When it comes to selecting a mortgage, the interest rate is an important factor to consider. However, it’s not just the interest rate number that matters; the method of interest calculation is equally significant. Financial institutions often use terms like “flat rate” and “reducing rate” to describe different interest calculation methods, along with other terms like “fixed rate,” “variable interest,” and “promotional rate.” In this article, we aim to explain these terms and help you understand their implications for your mortgage decision.
Understanding Interest Calculation and Mortgage Products: To grasp these terms, it’s essential to differentiate between the interest calculation method and the underlying mortgage product. While they can be combined in various ways, it’s important to understand their individual meanings.
Flat Rate vs. Reducing Rate – The Interest Calculation: Let’s start by understanding the interest calculation methods:
Flat Rate:
A flat rate is a straightforward approach where the annual interest is determined at the beginning of the loan based on the initial loan amount or principal. For example, if you have a 1,000,000 AED mortgage with a flat rate of 4%, the annual interest will be 40,000 AED, regardless of the year. Flat rates are appealing to many borrowers due to their simplicity. However, lenders are attracted to the relatively higher rate of return they offer.
Reducing Rate:
A reducing rate of interest, also known as a diminishing rate, recalculates the interest at the start of each year based on the current mortgage balance. Initially, the interest may appear higher, but as you make payments and the outstanding balance decreases, the interest also decreases. For instance, a 6% reducing rate on a 1,000,000 AED mortgage may result in 60,000 AED in the first year, but after fifteen years and a halved principal, only 30,000 AED will be added. Generally, a reducing rate is more beneficial, especially for long-term mortgages, as the reduction in interest has a greater impact over time.
Fixed vs. Variable – The Mortgage Product: Now let’s discuss the options for mortgage products:
Fixed Rate:
A fixed rate mortgage offers a predetermined interest rate for a specified period. It can be either a flat fixed rate or a reducing fixed rate, depending on the interest calculation method. Fixed rates provide stability and predictability, enabling borrowers to effectively plan their finances.
Variable Rate:
A variable rate mortgage involves an interest rate that fluctuates based on external factors, usually tied to inflation. Variable rates are typically calculated using the reducing rate method since calculating flat variable rates offers little benefit and can be confusing. While variable rates come with some uncertainty, they may present opportunities for savings if interest rates decrease.
Choosing the Right Mortgage for You: So, which mortgage is suitable for you?
Here are a few factors to consider:
Loan Duration: For long-term loans like mortgages, a reducing rate is generally more advantageous as it has a more significant impact over time.
Additional Payments: If you intend to make extra payments towards your mortgage, a reducing rate mortgage is beneficial as it can significantly reduce the interest calculated in later years.
Interest Rate Comparison: A flat rate is only preferable if the percentage offered is substantially lower than comparable reducing rate mortgages.
Conclusion: When selecting a mortgage, it’s crucial to comprehend not only the interest rate but also how the interest is calculated. Terms like flat rate and reducing rate can significantly influence the overall cost of your mortgage throughout its duration. Generally, a reducing rate mortgage is more favorable, especially for long-term loans, as it reduces the interest burden over time.
