When discussing mortgages, or any loan in Israel inevitably the subject of a madad-linked loan or Tzamud L’Madad comes up. Readers of Bizness Magazine know it is not my favorite types of loans (although there are times when it is appropriate to use) but I felt the time had come to explain what it is and how it works. Madad is the official index in English know as the Consumer Price index or CPI, which is one of the ways to measure inflation.
Simply put, when you repay your loan it is based on a loan agreement. That loan agreement sets the terms how and when the money you borrowed needs to be repaid. Included in those terms is the amount of money in addition to the original amount borrowed or “principle” needs to be repaid most. In many loans this additional amount is what is referred to as the interest some time in addition to the interest there are fees and sometimes like in our case of a Tzamud L’Madad loan there is a charge that looks a like interest.
So even though the inflation rate (or CPI) is expressed as a percentage just like the interest rate is it is treated differently like an fee or charge. Many years ago in the US, an interest rate on a mortgage could be quoted with an additional charge called “discount points”. For example, the lender would offer a borrower a mortgage of $10,000 (shows how long ago I am referring to) at 5% annual interest rate for 5 years, with 5 discount points (1 discount point equals one percent of the amount borrowed) so when the borrower received the loan instead of the full $10,000 they received $9,500 the $500, that is the 5% discounted ( deducted) up front. So on one hand the loan was advertised as having an annual interest rate of 5%, but over the course of the loan the borrower effectively paid a higher interest rate especially if it was paid off early. For example, if the paid this loan off after one year they paid the 5% interest plus the discount points so the effective interest they paid was approximately 10%. Legislation was introduced (in 1968, and has evolved many time since then) which was called interestingly enough “Truth in Lending” which required the lender to show the borrower something called an Annual Percentage Rate or APR which is what it is costing the borrower in total (defining that word has been the cause for many changes over the past 46 years) expressed as an interest rate. So if before they quoted a 5 years loan at an interest rate of 5% with 5 points after the law they needed to write next to that that an APR of 6%.
Benjamin Franklin is often credited with the quote “Time is Money” and while that has many meanings, when dealing with the value of money or paying back a loan it has very practical implications for example, a shekel today is worth more then a Shekel you are due to get in 20 years because of inflation. In addition the difference between the principle you have already paid back to the lender and your existing the principle balance (i.e. principle not yet repaid to the lender) is the existing the principle balance is generating interest owed to the lender. Now if for whatever reason that interest is not paid, then it generates more interest owed to the lender.
When discussing mortgages amortization usually refers to the period the principle is being returned based on that particular payment schedule e.g a a $10,000 @ a 5% annual interest rate will have a $189 monthly payment each monthly payment is allocated partially to interest and partially to principal. Fully amortized means at the end of the 5 years loan period will be fully paid. To illustrate see the first three months of payments in the $10,000 loan we have discussed
What if in month one the monthly payment made (the amount in the Payment Column) was not enough to pay the Interest column, so that not only is the principle not paid but there is interest left owing, which means the amount in the Balance column would increase instead of decrease. This is referred to as a Negatively Amortized loan
Dear reader (if you are still awake) although this is tedious and your eyes are rolling (assuming they are still open) , please understand I left out so much detail that the financial professionals reading this are rolling their eyes saying why didn’t you mention X. I did not meant this to be a comprehensive lesson I wanted to give you context so I can explain the following.
When you take out a loan that is linked to The Madad. The effective interest rate is not the one that is quoted in your loan agreement or commitment (Ishure Ekroni) it is that interest plus additional charges based on CPI linkage. for simplicity sake let’s say over the course of a year there was 2% inflation your “interest” rate in the loan agreement is 3% your effective interest rate would be approximately 5% (a bit more actually) In addition since the principle is also linked to the CPI your monthly payment is not enough to pay that off the result is the principle is increasing for years. Yes it is all a bit confusing but just remember that Fixed Rate Tzamud L’Madad mortgage you are being offered has an effective interest rate that adjusts often and can look a lot different than the one quoted.
Moshe Wilshinsky is the CEO of Moville Mortgage & Finance Ltd. Contact information: Israel: Dial: 073-796-2226 and then press the special 711 Bizness Magazine extension. In the U.S., dial: 201-377-3418; in the U.K., dial 208-596-4501. Website is at: www.movillefinance.com