Consumer inflation figures are out and they are not pretty. Inflation has risen 4.2% in Israel over the last 12 months-way above the Bank of Israel’s comfort range of 1-3%. The news is prompting many analysts to raise their forecasts for short-term interest rates. Forecasters now predict the BOI Prime rate will jump to 5.5% by year’s end and 6.5% by YE 2012. With the overwhelming majority of Israeli homeowners’ mortgages tied to the prime rate or inflation, what can homeowners in Israel do to protect themselves?
The nature of the problem: “Fixed rates at 3.5%? Sign me up! “
A popular mortgage loan product in Israel over the years has been fixed, linked to madad loans. These loans feature low fixed interest rates and as a result, low initial monthly payments with one caveat- the balance of the loan is linked to madad, or the inflation rate. As an example: If the inflation rate rises 4.2% in a given year, so will the borrower’s balance; despite the fact that the borrower has been making payments on time and did not borrow any additional money. Now, inflation in Israel has risen in all but one in the last 30 years, so borrowers who took madad-linked loans should have assumed their payments would start out low (due to the low interest rate) and rise throughout the loan term. This rise in monthly payments is due to the borrower’s principal payments being offset by the rise in inflation, thereby causing the need to amortize a higher balance in the remaining term of the loan than if the loan was not linked to inflation. Most borrowers do not realize that the combination of paying a 3.5% fixed interest rate and an average of 4.2% inflation rate is effectively equivalent to a 10.14% per annum interest rate over a 30-year term.
The best loan for you (if you are a bank)
You may be wondering, why would anyone choose a madad-linked loan and how would anyone ever be able to convince a customer to take one? The answer is: they don’t need to. Many borrowers convince themselves. When inquiring about mortgages, unknowing banking customers receive offers from “their” bank, which may seem very attractive. These offers are targeted at making the consumer feel he/she can afford the new house with a fairly low monthly payment. Interest rates are quoted as “3.5% fixed for 20 years”. What is often not stressed is that the borrower’s balance is linked to madad, which will cause the effective interest rate to be much higher. Consumers choose madad loans because they often carry the lowest initial monthly payment obtainable. Some aggressive lenders will even offer 40-year loan terms only on Madad linked loan products. Banks prefer to sell madad linked loan products for many reasons. Firstly, they are hedged against inflation- this means that the bank has essentially no risk in terms of the value of their outstanding loans depreciating. Second, linked loans carry a very low default risk because payments are rising gradually-especially in the first 10 years of the loan term. If an adjustable rate loan such as Prime adjusts upward by 2-3%, the monthly payments on the loan will rise much more than on a madad linked loan, even assuming a substantial inflation rate. The “payment shock” that the borrower will have to absorb on an adjustable Prime linked loan will be much more straining than on the inflation-linked loan. In a model showing a rapid 3% rise in interest rates to combat an elevated 6% annual inflation rate, the madad-linked loan’s monthly payment takes almost 7 years to catch up to that of the Prime loan. Despite the fact that the madad linked borrower paying a 3.5% fixed interest rate pays an effective 14.46% per annum over the life of the loan, the lack of payment shock in the first 10 years makes the risk of a borrower default much less likely.
One long-term solution available to borrowers is the fixed-unlinked loan or traditional fixed rate loan known in many countries simply as a 10, 15, 20 or 30 year fixed. These loans carry much less risk than any other product and are currently available at reasonable interest rates from a select number of Israeli banks. Borrowers need to be able to come up with larger monthly payments initially, however, the savings can be huge in the long run. Home-affordability is best measured via a true fixed loan and when planning long-term, should not be measured assuming one can afford a prime or madad-linked loan. Bankers will retort that a borrower’s income is likely to rise in tandem with inflation, thereby offsetting their risk. However, ideally, homeowners should have their incomes rising while their monthly payments stay the same.