Mortgages Assumed rate of interest: any reduction would be playing with fire

The assumed interest rate doesn’t reflect the mortgage interest you expect to pay, but the risk appetite of banks.

by Matthias Holzhey 10 Apr 2017

The assumed rate of interest of 5 percent applied by banks on issuing mortgage loans as a security buffer against abrupt rises in interest rates is completely out of place in the current interest landscape. By comparison, on July 1, 2016, Switzerland’s overall interest rate curve showed negative returns for the first time in history. The assumed interest rate level is based on long-term average mortgage interest, and is not laid down in a precise manner – although the affordability calculation was made official by the Swiss Capital Adequacy Ordinance of 2011 and the self-regulatory measures for banks.

Self-regulation by banks serves the following purpose: it dampens the “suction” effect that constantly falling mortgage interest rates have on house prices, and prevents the further buildup of interest rate risks. The flip side of the coin is that buying a home becomes more difficult for a substantial proportion of the population; households with low incomes or young families often fail to meet the affordability rules. This is increasing pressure to soften the restrictions on lending, or make these more flexible.

Market situation makes the loan-to-value limit less important

The application of an assumed rate of interest reduces the probability of a mortgage holder defaulting on payment. All too quickly, unforeseen costs, a rise in interest rates, or a drop in income can lead to payment default if the borrower has a high level of debt. To minimize this risk, the affordability calculation used by banks stipulates that the overall burden should not be above one third of income, even with an interest rate of 5 percent (plus maintenance costs and reserves of about 1.5 percentage points). According to this rule, debt may not exceed five times annual gross income. But even in this scenario, if full advantage is taken of loan-to-value limits, an interest rate increase of 2 percentage points will still result in a substantial additional burden that cannot be financed without cutting back on consumption.

If the assumed rate of interest sank to 3 percent, a household could take on more debt and borrow seven times its gross income to buy a home. With a mortgage of medium duration at current interest rates, living costs (including amortization and maintenance costs) would amount to about one third of disposable income. However, even if interest rates rose by less than 2 percentage points, living costs would then exceed half the disposable income and would no longer be affordable. Using long-term financing, this risk can be postponed, but not eliminated completely. Even increasing amortization to compensate the additional loan-to-value ratio is virtually impossible, given the limited room for financial maneuver.

Financial freedom limited by rising interest rates

Breakdown of a household budget by expense category*

A fixed assumed rate of interest guarantees stability

Relaxing the affordability rules would give house prices an enormous boost. A flexible, lower assumed interest rate would result in a new balance on the housing market, with higher debt and higher prices. So lower-income households would once again be excluded from home ownership, and dependence on ongoing low interest rates would be a greater threat. A fixed assumed interest rate, on the other hand, binds residential real estate prices to household income trends, which stabilizes the financial and real estate markets in the long term.