Choosing our new home is by no means the last major decision we’ll have to make before getting the keys. Under normal circumstances, we’ll need to turn to a bank for help paying for it; so we’ll have to go to the nearest branch to apply for a mortgage and, if they agree to grant it to us, decide among the options they present to us.

What’s more, another key step in the home-buying process is choosing a mortgage interest rate. To help you make the right choice based on your needs, we’ll explain here how it’s decided and why.

What is a mortgage?

Before discussing mortgage interest rates, it might be helpful to clarify what a mortgage is. The Bank of Spain defines it as “a loan whose repayment is secured by the value of a property.” Therefore, the applicant can access a significant amount of money for the purpose of buying or renovating a home.

But, of course, the bank formalizes this loan through a contract, in which the mortgage borrower agrees to repay that amount plus the corresponding interest (based on the agreed-upon interest rate) through periodic installment payments. And to ensure repayment, the customer also offers the property they are purchasing as collateral .

To understand what a mortgage entails, you need to be familiar with its three basic elements:

• Principal: the amount of money requested from the bank in order to purchase the vhome.. It is usually 80% of the property’s appraised value if it is the buyer’s first home and 70% if it is a second home. The buyer must contribute the remaining 20–30% up front as a down payment.
• Mortgage interest: The bank offers this loan to the buyer with the aim of making a profit in the medium and long term. Therefore, interest is the positive difference (from the lender’s perspective) between the amount the lender initially contributes to cover the payment and the total amount the lender will receive from the mortgage borrower once the borrower has completed all payments.
• Repayment period: As we have just seen, the buyer takes on a debt with the bank when taking out a mortgage. Therefore, when the contract between the two parties is signed, the repayment period of the mortgage is defined. In other words, this is the period during which both the principal and the interest must be repaid. Under normal circumstances, this period typically ranges from 20 to 30 years, although it may be shorter or longer depending on the borrower’s circumstances and the amount to be repaid.

Mortgage Interest Rates: What Are the Options?

When we commit to a bank, it’s also important to determine what the mortgage interest rates will be. This is mainly because the bank itself may offer us three different options.

Fixed-Rate Mortgage

In this case, the bank sets a fixed mortgage interest rate from the outset. Therefore, this rate does not change over time nor does it depend on external factors, such as the Euribor. The advantage is that the customer knows, from the moment they sign the mortgage contract, the payment (usually monthly) they will make until the mortgage is paid off. The downside is that this payment typically involves a higher fixed interest rate than the initial interest rate on adjustable-rate mortgages.

Adjustable-rate mortgage

This type of loan uses a reference index— primarily the Euribor—to determine the amount the borrower must pay. However, it is not determined on a daily basis; instead, the bank and the customer agree in advance on the review period (usually every 6 or 12 months) to determine the interest rate that will be included in the monthly payment. The advantage is that, during periods of low interest rates, the amount due is usually not very high; however, this comes with significant risks, and it’s possible that, if the payment term is long, you’ll end up paying more overall.

Hybrid-Rate Mortgage

With this type of mortgage, the borrower begins by paying a fixed interest rate for the first two or three years, and after that, the monthly payment is based on a variable interest rate. Due to its characteristics, this option typically offers a lower fixed interest rate than a 100% fixed-rate mortgage, so it is advisable for cases in which the customer is confident they will be able to pay down their mortgage during the first few years of the variable-rate period.

How does the Euribor affect the variable interest rate on a mortgage?

As of early 2023, it is clear that the variable-rate option does not seem to be the most attractive choice. The reason is that the Euribor (the most widely used benchmark index) has skyrocketed over the past year: between June 2022 and June 2023 it has risen from 0.852% to 4.134%.

The Euribor is the European Interbank Offered Rate (Euro InterBank Offered Rate). It is a rate that reflects the price at which major European banks lend money to one another; therefore, it also refers to the interest on these loans. Consequently, it is influenced by a wide range of factors, such as the financial situation in Europe and worldwide, the interest rates set by the European Central Bank (ECB), and even the U.S. Federal Reserve.

The energy and economic crisis that engulfed Europe in 2022 has caused the Euribor to reach its highest level since late 2008. This situation will increase the cost of variable-rate mortgages by around 3,500 euros per year. However, this amount depends on many factors, such as the date the mortgage was signed, the original principal and term of the variable-rate mortgage, the interest rate, the adjustment period (6 or 12 months), and whether a different interest rate applied at the outset.

How do we decide on the interest rate for our mortgage?

As of today, it is impossible to predict what will happen with the Euribor over the next year and a half, but we cannot rule out the possibility that it might even reach a rate of 4.5% in the worst-case scenario. However, the trend in recent months has been toward a moderation in its growth; therefore, it is likely not far off from reaching its peak, after which it will begin to decline gradually.

In any case, if our mortgage has a fixed interest rate, we’ll enjoy greater stability and peace of mind, even though the payments will be higher in the early years than with a variable-rate mortgage. That’s why it’s a good option if the mortgage term is going to be particularly long, because the longer it takes to pay off the loan, the greater the risk that fluctuations could negatively affect a variable-rate mortgage. It’s no surprise, then, that banks themselves typically offer them for a maximum of 30 years, fully aware of this situation.

And if we opt for a variable-rate mortgage, we should be aware that, although we’ll pay less in the short term, in the long term we’ll be at the mercy of changes in the benchmark rate. For example, between 2016 and 2022, holders of these mortgages benefited from low Euribor rates and paid low monthly mortgage payments; but this situation has changed radically, and over the past year they have been seriously affected by sharp increases in those rates.

What is the majority choice?

According to data from the National Institute of Statistics, by the end of 2022 in Spain, 2 out of every 3 mortgages taken out (65.5%) were fixed-rate, and the remaining 34.5% were variable-rate. This means that the current general preference is to take on less risk in exchange for paying a little more, rather than facing the uncertainty of enjoying lower monthly payments today while exposing oneself to risk based on market fluctuations.

Your personal situation is key to making the final decision

In short, if your monthly income isn’t very high and you plan to pay off your mortgage in 20 or 30 years, a fixed-rate mortgage is the best option for you. The downsides are that the interest payments are higher from the start and that transferring your mortgage will be more expensive; but in return, you’ll have the security of knowing that you’ll always pay the same amount, regardless of what happens to the Euribor.

On the other hand, if your salary gives you plenty of leeway to pay your mortgage,you want to pay less at the beginning, and you’re not concerned about the mortgage being structured to be paid off over a very long term (between 30 and 40 years), you can opt for the variable-rate mortgage. In the event that your monthly payment rises significantly, you’ll have the financial cushion to cover whatever is required of you; and you you might even consider saving to pay it off early to shorten the term and, consequently, reduce the risks as well.

We recommend:

• Mortgage Subrogation: Everything You Need to Know
• Bridge Mortgage: Move to a New Home Before Selling Yours