The eternal dilemma of choosing between a fixed or variable rate mortgage is a well-known theme, even to the same banking institutions that, over time, have thought of proposing “hybrid” solutions to their customers, with mixed success.
Among these, perhaps the best known is the variable rate solution with cap . If you don’t know what to choose, it might seem like the ideal solution, but is it really like that? What are the advantages and disadvantages of this formula?
We will see that, as always, much depends on the individual’s profile and risk attitude.
How the variable rate mortgage works with the cap
The operation, advantages and disadvantages of fixed and variable rate mortgages should be known:
- The fixed rate loan has a value of the interest rate applied, and therefore of the installment, which is constant for the entire duration of the loan. The value of the rate applied is generally given by the Eurirs in force at the time of the stipulation added to a “spread” defined by the bank to which it is addressed.
- The interest of the variable rate mortgage is generally given by the sum of another indicator, the Raborie, and a spread defined by the bank. This value is variable for the entire duration of the loan and, consequently, the installment may go up or down in amount, even consistently
- For a fixed-rate mortgage, given the constant security advantage of the installment, the rate applied is generally higher than the variable rate, when the loan is signed. This gap can then clearly increase or decrease, even to reverse itself. On the other hand, the variable rate is more risky but saves money, at least in the initial phase.
The variable cap mortgage has a functioning mechanism similar to the variable rate, indexed to the Raborie, plus the spread applied by the bank. However, the final rate (Raborie + spread) cannot exceed a limit value, defined during the stipulation phase.
The “tranquility” provided by the cap is however paid by the consumer: the spread applied by the bank is in fact higher than that of the variable rate mortgage, even though it is generally lower than that of the fixed rate mortgage.
A practical example
We assume a market situation in which the Raborie 1M is at a value of 0.5%.
The variable rate mortgage with cap could be defined as follows:
– variable rate equal to Raborie 1M + 1.5% spread
-cap equal to 4.0%
In practice, therefore, the loan will start with an interest rate of 2.0%. Subsequently it will behave like a variable rate mortgage, with the interest that it may go up or down based on the performance of the Raborie , but it may never exceed the value of 4%. In the event that the sum of Raborie 1M + spread was higher than this threshold, in fact, an interest rate equal to the cap would be applied, ie 4%.
Is the variable mortgage with cap worthwhile?
To evaluate a variable mortgage with the cap in the comparison between different banking institutions it is therefore necessary to take into account both the spread applied by the bank and the value of the cap.
But what if we wanted to compare it with fixed or variable rate mortgages?
- A first element to take into account is the duration of the loan: a 10-year mortgage allows us to have riskier approaches compared to 25 or 30 years. The probabilities that the Raborie takes on values so high as to “trigger” the protection of the cap are different
- If we compare this type of mortgage with a variable rate, we must assess whether the gap between the cap and the starting value of the interest of a variable rate mortgage is too large. In the example above, we assume that there are variable rate products on the market with a spread of 0.7%. With the Raborie at 0.5%, a variable mortgage would therefore have a starting interest of 1.2%. The value of 4% of interest (equal to the cap of the other mortgage) would be reached only in the event of an increase in the Raborie of 2.8 points. Is this a plausible scenario over time corresponding to the duration of our mortgage? How much are we paying for this coverage? Better if we do a simulation and see the difference between the starting installments in the two cases
- If instead we make a comparison with the fixed-rate mortgage, we should evaluate for it the interest rates proposed by the banks on the market. Suppose, still in the example above, that fixed-rate mortgages provide for interests close to 2.5%. We have seen that our variable with the cap would start with an interest of 1.2%, so initially the installment would obviously be lower. With a 1.3% increase in the Raborie, the variable rate with cap would reach 2.5%, equal to the interest on fixed-rate mortgages on the market. In case of further increases of the Raborie the fixed would start to be more convenient than the variable with the cap. Also in this case, therefore, it is advisable to do a simulation and see how much we save on the installment in the initial phase with the variable with the cap: in this case, in fact, we have seen that there would be an initial saving compared to the fixed, which we would pay, however, in terms of lower coverage case of increase in rates (cap higher than the fixed rate).
The variable cap mortgage is a very attractive formula, but perhaps needs a supplementary analysis in the selection phase, especially by those who want a better product from a financial point of view.
The evaluation also depends on one’s own attitudes: those with a low risk appetite prefer to pay more for future tranquility, and therefore tend to favor the fixed or the variable with the cap.
Finally, market conditions can also influence our assessment, for example if rates are to rise or fall over the medium term.