I was going to title this article “Why you should be more interested in the type of interest rate than the rate of your interest rate” but while it properly described the subject of the article it was too long of a title, so here I am opening it with it. I am often asked about getting the best “Interest Rate” and over the three decades I have been involved in this industry I always answer the same you thing, first you should make sure you have the best Type of interest rate.
In the simplest terms there are two types of interest rates, Fixed and Adjustable. Simply put a fixed rate loan is, well fixed meaning the interest rate doesn’t change(for the “fix” period of time, and adjustable rate loan “Adjusts” based on a Index rate plus additional interest that is referred to as a “Margin” adding the two together is the interest rate charged on the loan. While everyone understands the general idea it is important to understand what ramifications are of each type of loan.
The easiest way to understand these ramifications is by comparing two extremes, so we will as our Adjustable loan a loan based the Prime Interest Rate (as set by Bank of Israel) or “Prime” and as our Fixed a Thirty year fixed rate, Nominal rate of course meaning it is not linked to the Madad. The Adjustable rate loan (in NIS) based on the Bank Prime Rate can adjust whenever the Bank of Israel changes the Prime Rate index, the frequency or degree of those changes are anybody’s guess. Whenever the interest on the loan increases your cost of money increases and so do your payments.
You can think of it as rent you are paying on your money, in the analogy the monthly rent is not set up front but is determined in the future. So with the adjustable loan you do not know what your payment may be in the future or how much the money will cost you.
To understand the fixed rate loan, we will use a fixed rate loan that is fixed for thirty years in NIS (Fixed in Nominal terms e.g. not linked to the Madad) with this loan you know your first payment and your last payment, your payment and the cost of your loan never changes.
Those are the two extreme cases; there are many variations in between. There are loans with interest rates fixed for Five years (again in NIS in Nominal terms, not linked to the Madad). In foreign currency loans there are LIBOR Based loans in Israel these are most commonly with interest rates that can change at three month, six month, one year or five year intervals. Then for those of you who have read my previous articles one of my frequent subjects is how “Fixed” Madad indexed loans, aren’t. in that with this fixed rate loan unlike the other fixed rate loan we discussed, your Nominal (what it is actually costing you) can change, yes in other words the Madad loan is a fixed rate loan that adjusts. To be fair a fixed rate NIS loan linked to Dollars will have a payment (and thereby interest rate) that adjusts in NIS terms but the whole reason to get a US $ linked loan is because you are worried about the cost in US$ not NIS. I believe it is easier to understand Madad loans if you think of as an adjustable rate loan, the loans index being inflation and the interest rate stated on your loan as the margin. Another unique attribute of these loans is they give you a payment that is not fully covering what you owe that is why after paying a loan for ten years people find they own the same or even more. This is because the loan payment is increased by the rate of inflation but not recalculated by the principles increase based on inflation.
Once you have get beyond the other issues we have discussed in previous article regarding a borrowers qualifications, and loan to value ratios, the key factors that determines the interest rate are currency, the number of years (Term) the interest rate is fixed for and the number of years (Term). In today’s economy long term rates are higher than short term all though because we are in a such a low interest rate economy the difference between a the longest fixed rate thirty years and a five year fixed rate is not that far apart.
There are many reasons why someone chooses one type of loan over another and sometimes a borrower will only qualify for particular type of loan. We work with our clients to make sure they understand what their options are and on what basis they should make choose and the ramifications to those choices. So remember when you are when comparing rates be careful not to compare apples to oranges and in any case make sure you understand what you are biting into.
Moshe Wilshinsky is the CEO of Moville Mortgage & Finance LTD. Contact information: Dial 073 796 2226 and press the special 711 Bizness Magazine extension. U.S.: 201 377 3418; UK: 208 596 4501. Website at www.movillefinance.com