Mortgage rates continue to be at very low levels. The average interest rate is around 1.5 percent and some of you out there have also managed to get lower interest rates than that.
The interest rate is thus a fairly small part of the housing cost at present. Nevertheless, the banks run with much higher interest rates when they figure out if you can borrow, which can limit how much you can borrow and how expensive housing you can afford to buy.
What is the interest rate and when is it used?
When you want to take out a mortgage, the bank makes some calculations on your finances based on the price of your home, your income and expenses and the cost of the loan to make sure you have an economy strong enough to manage to borrow so much money (and to repay them). The idea is, in principle, to see how much you can borrow the most from your circumstances without having problems with the payments to the bank.
When you apply for a loan promise, these calculations are made and you find out how much you can borrow. Since a normal mortgage loan lends up to 85% of the value / price of the home, you can be granted a loan promise of USD 3,400,000 for a purchase of about 4 million. Of course, it is then also required that you have USD 600,000 to put in cash yourself, but if we expect you to do so, it is basically how it works.
To calculate how much you and your finances can manage, you calculate the cost of the loan in relation to a certain loan amount. So if, for example, you would like to borrow USD 3,400,000, the bank calculates the interest cost plus how much you repay each month (for new mortgages, you must repay at least 2% until you reach a lower mortgage rate) to see if there is a reasonable amount remaining to live on, based on what you have to dispose of in a normal month.
When calculating the interest rate
However, you do not expect 1.5 percent or something, even though the average interest rate is around there today. Instead, one calculates an interest rate that is supposed to have good margins for the future, for interest rate increases and some extra buffer. Many banks expect a discount rate of up to 7 percent. This means that the interest rate that you must manage is about 5.5 points higher than what you currently need to manage. But the banks want to be on the safe side.
The idea is that you should always have a certain amount of money left over to live on when you have paid in housing costs and the like. So that you can afford food and anything else needed. Exactly what amount the bank thinks is reasonable can vary but they get this figure by taking your or your wages after tax and deducting the expenses for the mortgage loan etc.
The bank is thinking ahead and knows that there will be interest rate hikes and that one should have good margins in their finances and therefore they are drawing on an interest rate that is clearly higher than the current average interest rate. However, 7 percent is still a high interest rate and if you want to borrow USD 3,400,000, with just the interest rate, there will be a monthly cost of USD 19,833.
Excessively high interest rates?
I clearly understand that the banks want to expect a calculation rate that is higher than the interest rates (and even better the average rates). Especially in these times when interest rates are historically low and we know that higher interest rates will come in the future. Having a higher interest rate when doing their calculations is logical to make sure that people do not have financial problems when the interest rate goes up a bit.
In 2008, the interest rate was up around 6 percent, so it’s not that long since it was a completely different interest rate situation. Many may not remember this anymore or were so young that they were not affected by it at that time. However, it clearly shows that 7 percent is not a fantasy interest but something that has happened and that could happen again in the future.