Rate types explained
What is an interest rate?
The interest rate represents the cost of money: the price to pay today to get the money that will be earned tomorrow. The uncertainty about the future and the risk of rising rates over time influences the determination of a long-term interest rate. That's the reason why traditionally, the longer the loan period, the higher the rate. Time and risk are key elements in defining an interest rate.
In Luxembourg, the price of money is set by the European Central Bank (ECB), the institution supervising the banking industry and acting as a conductor of credit distribution. When the ECB estimates that credit distribution is too high, it increases interest rates. On the other hand during a continued period of low credit demand, ECB reduces interest rates to facilitate access to credit. This mechanism directly impacts the evolution of a variable rate, and to a lesser extent, the evolution of a fixed rate.
Fixed vs variable rate
The choice between fixed or variable rate financing depends on the anticipated duration and the nature of the project. A fixed rate is preferred for the long term financing of a primary residence, especially during low interest rate periods. On the other hand, for a short term investment, a variable rate solution may be more appropriate.
|Fixed rate||Variable rate|
Fixed monthly payment
No penalty if early repayment
Cheaper when rates decline or stay stable
|Risks||Penalty if early repayment
Missed opportunity if rates decline
|Expensive when rates grow
Monthly payment may significantly vary
A fixed rate financing is the guarantee to get fixed monthly payments defined at the loan contract signature. In exchange for this guarantee, the rate is higher and the capital repayment starts more slowly. This type of financing does not allow to take advantage of a possible fall in interest rates over time and early repayment can be subject to penalties.
A variable rate privileges flexibility. No penalty is charged in case of early repayment and the possibility is offered to take advantage of a lower rate. At the beginning of the period, the interest charge is lighter due to the lower initial rate ; the capital repayment starts faster. However, there is a fluctuation in the monthly payments which can be significant in the event of strong medium-term growth in the rate.
A good compromise may be the choice of a revisable rate financing. This solution allows to control the risk during the first part of the loan, either for 5, 10, 15 or 20 years, by fixing a shorter term interest rate (shorter than the total financing duration) and therefore, significantly lower (for instance a 30 years loan with a fixed rate over the first 10 years). Once this first period has elapsed, the borrower may choose to either make a total or partial repayment of the borrowed amount, to subscribe to a new fixed rate on a new period to be defined, or to opt for a variable rate at market conditions that apply at that time. This solution is interesting for:
- First-time buyers who only want to stay in their home for some years before reselling it.
- Young workers who want to secure their monthly payments during the first years of their careers.
- Any buyer who anticipates significant cash inflows in the medium term and wishes to have the opportunity to repay all or part of his loan without penalties.
Nexfin provides you with guidance to build a mixed structure and mitigate your risk.
Early repayment fees: Indemnity owed by the borrower to the lender in the
event of reimbursement of the loan before its contractual end date. In the case
of variable rate financing, this cost is close to zero. However, in the case of
fixed rate financing, the indemnity could be significant. The indemnity amount
is based on the evolution of interest rates between the signing date and the
early repayment date. It also depends on the general terms and conditions of
the loan agreement which may vary from one bank to another. However according to
the law, the fees cannot exceed the financial loss of the lender. In a
simplified way, the indemnity of a fixed rate loan early repayment increases as
interest rates fall between the loan signing date and the early repayment date.
Borrowers who have subscribed to a property loan after December 31, 2016 to finance a primary residence and for at least two years, benefits from an indemnity capped at six months of interest payments on the repaid principal at the applicable rate of the loan agreement (cf payment schedule provided by the lender). This cap does however not apply on the repaid principal amount exceeding the sum of € 450 000. Beyond this amount, the calculation rule of the lender general terms and conditions apply.
Deductible mortgage interest: Interest paid on a mortgage loan related
to a rental investment is entirely deductible.
Interest paid on a mortgage loan related to a primary residence (excluding any potential tax-exempt interest subsidy) is deductible with the application of the following ceilings:
- € 2 000 per person in the household (including dependent children) for the first 6 years
- € 1 500 per person in the household (including dependent children) for the next 5 years
- € 1 000 per person in the household (including dependent children) for the following years