Yes, everything is relative! Interest rate: fixed or variable?
“Why do we pay interest on an approved loan?” In short, because the interest is the PRICE for the money that is rented to us (loan), as, for example, we pay a certain price for a rented car or apartment.
However, we generally rent the vehicle for a few days at a pre-determined price, while the money we need is usually borrowed for the medium or long term (1 to 30 years), and that is why the choice of the type of interest rate at which the interest will be calculated during repayment is loan is one of the most important issues for making a decision on taking a loan.
The interest rate can be fixed (fixed) or variable. The fixed interest rate, as the name suggests, will not change during the entire loan repayment period. The variable rate will change during the repayment of the loan, depending on how the values of the elements on the basis of which the rate is calculated, and which we agreed upon in the loan agreement, change. With us, the variable interest rate is usually the sum of two elements:
variable interest rate = fixed percentage + variable reference rate EURIBOR.
Now that we know that a fixed or variable interest rate can be negotiated with the bank, let’s see how two brothers, building a house with loan funds, went with their loan decisions.
Marko, younger brother of entrepreneurial spirit and boldness, 2020. he took a loan in the amount of 20,000 KM for a period of 10 years with a variable interest rate, which was calculated according to the formula:
interest rate (Marko) = 3.25% (fixed) + 12M EURIBOR (variable*)
As the annual EURIBOR had a negative value (-0.5%) at the time of the conclusion of the loan agreement, Marko’s loan carried an interest rate of: 3.25% + (-0.5%) = 2.75% (variable)
Mark’s annuity amounted to 190.82 KM, total interest 2,898.65 KM (estimated at the time of conclusion of the contract), and total debt (loan + interest) 22,898.65 KM. This, of course, under the condition that the interest rate remains unchanged, i.e. 2,75%.
At the same time, Nikola, the older brother, less prone to risk, an employee of the city administration, decided on a loan from the same bank, in the same amount and for the same period, but with a fixed interest rate of 4.00%. So, Nikola’s interest rate was:
interest rate (Nikola) = 4.00% (fixed)
Nikola’s annuity amounted to 202.49 KM (and will certainly amount to that much while the loan is being repaid!), interest 4,298.83 KM, and his total debt (loan + interest) was 24,298.83 KM.
During 2022/23. due to a number of economic reasons, there was a significant increase in the EURIBOR rate to 3.30%, and the bank, starting on February 1, 2023, began to apply the new rate for Mark’s loan. By then, Marko had paid the bank a total of 6,106.24 KM. Mark’s new interest rate was 6.5% (3.25% fixed + 3.30% variable).
At this rate, for the remaining 88 months of repayment, the new amount of the annuity has increased to 217.87 KM, thus the remaining interest to 3,980.23 KM, i.e. total debt to 25,278.50 KM. If there were no further changes, by the time the loan is repaid in 2030, Marko would have to return KM 980.00 more to the bank than Nikola, even though at the time of the conclusion of the contract, his total debt to the bank was lower by an entire KM 1,400.00.
Although these two loans, in the end, brought different amounts of debt, due to the movement of the variable interest rate, it should not be concluded that contracting a variable rate is always less favorable than contracting a fixed one.
Namely, the rates sometimes fall and every time they decrease, the amount of the annuity and the total debt will decrease. For example, the value of the 12M EURIBOR rate in October 2008. it was 5.50%, and already in October 2009 it was around 1.22%, while in the period from 2017 to 2022 that rate was negative, i.e. smaller than 0. E.g. the value of the 12M EURIBOR rate in May 2020, which is relevant for our example, was -0.5%.
Given that there is a risk when contracting a variable interest rate, because it is not known in which direction the rate will change during the duration of the contract, the fixed interest rate offered by all banks is always higher than the variable rate.
Therefore, it would be best for the loan user to choose the type of interest rate that better suits his financial position and habits, some knowledge and overall character, i.e. how much he is willing to take a certain risk.
And, don’t forget that although the brave are lucky, sometimes it’s wise to back down!
What is EURIBOR?
EURIBOR is an abbreviation of the English words Euro Interbank Offered Rate, which means the average interest rate at which certain European banks lend money to each other. It is not a single interest rate, but a group of interest rates, depending on the maturity, and in everyday banking the most commonly used are: three-month (3M EURIBOR), six-month (6M EURIBOR) and annual (12M EURIBOR).
The official source for the publication of these rates is the European Money Markets Institute, and their values are determined daily around 11 a.m. Data with a certain delay can be found on numerous websites, of which we single out: https://www.euribor-rates.eu/en/.
It is considered that EURIBOR rates are the basic benchmark for the formation of prices of various financial instruments and services, all over the world! Domestic banks cannot influence them!