inflation generated by increased consumption or a shortage of available resources.

In the case of home loans, the cost of refinancing varies depending on the type of rate chosen.

• • Fixed rates are essentially determined by the long-term rates prevailing on the interbank market in the euro zone. Once fixed, these rates do not change for the term of the loan. Based on our research, the total term of a fixed-rate home loan in Luxembourg may not exceed 30 years.
  • Variable rates are determined on the basis of interbank fixing against reference rates such as Euribor (1-month, 3-months or more). This is also the reference rate at which banks lend money to each other within the eurozone, but this time on a short-term basis. This rate is very much dependent on the ECB’s main refinancing operations (MRO) rate, i.e. the rate charged to banks that borrow money from the ECB. When ECB rates change, benchmarks such as Euribor follow suit and banks usually end up passing on all or part of this change to their clients.

When ECB rates change, banks usually end up passing on all or part of this change to their clients.

Risk assessment

Lending money always involves a risk of borrower insolvency. Your bank agrees to take on this risk in exchange for financial consideration expressed in your loan rate. This consideration is calculated based on your personal circumstances when taking out the loan. In addition to the term of the loan, it mainly takes into account two criteria.

• • The loan-to-value (LTV) ratio. This ratio simply shows how much of the property’s total value the loan represents. The larger your personal contribution, the lower the risk for the bank. In fact, thanks to your deposit and the first-rank mortgage on the property, the bank has a guarantee at the time of signing that the property is worth more than the amount it agrees to lend you. As a general rule, a deposit of at least 10% is required. A larger deposit may be required for a rental investment. A larger deposit may also lower your rate.
  • The debt-to-income ratio. The more your loan weighs on your budget, the greater the risk of insolvency, i.e. the inability to repay the loan over its entire term. This is why banks generally refuse loan applications where the repayments exceed 40% of income. This limit can be even lower if you have other outstanding debts. The bank will also pay particular attention to your “disposable income”, i.e. the resources still available to you each month after your monthly loan repayment. It is very difficult to live comfortably below a certain level of income and the bank will refuse to lend to you if this threshold is breached. Banks will determine your “disposable income” based on your personal circumstances (single, married, children, etc.) and their own criteria.

Your bank will pay attention to your “disposable income”, i.e. the resources still available to you each month after your monthly loan repayment.

When calculating your rate, banks also take other aspects into account. For example, borrowers can provide additional collateral, such as life insurance, home insurance, a savings plan, an investment portfolio, etc., which can be used as leverage when negotiating their mortgage rate.

What to remember

The ECB sets the MRO interbank rate, which essentially determines the rate on your home loan. For variable-rate mortgages, the amount of the monthly repayments will change throughout the term of the loan based on changes in interest rates. It is therefore essential to understand the advantages and disadvantages of the various loan options available before signing. If you’re considering a variable rate loan or wish to anticipate the impact of potential future rate rises, be sure to perform simulations with different rates in order to measure the impact of such changes on your monthly repayments.

Fixed-rate loans have a higher rate initially but offer the peace of mind of fixed monthly repayments throughout their term. Variable-rate loans are more attractive initially but by definition their rates change, which impacts your monthly repayments. Should this happen, avoid any hasty decisions and talk to your banker if necessary. Before you decide to pay back your loan or switch to a different loan type, bear in mind that there may be costs involved, with no guarantee of a better result over the long run. To find out more about loans in general and home loans in particular, visit our special “loans” section.