How does a home mortgage work?

A mortgage is a financing agreement whereby one party receives a sum of money from a bank to purchase an asset, typically real estate. Since it's a long-term commitment involving significant amounts of money, having a basic understanding of the subject can really help avoid mistakes due to inexperience.

In this article, we offer general advice for choosing the most suitable mortgage, focusing on key aspects such as the required capital, the loan term, and the interest rate applied to the loan.

Basic concepts for choosing a mortgage

The first step is to select the funds you wish to request and the loan term. These two closely related values, together with the interest rate, determine your monthly mortgage payment.

Another parameter to consider is the ratio between the amount disbursed by the bank and the value assigned by the appraiser to the mortgaged home, called the "loan-to-value" or "LTV," which will be registered as collateral for the lending institution. This ratio typically does not exceed 80%.

Regarding the monthly payment amount , banks cannot grant a loan exceeding 33% of the applicant's monthly income. This is for several reasons: first and foremost, to avoid the risk of missing out on full repayments or being late with payments. From the customer's perspective, the risk of over-indebtedness is kept low. If one wishes to increase the payment this much, additional guarantees are required, such as the involvement of a guarantor who can provide cover should the borrower default.

Mortgage terms range from 5 to 40 years. As a general rule, a longer term corresponds to a higher interest rate and a lower, more affordable payment. The downside is the higher interest rate, which reflects the lender's risk of being repaid in full over a longer period.

To better understand these concepts, a simple practical example will suffice.

A customer with a monthly salary of €1,500, taking out a 3% mortgage repayable over 20 years, could receive a loan of €104,130 to purchase a home with an assessed value of €130,163. This would require a cash outlay of €26,033.

Fixed or variable rate?

With a fixed rate , the payment remains the same for the entire term of the mortgage. The mortgage interest rate is set at the time of signing the loan, based on the bank spread and the IRS (interest rate swap).

A variable rate loan is lower in cost than a fixed rate loan. The installment is determined by the sum of the spread and the Euribor reference rate (set by the ECB). In cases where the rate is negative, as has happened in recent years (with a Euribor below zero), banks have often applied a floor, a limit that prohibits the application of negative variable rates, so as not to be disadvantaged by the contract. Therefore, be careful about this aspect, which is easily verifiable in the contract, as it tends to shift the burden of this situation onto the customer.

With a mixed rate , you gain flexibility compared to a fixed rate, but you pay a higher spread than a variable rate mortgage. These include: variable rate mortgages with constant installments (which include an extended repayment plan and a large final installment in the event of an interest rate increase), variable rate mortgages with caps (where rates cannot exceed a certain level), and mortgages with predefined renegotiations (variable at the start and negotiable every 3-5 years).

What we recommend

Now that you've clarified the basic concepts governing mortgage lending, all you have to do is choose the ideal one after comparing several competing offers. You'll receive an offer from your lender, but don't stop there. Try evaluating other options online, always keeping in mind that the loan's APR will already provide you with an important benchmark. A low APR alone doesn't necessarily mean the mortgage is a good deal, as additional costs must also be considered.

In some cases, the mortgage is accompanied by a life insurance policy guaranteed by the lending bank. The bank has the right to require it, but in that case, obtain two additional quotes from outside the lending institution to evaluate it.