Those who have the audacity to buy a home at this time should think twice. The foreseeable increase in interest rates in July, announced by the president of the European Central Bank (ECB), Christine Lagarde, is already generating real problems in the mortgage market. And it is that the already high expenses of electricity, gasoline and the shopping basket are now joined by the increase in the cost of mortgages, which will directly affect the disposable income of households. If in 2021 we allocated 37% of the family budget to paying for housing (according to the OECD), now that percentage will rise even more. Under this scenario, it will be an impossible mission for a family not only to save but to make ends meet.
But why does this happen? Why is the Central Bank raising rates now when we are coming out of a pandemic that has left the world economy so shaken? The professor of Economics at the European University of the Canary Islands, Francisco Concepción, explains it very clearly. “We are at a time of obvious inflationary tension and what monetary policy is trying to do, said in a colloquial way, is to cool down this situation, that is, the cost of financing is raised so that consumption and investment are slowed down”. It must also be taken into account that part of this inflation is fueled by the ultra-expansive monetary policy of recent years, where interest rates were at zero and even negative.
Since the 2008 crisis, banking has lived in a situation where its main business, that is, borrowing money to lend it more expensively, was pushed to the limit by the ECB’s economic policy, which lowered interest rates to try to make money flow. which in turn penalized the income statement of financial entities. “Now in a period of high inflation like the one we are in, monetary policy has no room for action,” explains Concepción. The consumer retracts because loans become more expensive, and, on the other hand, by raising rates “hyper-indebted governments will have a serious budget problem because they will not be able to reduce their spending policy.” Therefore, the effects of the return to “monetary orthodoxy will be very harsh”, because on the fiscal policy side, very large budgetary problems will be generated in heavily indebted economies that, moreover, will not be able to refinance. “If you are from a country like Spain that, on a recurring and chronic basis, spends more than you earn and you ask for a loan to make up that difference, two things can happen to you: either you do not find someone to finance you or, if you find one, you will finance more expensive because your risk profile is different. And in the end, who pays for it? Well, the usual ones, the citizens”, she clarified.
This situation was going to be normalized a couple of years ago, but the pandemic arrived and the rate hike lasted longer. Now it is real and the banks have begun to reorganize their commercial strategy by modifying their spreads and betting on variable rate mortgages. When rates were negative, financial institutions turned to fixed-rate mortgages. In fact, according to data from the Bank of Spain, in January these accounted for 70% of home loans. With a rise in rates, it is logical that variable-rate mortgages increase.
Which is better or worse? “Well, there are many nuances,” says Concepción. “The first years, depending on the duration of the mortgage, are enormously expensive because what you pay is all interest, that is, in those first years you are barely repaying what they have lent you.” In this situation you can fall into what Concepción calls “a financial illusion”, because you think that you pay little interest and that you are amortizing your home and it is not like that. The main difference between a fixed and a variable mortgage has to do with its interest: with a fixed-rate loan you will always be charged the same interest rate, while a variable-rate one will change over time, which will that your quota also goes up or down.
But Concepción highlights an important issue. The financial culture. “In Spain it is lacking and it is very relevant, especially when it comes to deciding issues like these. When a family decides to buy a home, it is recommended that they do not allocate more than 40% of their net income to it and not leave for more than 25 years”. Concepción gives an example: When you sign a 20-year mortgage, you will have paid for your house for three. “That is why it is a financial illusion that you say: I bought the house for 150,000 euros and sold it for 250,000! I have won 100,000 euros”.
Practical example
To give us an idea of how a rate hike could affect us next July, Concepción gave a practical example. An average mortgage of 120,000 euros over 25 years with a 0% rate would pay 400 euros per month. If we raise the interest rate to 1% (which is the forecast of the European Central Bank), the installment would rise to 452.25 euros. Therefore 52.25 euros more for 12 months, would be 627 euros more per year. A figure that will disrupt some family economies. In this sense, it is time to prioritize. “There will be families that have no margin, but those that do will have to try to eliminate from other expenses those 52 euros more per month that the household income will have to support. To give an example: HBO, Netflix, the club fee… What cannot be is that they continue with the same expenses in a tight economy. And that is where Concepción insists on the importance of a good financial culture that, in other European countries, is taught in the classroom. And he gave another example: “Families spend much more time buying a television or a mobile, comparing prices, searching the internet and going to different stores for a good that has a residual value, than a mortgage whose value is evident.”
In this sense, he insisted that when there is no financial culture, many setbacks are faced. “There is talk that many households have no room to deal with a setback, such as a car breakdown, for example. There will be many families that have no room for savings, but there are others that have made choices, such as, for example, buying a 1,000-euro TV or taking a trip that they have financed, abandoning the possibility of saving. In these cases, we can’t complain later and say that the family budget doesn’t come and I can’t afford to fix the car because, at a certain moment, you took that option”.
Concepción, furthermore, is blunt on one issue: “The subsidy will never lift a family out of poverty; employment will do it” and she sent a message to politicians: “what gives votes is an efficient spending policy, because when you cut, you don’t cut spending, what you cut is waste”, she clarified. In this sense, she recommended that families calculate their fixed expenses. “I calculate what my monthly fixed expenses are: mortgage, electricity, water, children’s school, car bill… and I can even add 10% to that calculation for leisure, how to go out to dinner or eat, etc. Let’s take as an example that they add up to 500 euros per month. Well, we know that a year we have to have sections and without touching 6,000 euros. Then I live day to day, but I know I don’t touch that. Why? Well, because I know that the day my car breaks down, I can afford it without having to cut back on fixed costs”.
“Saving is like diets,” he explained. “When I start losing weight and I give up chocolate, sweets and everything I like, I have a really bad time, until I see the results. When I look slimmer, it’s easier for me to give that up. Well, saving is the same. There is a lot of psychology in financial policy,” she added. “Why would I save for retirement if I still have 30 years to go? The reality is that people live wrapped in a monetary illusion that generates enormous problems.
The problem is that not only mortgages are becoming more expensive, but also the interest on consumer loans. Concepción explains that everything related to consumer finance is “doubly expensive”, due to the financial cost and the obsolescence and residual value of what you are buying. “It’s a double loss, people don’t see it but financially it’s a mistake.” “People do not realize that when they ask for a loan to buy a TV, they are left with paying 50 euros a month for 6 years, but of those 50, 2 euros are for the TV and 48 are for interest when the TV loses its value. ”.
According to the Bank of Spain, the rate hike will subtract four tenths of GDP for the payment of interest on the debt. An increase of 1% would entail an increase in interest payments of four tenths of GDP in 2024. Specifically, it estimates that the proportion of families and companies with debt that would have a high net financial burden will increase considerably. In the end, banks face this rise in rates optimistically after several years at zero rates, while families, starting in the summer, will begin to notice a deterioration in their income.
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