So, you’ve successfully traversed the application process and have been approved by the bank. One of the first major issues that you will have to ponder is the question of what product or blend of mortgage products is best suited for your particular situation. In this article, I’d like to review the main products that are available and the pros and cons of each.
In accordance with Bank of Israel regulations, Israeli citizens are required to take at least 33% of their mortgage as a fixed rate, but a) there is no limit on the amount of the loan that can be fixed, and b) the other 2/3 can be a mix and match of any of the other mortgage products. Here is a review of all the major mortgage products that are available.
The mortgage products that are available fall into four basic categories;
- Fixed Rates
- Prime based Rates
- Adjustable Rates
- Foreign currency products
Furthermore, any of the above categories, save for foreign currency, may be linked to inflation, whereby the principal balance is adjusted monthly based on the change in the inflation index.
A fixed product is a mortgage whereby the annual percentage rate of interest is fixed at the time of funding the mortgage and will remain the same until the final payment is made. The payment schedule is also set upon the funding of the mortgage and will remain unchanged throughout the entire term of the mortgage.
The main benefit of fixed products as that they afford the borrower peace of mind with regard to possible future increases in interest rates. When interest rates are relatively low, it allows you to fix the rate and you will not be subject to higher interest rates no matter what happens to interest rates in the future.
Interest rates on fixed products are generally higher than Prime based or adjustable rates at the time of funding. For instance, while Prime rates may start at around 1.4% and adjustable rates at around 2.5%, fixed rates may be 3% – 4%. This higher rate will impact expected monthly payments which, in turn, could impact the amount for which a borrower may qualify (see part 1 in the series which explains how approvals are related to expected monthly payments).
In the event interest rates fall after the mortgage funds, while Prime based/adjustable rates will follow – fixed rates will not. This is coupled with the fact that most fixed rate products are subject to prepayment penalties, making it less attractive to refinance a mortgage in order to take advantage of lower interest rates. We will discuss prepayment penalties in greater detail below.
Prime Based Rates
A prime based mortgage is an adjustable rate that is linked to the Israel Prime Rate published by the Bank of Israel. It is published monthly and can change from month to month.
The effective rate on Prime based products is often the lowest rate available. This is, in part, due to the fact that the rate can change monthly – therefore minimizing the bank’s risk of fluctuating interest rates.
The Prime Rate has been relatively stable. Even though it can potentially change from month-to-month, between Sept of 2014 and January of 2021, the rate has not risen above 1.75% and not fallen below 1.60%
Prime based mortgages are not subject to prepayment penalties.
While the bank’s risk of fluctuating interest rates is lowered, the converse is that the borrower’s risk is increased.
An adjustable rate product is a mortgage that is pegged to an index, and re-adjusts at regular intervals. As an example, an adjustable product might be linked to the 5 year bond plus a spread of + 1.50%, re-adjusting every 5 years. Let’s say that the bond rate is 1.25% at the time of the initial funding. In this case, the first 5 years of the mortgage will be fixed at 2.75%. At every 5 year interval of the funding, the rate will change based on the prevailing bond rate and will remain fixed for an additional 5 years.
The effective rates on adjustable products are generally lower than fixed rates at the time of initial funding.
This product gives some predictability to the future monthly payments, at least until the next period of the rates re-adjusting.
In the event interest rates are lower at the time of that the rate re-adjust, the borrower will enjoy the benefits of lower interest/lower monthly payments during the ensuing period.
While adjustable rate products are subject to prepayment penalties, the penalty is calculated only from the time of prepayment until the period of re-adjustment. This would mean that on a 5-year adjustable product, the maximum prepayment penalty calculation could only include 5 years.
Although there is some stability provided with an adjustable rate mortgage, interest rates could change significantly during the period and the borrower could find themselves facing higher interest rates/monthly payments during the next period.
Foreign currency products
Some banks, but not all, offer foreign currency products. The products offered are generally limited to the largest foreign currencies such as the US Dollar, Euro, British Pound Sterling and a few others.
The mechanics of foreign currency products is that at the time of funding the mortgage, the principal that was funded in shekels is recorded in the bank’s ledger according to the representative rate of exchange in the foreign currency in which the mortgage was taken. Monthly mortgage payments are made in shekels according to the representative rate of exchange and the principal balance is kept and amortized in the foreign currency.
Having a foreign currency product may be very important for those earning income in a foreign currency. This would obviate the foreign currency risk that could lead to higher monthly payments in the currency of income.
The fixed rates on these products are generally higher than shekel fixed rates.
Tying the mortgage payments to a foreign currency will avoid the foreign exchange risk with regard to monthly payments. On the other hand, the borrower now has a significant asset (the property) valued in shekels. If the mortgage principal balance (a significant liability) is kept in foreign currency this represents a risk when re-selling the property in the event that the foreign currency weakens against the shekel in the future. Keeping the mortgage shekel denominated is a partial hedge against this risk.
Inflation Linked Products
Any of the above products, save for the foreign currency product, may also have the principal balance linked to inflation. This would mean that on a monthly basis, whatever principal balance exists on the mortgage will be increased at the same rate which the inflation index, as published by the Bank of Israel, increases. In the event the index decreases, the principal balance can go down but not lower than the original balance.
The interest rates on all products that are linked to inflation are lower than the same product not linked to inflation. The difference in rates could be significant.
Since the rates are lower, the expected monthly payments used during the approval process are lower, and may allow for a higher amount being approved.
While the quoted interest rates are indeed lower, when taking inflation into account the overall cost of the mortgage could increase significantly. To put it into perspective, while linked rates might be 1-1.25% lower than unlinked rates an inflation rate of only 1.5% per annum would more than wipe out that benefit. An inflation rate of just 4 or 5% could increase the cost by double or more.
Since the inflation index increase is added on to the principal balance on a monthly basis, it is possible to have ‘negative amortization’ – whereby the principal balance increases instead of the expected decrease. This is especially the case in the early years of the mortgage, when the majority of the monthly payments are mainly applied towards interest.
Prepayment fees (often referred to as “penalties”)
When a borrower wishes to pay off all or part of a mortgage prior to the end of the agreed upon term of the loan, the banks are allowed to calculate the loss of interest that would occur in the event interest rates at the time of prepayment are lower than the interest rates prevailing when the mortgage was first funded.
As an example, if the original loan was for NIS 1,000,000 for 30 years at a fixed rate of 3.5%, the bank would expect to earn NIS 616,561 interest over the 30-year life of the mortgage. If, after five years, the borrower wishes to pay the principal balance (which would be NIS 895,096), and the prevailing interest rate is 3.0%, the bank will be losing 0.50% interest on the amortization of that NIS 895,096 for the next 25 years. The calculation would show a loss to the bank of NIS 104,323.
Here are some guidelines that govern prepayment fees;
Other that a small administrative charge, there is no significant fee for early payment outside of the calculation of the interest that the bank would lose due to the difference in interest rates.
There is never a prepayment fee for mortgage products that are liable to vary more than once every year. This would be the case for Prime based products, which could change every month.
On adjustable products that are fixed for at least one year, for instance a 5-year adjustable rate, the calculation of the banks loss is only made from the time of prepayment until the next “adjustment” of the interest rate. So, on a 5-year adjustable mortgage, the maximum calculation would be 5 years.
The good news is that Bank of Israel regulations require that the banks discount the loss calculation as follows; 20% after 2 years and 30% after 5 years.