The effect of rate rises

Borrowers will have to pay an additional 1 billion euros if the rise in the European Central Bank’s benchmark interest rate reaches 0.75 percent this year, as the market expects. Last week the ECB notched rates up by another 0.25 percent (or 25 basis points) to 2.50 percent, after the original hike of 25 bp in December ended a period of about two-and-a-half years of unchanged rates in the eurozone. Some analysts even expect a full percentage point rise before the end of 2006. The first effects on borrowers are going to be reflected in the budgets of households that have taken out a mortgage or consumer loan, as well as on companies that have resorted to bank loans. The interest rate rise will immediately get passed on to all loan categories whose rate is pegged to that of ECB or Euribor, which includes corporate loans and mortgages, since in both the rate adjustments are made automatically. The only difference is that loans with Euribor interest rates incorporate changes in the money market faster, as the banking market forecasts developments in the ECB rate. The first rate rise, on 2 December, was automatically rolled on to any floating-rate loan pegged to the ECB key rate, while the hike had already been phased in by loans pegged to the one-month, three-month and six-month Euribor. Greek households are expected to bear the burden of more than 500 million euros if the rise does come to 75 bp, having a total of 65 billion euros in loans. The total burden on the country’s private sector, whose borrowing costs have reached 150 billion euros, is bound to exceed 1 billion euros. Spread adjustment? Even after the recent ECB rate rise banks have not clarified their policy, as they can always reduce their own margin («spread») and ease the impact on borrowers. Although Greek banks argue in favor of wide spreads due to high inflation, one cannot rule out that market mechanisms may react to the fear of a drop in demand for mortgages and an overall market freeze. Rate-rise prospects will increase pressure on households, making the current picture even grimmer; Bank of Greece (BoG) data show 230,000 problematic loans with a debt of 3 billion euros. The added burden on the monthly installment of a 100,000-euro loan with an introductory rate of 4 percent to be paid off within 20 years is calculated at 53.98 euros, totaling 647.76 euros per year and 12,955 euros at the end of the 20-year period. Turn to fixed-rate loans To avoid such developments, banks are promoting fixed-rate loans, whose level now appears attractive even for those who prefer floating interest rates. Banks responded immediately to the December hike by reducing fixed rates, which has cut the gap between Greek interest rates with those in Europe, although they are still some way from reaching the lowest levels in the eurozone. This move was interpreted in the context of the effort begun by banks after the recommendation by BoG Governor Nikos Garganas to turn borrowers to fixed-rate loans. Bank officials note that these interest rates are mainly addressed to households with strict planning of monthly expenses or with marginal coverage of their needs and therefore the least open to a rise in monthly installments. Banks seem ready to respond to the demand for turning floating-rate loans to fixed-rate ones, even at virtually no extra cost. The process for that is rather simple; it only requires that a borrower visit the bank to sign a new contract that includes the condition of a penalty in case of premature payment. Some banks will charge a small commission for the change of contract, which usually does not exceed 100 or 200 euros. Fixed rates in Greece cover periods as long as 25 years, starting from 1, 3, 5, 7, 10, 15 and 20 years. The banks’ view is that the fixing of rates for up to five years is normal given today’s conditions. Borrowers will have to be particularly careful with contract terms and the interest rate applied after the fixed-rate period ends, securing the free choice of rate for the remaining period until the repayment of the loan. A safe medicine is protected-rate products, which several banks have promoted, including Geniki Bank, EFG Eurobank and Alpha Bank, while similar products are planned by the National Bank of Greece and ATEbank. These products safeguard borrowers from dramatic interest rate increases, as they incorporate a rise ceiling that usually is 2 percent. They are floating-rate programs combined with the security of fixed rates, ensuring that regardless of how much European rates rise, the increase in the interest rate will not exceed 2 percent. The rise in demand for such products is expected to turn all other banks to planning similar programs, as they are available at particularly attractive rates that can compete directly with fixed rates.