Multi-layered mortgage loans with various durations

Author : Kristen

Multi-layered mortgage loans with various durations

Once mortgage financing is obtained, the future owner will be faced with the question of interest-rates. Again, the most common possibilites are variable rates, the LIBOR, and fixed rates.

If the variable rate is barely used, the LIBOR could replace it. This rate is offered by most financial institutions. The LIBOR has the following advantages: transparency (published rate + bank margin = client rate), reimbursement flexibility, and a current cost that is close to zero. Its disadvantages are the insecurity and fluxuations in bank rent given that the interest terms are generally modified every 3 months.

Fixed rates are, in themselves, much more secure, given that they do not vary based on the chosen duration. However, they do not offer much flexibility since the loan can be neither partially nor completely reimbused without incurring fees and penalties.

Choosing to integrate the LIBOR into the mortgage loan could be a good option for investment properties when perceived rents allow for a margin of increase in interest fees or for personal residences when the debtor's credit standing authorises significant budget fluctuations.

By applying a fixed rate to the mortgage loan, you gain the comfort of a protected rent that does not change with time. However, the unknown factors of renewal rates should also be taken into consideration since, in the case of significant increase at the time of expiration, the difference could put the financial ressources of the owner at risk.

In order to qualify the disadvantages of one system or another, the financial institutions often suggest that you put together different types of rates and durations, thus spreading the loan out in different layers. Generally, it is advisable to sucure 50-60% of the loan over a long period and then to opt for the mid-range and short durations, or even keep the LIBOR balance.

In doing so, you gain a certain flexibility because at the expiration of each layer of the mortgage, you can revisit your financing strategy and pay back a part of your debt. Also, the average rate of the loan is lower since the short durations are less "expensive" that the long durations.

Consider the example below for a mortgage loan of CHF 1,000,000:

Scenario 1

A layer with a fixed duration of 10 years at 1.80%

  CHF 1,000,000
Interest CHF 1,000,000 x 1.80% = CHF 18,000

Scenario 2

Layer 1 with a fixed duration of 10 years at 1.80%   CHF 6,000,000
Layer 2 with a fixed duration of 5 years at 1.30%   CHF 300,000
Layer 3 in LIBOR at 1,00 %   CHF 100,000
Interest from layer 1 CHF 600,000 x 1.80% = CHF 10,800
Interest from layer 2 CHF 300,000 x 1.30% = CHF 3,900
Interest from layer 3 CHF 100,000 x 1,00% = CHF 1,000
Total annual cost   CHF 15,700
Average annual rate of   1.57%

Though there are many advantages of the multi-layer system, the disadvantage is that the debtor becomes prisoner to the bank. Indeed, when the moment comes to renegotiate with the expiration of the first layer, no banks will be inclined to offer less favourable terms since the client does not have the possibility to turn to the competition. The client must stay in the same institution until the end of the longest layer of the loan.

In order to avoid disagreements, it is essential to know the bank margins derived from the "rating" applied to the file. This margin should not change, except if the financial situation suffers or if the property loses value. With this said, a modification of the credit policy of the creditor could also lead to more advantageous rate terms upon negotiation.

In conclusion, there is no model that applies to every new owner. It is up to the client to weigh the positives and negatives of each formula, to anticipate his or her future personal situation and to choose the solution best adapted to potential risks and the pursuit of comfort and security.

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