Mistakes to Avoid When Taking Out a Home Loan

Taking out a personal loan to pay the down payment on your first home

Buying your first home involves a higher initial investment. And one of the biggest obstacles to buying a house is that even if you take out a home loan, you'll have to pay around 10% to 20% of the property's value out of your own savings.

In other words, if you want to buy a house that costs 150,000 euros, you need to have at least 15,000 euros in savings to cover 10% of the property's value. Please note that the costs don't end there. Your savings must exceed this amount in order to pay for the costs of the purchase process, financing and taxes.

Although this limitation has been in place since 2018 - after the Bank of Portugal decided that no financial institution can finance more than 90% of the value of the purchase deed or property valuation - some people want to take this step without having any savings in place.

After all, in most cases, the initial down payment for a house requires saving thousands of euros. And this isn't always easy to achieve, especially when your income isn't high. The problem is that if you don't build up savings and take out a personal loan to cover the down payment on your future property, you could have your mortgage application rejected and even default.

And why do banks often refuse to finance a property in this way? Because, in most cases, the client's effort rate is too high. Since the effort rate is one of the most important factors when a bank is assessing the risk of granting you a loan, you need to do some math before buying your first home. After all, the maximum limit recommended by banks for the effort rate associated with a home loan is 30%.


The weight of other loans in your effort rate

For example, let's say you want to buy a property that costs 150,000 euros and your household has a monthly net income of 2,000 euros. As banks don't lend 100% of the value of the property, your maximum loan would be 135,000 euros. Therefore, if you were to get a loan proposal with a 2% APR (spread + index) with a maturity of 360 months (30 years), your monthly payment would be 498.99 euros.

In this case, if you don't have any other loans, your effort rate is 25%. This is because the calculation of this rate is based on dividing your credit costs by your net household income and multiplying the result by 100% (498.99 euros / 2000 euros x 100%). This means that you would be well on the way to having your mortgage approved.

But the scenario changes if you have other loans. For example, if you are still paying off a car loan, where the monthly payment is 150 euros, your effort rate would rise to 32%.

Now imagine that you need to take out a personal loan to cover a down payment of 15,000 euros. Since this personal loan may be associated with a multifinality loan, the APR can be quite high. And the longer the loan matures, the more expensive the final amount of your loan will be due to the associated taxes.

For a loan of 15,000 euros, with an APR of 11.2% and a maturity of 60 months (5 years), your monthly payment would be 307.75 euros. If this is your only loan apart from your mortgage, your effort rate would go from 25% to 40%. But if you're still paying for your car (150 euros), your effort rate would rise to 48%.

It is therefore advisable that before buying your first home, you try your best to pay off other loans. This includes debts on your credit cards and other personal loans. If you don't have the necessary amount to put down, remember that it's better to take a few years to achieve this goal than to put your finances at risk.

What's more, if you apply for a personal loan to pay the down payment before your mortgage is approved, you run the risk of having your application denied and ending up paying a credit for a down payment on a property you haven't managed to buy.


Not analyzing possible interest rate rises

If you're thinking of buying your first home by taking out a loan with a variable or mixed rate, it's essential that you don't get hung up on the monthly installment you're going to pay initially. This is because these two rates rise and fall according to fluctuations in the Euribor rate applied to the mortgage.

In the case of the mixed rate, the monthly payment only changes after Euribor becomes a component of the interest rate. And this only happens after the initial fixed period ends. During this initial period, your interest rate is calculated based on the value of the swap plus the spread.

In a credit agreement linked to a variable rate, your installment is subject to Euribor fluctuations throughout the agreement. However, this update is made within the term of the Euribor associated with your loan.

If your mortgage is indexed to the three-month Euribor, your monthly payment is reviewed every three months. If the Euribor rate is six months, the review takes place every six months. With 12-month Euribor, there is only one review per year.

Regardless of the Euribor term, before finalizing the mortgage loan process, you should simulate the impact of the rise in Euribor on your loan payment and consequently on your family budget.


Understand the impact of rising interest rates before buying your first home

To give you an idea of the impact that the rise in the Euribor rate could have on your family budget, here's an example to help you understand the impact of the rise in interest rates on home loans.

Imagine that you have taken out a home loan linked to a variable rate with the 6-month Euribor, where your first installment after the half-year review is in October 2022. If your spread is 1.2%, the amount owed is 120,000 euros and there are still 300 installments outstanding, the Euribor to be applied is 0.837% (reference value in August 2022). Therefore, your monthly loan installment will be 510.79 euros.

Although interest rises progressively, if in the next six months the 6-month Euribor is 1.5%, your monthly payment would rise to 550.51 euros. In other words, your monthly payment would increase by 39.72 euros.

But if you want to see the impact of a sharper rise, if the Euribor reaches 2.5%, your monthly payment will rise to 613.70 euros. Taking into account the installment of 510.79 euros, this would be an increase of 102.91 euros. In a more alarming scenario, with the 6-month Euribor at 4%, your monthly payment would rise to 715.56 euros. In other words, in this situation, there would be an increase of 204.77 euros compared to the current payment.

Although it is not possible to predict the evolution of Euribor rates, this increase will never happen immediately. At most, interest rates will rise progressively in an attempt to curb rising inflation.

If you want to simulate the impact of the rise in Euribor on your loan installment, you can consult the FINE of your mortgage loan (which contains some simulations of the rise in interest and how it affects your installment) or use the simulator of the Euribor variation in the mortgage loan.





Source: Doutor Finanças