Financing construction endeavors: The impact of interest rates and repayment terms on total expenses
The European Central Bank (ECB) recently lowered interest rates by 0.25% to 4.25%. This reduction in interest rates should make loans more affordable. However, the situation in real estate financing appears to be different.
Individuals who meticulously compare bank offers when purchasing a property or a house can save thousands of euros in financing. Small percentage differences behind the decimal point of the effective annual interest rate can have a significant impact over a long period, often spanning several decades. It also aids quick repayment and keeping the term short. The question arises: How much can these parameter differences influence the outcome?
Reaching the right balance between interest rate, repayment rate, and term is not an easy task. "Many buyers focuses on the affordable monthly payment," says Roland Stecher, a financial expert at the Bremen Consumer Center. "We recommend not spending more than 30 percent of net income on the real estate loan." However, the interest rate can influence savings of several thousand euros, depending on whether the monthly payment mainly contributes towards loan repayment or bank interest payments.
As per the current construction interest comparison of the magazine "Finanztest" (9/2024), construction interest rates currently start at around 3.2% for an 80% loan with a 10-year interest period. Interest rates can vary depending on providers, ranging up to 4%. "This is moderate but high compared to the low-interest phase a few years ago," says consumer protector Stecher. "Prices for real estate are also rising, so homeowners need large loans."
Example calculations demonstrate effects
Sebastian Schick, editor-in-chief of the financial platform biallo.de, suggests interested parties start by researching their own bank's conditions and then consider online banks in the second step. "Those who then receive the conditions of an independent credit intermediary gain a comprehensive understanding of current values," says Schick.
"To compare bank conditions, one must obtain offers where the term, monthly payment, and repayment conditions are standardised," says Max Herbst from the FMH financial consultancy. "Otherwise, it becomes difficult to keep track."
The impact of small interest differences is demonstrated by several example calculations set up by Herbst: A customer pays a monthly rate of 1806.67 euros for a 400,000 euro loan. With an interest rate of 3.42% and a repayment rate of 2%, they pay 121,577 euros in interest after 10 years. The loan is repaid by 95,223 euros by then. The remaining balance as residual debt is 304,777 euros. If the financing continues under the same conditions after 10 years of interest-binding, the homeowner would need 29 years and 3 months to fully repay the loan. They pay a total of 232,883 euros in interest.
Higher repayment must be affordable
If they take out a 400,000 euro loan at an interest rate of 3.52% – a tenth of a percentage point higher – they can only afford a 1.90% repayment rate. The total interest paid over the entire term increases to 246,588 euros and thus 13,705 euros more. The homeowner also needs seven more months to repay the entire amount than in the example with the more favorable interest rate of 3.42%, i.e., 29 years and 10 months.
It may make sense to accept a higher monthly rate in favor of a higher repayment rate. Someone financing a 400,000 euro loan at an initial interest rate of 3.42% and repaying at 2.3% must pay a slightly higher monthly rate of 1,906.67 euros, which is 100 euros more than in the two preceding examples. They only need 26 years and 9 months to repay the entire amount and pay a total of 210,372 euros in interest over the entire term. The interest burden is 22,511 euros less than with a two-percent repayment at otherwise identical conditions – and the loan is repaid 2.5 years earlier. "But the rate is also higher, and one must be able to afford it," says Herbst.
A repayment rate of two percent should be included
The repayment rate should not be too low from the start. "A repayment rate of 2% should be chosen in the current interest environment, ideally 2.5 to 3%," says Sebastian Schick. However, many homeowners may reduce their repayment rate if interest rates rise after the interest rate fixation period, ensuring the monthly rate remains the same. However, this has a clear impact on the term and interest payments.
The lower the repayment rate, the longer it takes to fully repay the loan. "The loan term can almost double," says Roland Stecher. However, speed is not everything, the consumer advocate points out – because with increasing repayment, the monthly burden also increases. Someone who spends every cent on the monthly payment at the end has less money for living expenses – and that is not suitable for everyone.
Flexibility in financing is also important. "Customers should only accept offers that grant the right to make special repayments without charge," advises Sebastian Schick. The ability to change the repayment rate as needed is also a crucial factor. "This allows the customer to respond to possible changes in their financial situation during the term."
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Instead, they could settle a larger amount all at once annually, like after collecting a life insurance payout or an inheritance. Alternatively, if finances get tougher, the repayment rate can also be decreased, resulting in a lower monthly payment.
Financial advisors often recommend utilizing large financial windfalls, such as life insurance payouts or inheritances, to make a lump sum repayment annually. Conversely, if financial circumstances become strained, the repayment rate can be lowered, reducing the monthly payment. Additionally, it's vital to consider flexible financing options, ensuring the capability to make special repayments without fees and altering the repayment rate as needed during the loan term, as suggested by Sebastian Schick.
