How does a mortgage work?

The most important points for understanding how mortgages work
A mortgage consists of receiving a certain amount of cash - principal - from a bank in exchange for the commitment to repay this amount, plus the associated interest - based on an interest rate -, through payments made periodically, usually monthly. The property purchased is also given as a repayment guarantee.  That is the definition of a mortgage given by the Banco de España and it contains the three key elements you need to be able to understand how a mortgage works: capital, interest and repayment period.
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Key Element 1: the capital

This is the cash amount we ask our bank to give us when we purchase or renovate a house. As a general rule, the banking institution finances up to 80% of the appraised value of the property, if it is a main home, and around 70% if it is a second home. What happens with the remaining 20%? The customer must provide this as a first payment or "deposit" at the time of purchasing the property. This is for two main reasons: on the one hand, the fact that the customer has an amount equivalent to 20% of the value of the property shows the bank that they have an ability to save, an important consideration for banking institutions; on the other hand, when it finances 80% of the property purchase, the bank does not assume the whole risk of the operation if the buyer fails to repay the loan.

For example, if the house we wish to buy costs 100,000 euros, the bank will normally lend us up to 80,000 euros. However, we should point out that there are also mortgages for up to100% of the value of the property. Banking institutions offer these to customers who demonstrate solvency and considerable economic stability, making the risk of default assumed by the bank much smaller. In this respect, owning a second home or the solvency of those backing our application are also important points when granting this kind of financing.

An appraisal of the property can be another way of obtaining a 100% mortgage. If, after appraising the property we wish to buy, its value is found to be greater than the market price, the banking institution may offer to finance the whole cost.

Another way of obtaining 100% financing is to purchase a property that the bank itself is offering for sale.

Key Element 2: the interest

The interest is the bank's profit in return for granting the customer access to the requested financing. In the case of a variable interest rate mortgage it consists of two parts the reference rate and the differential. The sum of the two will give us the interest rate we will pay for our mortgage.

- The benchmark rates. These rates are used to modify the interest rate of a variable rate mortgage, i.e. they indicate the evolution of the cost of money and that influences the total amount the customer will have to repay in the monthly payments and, therefore, the total to be repaid at the end of the loan life.

In Spain, the most frequently used reference rate is the Euribor, which shows the price at which European banks lend money to each other. They are normally revised once a year, although this may be done every three or six months After this revision the customer's monthly payment may go up or down, depending on the evolution of the Euribor.

There are also other reference rates, including the IRPH Conjunto de Entidades.

- The applied differential. This is what the bank charges for assuming the risk of financing the purchase of a property.

With these factors we can differentiate three kinds of mortgage, depending on the interest rate applied:

- Fixed rate: To calculate the cost of fixed rate mortgages, the Euribor is not taken into account, just the fixed interest rate applied by the bank. This means we will always know our monthly payment.

- Variable rate: In the case of variable rate mortgages, it is most common to use the Euribor as a reference rate. This rate varies daily, although the interest rate on a loan is normally updated every 6 months, taking the value of the Euribor at that time. In this way, the reference rate conditions the cost of the mortgage: the lower the Euribor, the less the customer will pay monthly for their mortgage.

- Mixed type: These mortgages apply a fixed rate during the first years of the loan and after that a variable interest based on the Euribor.

Another two important concepts regarding the price of a mortgage are the NIR and the APR:

- NIR stands for Nominal Interest Rate: the price the bank charges for lending money for a certain period. This figure does not take into account any additional expense associated with taking out the mortgage, for example, a start-up fee. It is a useful indicator of the price of that product or financial operation in the same bank; it is not useful for comparing product prices either in the bank in which we requested the loan or in other banks.

- APR stands for Annual Percentage Rate: it indicates the actual cost of a loan during a specific period based on a standardized mathematical formula that is used by all banking institutions, in other words, it allows you to compare the cost of the same product in different banks. The APR does include the fees and some of the costs associated with the loan.

When a bank offers a variable rate mortgage, it is usual to see the cost expressed in three different ways: through the NIR, the Variable APR and the Euribor + applied differential formula.

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Key Element 3: the repayment period

This how long we are going to take to return the capital that has been lent to us plus the interest. Mortgages In Spain usually come with a repayment period of between 20 and 30 years, although they can be as short as 5 years or as long as 40 years.

During this repayment period, we will have to make a series of monthly payments, the amount of which will depend on the time we have to repay the loan, the capital we have borrowed and the amount of interest we have to pay. A longer repayment period means lower monthly payments, but the interest we will pay at the end of the life of the mortgage will be higher, and vice versa.

In summary, the monthly payment will be the sum of the interest plus the capital, although its composition -what we will pay at any particular time- will vary over the life of a variable mortgage, while the monthly payments on a fixed-rate mortgage will always be the same.

The most common way of calculating the monthly payments is to use the so-called "French method", whereby at the beginning of the life of a mortgage we mainly repay the interest on it and a smaller percentage will be for capital repayment. As time goes by, this proportion is inverted and the final payments will be mainly capital.

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