Housing Loans and Mortgages

Introduction

Housing is probably the single biggest purchase in any individual's or family's life. Most home buyers will need financial assistance to purchase their homes and that means long-term bank loans. It is essential clients fully understand every aspect of their housing loan, as it is a long-term financial commitment that affects their present and future financial position.

Housing loans are a special kind of long-term loan earmarked for the purchase of an apartment or house or to build new or reconstruct and upgrade existing housing. Housing loans normally take the form of mortgages and that is what we will concentrate on here (in this country, housing loans can also be personal loans unsecured by real property. For more information see Personal Loans).

A mortgage loan is a loan secured against real property by the use of a legal instrument called a mortgage. A home buyer or builder obtains financing (a loan) from a financial institution like a bank against either a new or an existing property. The mortgage relates to the pledging of the property as security or collateral for the loan. Once the debt has been paid off, all interest in the property reverts back to the owner. The mortgage is not the debt. It is the security. So, taking out a mortgage on a house means putting up the house as collateral for a loan being taken out.

The terms of mortgage loans, including amount, maturity, interest rate, payment dynamic, and so on, can vary considerably. Conditions also vary, depending on the type of property being mortgaged (primary residence, second home ...). In general, banks offer better terms for mortgage loans to buy a primary residence.

Mortgage

Mortages can be taken out on:

• Land (agriculture land, woodland, zoned and unzoned building land...),
• Apartment and office buildings,
• Apartments within a building,
• Family homes,
• Weekend homes,
• Business premises,
• Garages,
• Other buildings or facilities for which the borrower has clear title.

Mortgages can be for an entire property (i.e. an entire building or an apartment) or a partial interest in one (i.e. half or a third of a house, building, or apartment). The main precondition is that the property must be entered with the land registry. The bank, as lender, should check the property's legal ownership and economic value.

A bank will want to check the following important proof of ownership:

• Authentic ownership deeds from the public records office;
• Proof that the property is not already mortgaged (or if it is, priority of claims must be determined);
• Proof that the land registry records are in order and the bank can enter a lien on the property.

Since the property's value is an important factor in assessing risk, determining it is a key factor in mortgage lending. This can be done in various ways, the most common being appraisal by a licensed or court-registered professional. The associated costs will normally depend on the value and are usually borne by the client.

Appraised value depends on:

• Purpose and location,
• Type and age of construction,
• Quality of construction materials used,
• Usability and level of equipment,
• Availability of public utilities (roads, water, electric grid, gas installation etc.).

Once proof that all necessary legal arrangements have been made is submitted, the bank can make the loan funds available. Once the loan has been repaid, the mortage can be voided, with the bank providing documentation confirming repayment in full and the borrower requesting the court to expunge the mortgage.

Prepayment flexibility

Rules about early or extra payments should be checked. When allowed, prepayment can involve considerable savings on interest charges. Many borrowers prefer to shorten the loan period by using surplus savings or extra income for partial prepayments. Some banks restrict how much can be pre-paid, while others impose penalties. Prepayments in the early years are an extremely effective way of reducing interest charges.

Similarly, banks often penalize full prepayment of the loan. This is because when it grants a loan with a given term, the bank plans its cash flow on the basis of repayment over the period agreed. Early termination may disrupt the bank's plan. Penalties discourage such disruptions.

Loan agreement

The primary document for a housing loan is the loan agreement. A loan agreement is a contract between a client (borrower) and a bank (lender). It contains major provisions, like the terms, the principal sum, interest rates, currency, the interest rate to be applied in case of default, penalty charges and repayment terms. It also sets out the duties of borrower and lender and their rights and remedies in the event of default. The client should remember that the bank has a claim on their property until the loan is repaid. The client should ask the bank (and his or her lawyer) for explanations of major clauses and their implications.

Foreclosure

When a borrower does default, the bank can recover the outstanding amount by selling the mortgaged property. Execution of these provisions of the mortgage contract may be sought through the courts (judicial execution) or by agreement (non-judicial execution) with the defaulting client.

Judicial execution involves appointing an entity to sell the mortgaged property, so long as certain contractual conditions have been met, normally failure to pay off the loan in full.

Non-judicial execution means that the lender can offer the mortgaged property for sale via a notary, without court proceedings.

Downpayment

When funding a property purchase by mortgage, lenders usually require a downpayment, whereby the borrower puts up part of the cost of the property. This downpayment is often a percentage of the property's value (5%, 10% or 20%).

Loan tenure

Loan repayment periods can last up to 25 years or until the borrower reaches retirement age (65 years or less), whichever is shorter.

Creditworthiness

Creditworthines is the borrower's financial capacity to repay both the principal and interest on the loan. Monthly installments should not normally be more than half the gross monthly household income or combined salaries. Savings or bank deposits can be used to support a loan application and may be taken into account in evaluating eligibility. Different banks use different criteria to calculate repayment capacity, but all tend to use the central credit registry for information on how timely a client's previous loan repayments have been. For loans with a floating interest rate or in a foreign currency, monthly repayments can vary substantially with the interest and exchange rates.

The mortgage plays a major role in securing a loan, but is not the key to loan approval. Even a high-value mortgage cannot compensate for poor creditworthiness or financial problems. Loan approval based on the value of the mortgage alone may give rise to suspicion that the bank is primarily interested in taking possession of the property.

What security do banks ask for loan repayments?

Banks normally require the following (all or some of them) to secure their loans:

• Two creditworthy guarantors who are legally bound to pay off the debt if the borrower fails to
• A mortgage on a property whose estimated value is at least 1.5 times that of the loan (ie. the maximum possible loan for a property worth 150,000 KM is 100,000 KM)
• General risk property insurance for the full period of the loan with the bank as beneficiary
• Proof of salary assignment by the borrower and the guarantor(s) (with a notarized undertaking by the latter's bank, if not the same one), which allows automatic deduction of funds to an agreed level from their accounts in the case of default. A standing order is sometimes accepted in lieu of salary assignment
• A promisory note
• An agreement on seizure for borrower and guarantors
• A life insurance policy on the borrower, with the bank as beneficiary

Rights and duties

Both borrowers and bank have certain rights and duties over the life of the loan.

The borrower's rights are:

• Acccess to all information relevant to the decision to borrow
• To be treated professionally and without prejudice
• To be consulted on changes to the terms and conditions of the loan
• To legal action in the event of a breach of contract

The bank's rights are:

• To full relevant disclosure of the borrower's credit status
• To correct and truthful information on the borrower
• To timely repayment of the loan
• To legal action in the event of default or breach of contract

The borrower's duties are:

• To read and understand the terms and conditions
• To observe the terms and conditions of the loan at all times
• To seek clarification of all aspects of the loan
• To make prompt payment of fees, charges, interest and loan instalments

The bank's duties are:

• To ensure the borrower understands all the obligations set out in the loan agreement
• To consult the borrower of any changes to the terms and conditions, fees charged and other relevant information
• To respond to all queries made by the borrower

A loan officer's help can be invaluable in clarifying issues the borrower is unsure about. Discussing questions at length with a loan officer can be very helpful in choosing the right loan facility for the borrower

Interest rates

The interest rate is the "price" banks charge for loans. Interest is calculated as a percentage (or rate) on the outstanding principal. Banks can set whatever interest rate they want, but tend to reduce it if the borrrower's financial position is good, for good collateral, and when the amount is well below the nominal value of the mortgaged property. The interest rate can be fixed or variable, depending on whether it will remain constant over the life of the loan.

Loans with variable interest rates have rates that vary according to reference interest rates through the loan period. Variable means that the interest rate changes continuously. This makes loan payments more difficult to predict and manage. The variable interest rate is usually calculated as the sum of a variable benchmark index (like the Euribor or Libor) and a constant marginal percentage.

The interest rate on a loan might thus be refered to as the Euribor (the rate at which banks buy and sell money to each other in the Euro area) plus one point. That means that over the life of the loan the borrower will pay a rate of interest equivalent to the rate of the Euribor (the variable component) at the time of each revision plus one percent (the fixed component).

With a variable interest rate, the borrower carries the interest rate risk, as any change in the reference rate affects the loan interest rate and the monthly instalment. The bank adjusts the variable interest rate to the reference interest rate in accordance with its business policies. The reference interest rate (Euribor or Libor) may change drastically during the life of the loan and borrowers should know that these changes are unpredictable. Before signing a loan contract the borrower should find out the current level of the reference interest rate (Euribor or Libor) and investigate expectations regarding future movements.

The following table shows end-of-quarter data for the 3-month Euribor over the last 5 years:

Data are for illustrative purposes. For actual data consult official Euribor sources.

During this five year period, the Euribor fluctuated between 4.96% and 0.66%, suggesting that potential borrowers would have difficulty predicting swings at whatever point they entered on their loan contract.

To sum up, the amount of future repayments may change up or down, following the movement of an index or benchmark interest rate (at the agreed times of revision). Some banks limit upward and/or downward variations in the interest rates they charge in the case of sharp fluctuations in the benchmark interest rates.

The bank must inform the customer of new rates due to any changes in the benchmark and borrowers should take due notice of rate changes. Offers with a low initial interest rate should be treated with caution, as they are normally valid for a short time only (usually 6 months to a year), after which the reference rate (benchmark index) plus margin will come into force.

Fixed rate loans are locked in at an interest rate that is set for the entire term of the mortgage, which will typically be between 15 and 30 years. The term fixed means that the interest rate remains the same throughout the loan repayment period. The borrower knows from the beginning the total amount of interest to be paid. The main advantage of a fixed rate mortgage is that borrowers can accurately predict repayment amounts. If the interest rates are low, a fixed rate loan is a good option, because the loan will be locked in at a lower interest rate

Since there is no risk of increased cost of borrowing, fixed rates are usually higher than the variable ones on offer at time of contract. Fixed-rate mortgages are also usually much shorter than variable rate ones.

The effective interest rate (EKS) incorporates all the costs of a loan and so makes for easier comparison between banks. All banks are obliged to post the effective rate along with the nominal rate. The effective interest rate comprises the nominal interest rate (variable or fixed) and the other costs and fees borrowers have to pay before the loan is approved. Some costs are not included in the effective interest rate (like appraisal of property, fees for certificates from other institutions, etc.) and the borrower should ask the credit officer about them. It is worth mentioning that effective interest rates are only comparable for loans in the same currency.

Foreign currency and indexed loans

Foreign currency loans are loans contracted in a currency other than the local one. Indexed loans or loans with a foreign currency clause are loans where the total debt and installments are denominated in foreign currency (i.e. Swiss franc, American dollar, etc.) and are practically identical to foreign currency loans in terms of repayment. Each installment is converted into domestic currency at the exchange rate of the day. Borrowers should be aware that these loans entail foreign exchange risk. If a borrower takes a loan of 10000 Swiss francs, the bank will issue them the equivalent of 10000 Swiss francs in KM using the exchange rate of the day. Repayment installments will first be denominated in Swiss francs (say 200 francs) and then converted into KM at the exchange rate on the day. Any fluctuation in the exchange rate between the domestic and the contracted currency has a direct impact on repayment.

Loans with a foreign currency clause may seem very attractive due to the low interest rate at the time of contract. Such loans do not always prove cheaper or more convenient for borrowers, as there may be very pronounced and unpredictable variation in the exchange rate. The current crises have left large numbers of borrowers in Central Europe (especially Hungary) in trouble over serious increases in their repayments, as foreign currencies have appreciated against their domestic currencies. Some borrowers in this country have also experienced problems repaying loans indexed to the Swiss franc due to its sharp appreciation.

The best option for borrowers is to borrow in the same currency as they earn their income in. If borrowers want (or are forced) to borrow in a foreign currency, they should be aware that the repayment amount will depend heavily on both the exchange rate and the reference interest rate.