When it comes to choosing a mortgage, the interest rate is often the primary consideration for most borrowers. However, it's not just the number itself that matters; the method of interest calculation is equally important. Unfortunately, financial institutions can sometimes confuse borrowers with terms like "flat rate" and "reducing rate," along with others such as "fixed rate," "variable interest," and "promotional rate." In this article, we'll unravel the mystery behind these terms and help you understand what they mean for your mortgage decision.
Understanding Interest Calculation and Mortgage Products: To make sense of these terms, we need to distinguish between the interest calculation method and the underlying mortgage product. Although they can be mixed and matched, it's crucial to comprehend their individual meanings.
Flat Rate vs. Reducing Rate - The Interest Calculation: Let's start with the interest calculation methods:
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Flat Rate: A flat rate is a straightforward approach where the annual interest is set at the beginning of the loan based on the initial loan amount or principle. For instance, 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. The simplicity of flat rates makes them appealing to many borrowers. However, it's the subtle high rate of return that attracts lenders.
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Reducing Rate: A reducing rate of interest, also known as a diminishing rate, recalculates the interest at the beginning of each year based on the current mortgage balance. Initially, the interest may seem higher, but as you make payments and the outstanding balance decreases, so does the interest. For example, a 6% reducing rate on a 1,000,000 AED mortgage may generate 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 explore the mortgage product options:
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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, allowing borrowers to plan their finances effectively.
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Variable Rate: A variable rate mortgage involves an interest rate that fluctuates based on external factors, typically tied to inflation. Variable rates are usually reducing rates since calculating flat variable rates offers little benefit and can be confusing. While variable rates come with some uncertainty, they may offer opportunities for savings if interest rates decrease.
Choosing the Right Mortgage for You - So, which mortgage is right for you? Here are a few considerations:
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Length of Loan: If you have a long-term loan, such as a mortgage, a reducing rate is generally better as it has a more significant impact over time.
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Additional Payments: If you plan to make extra payments towards your mortgage, a reducing rate mortgage is advantageous, as it can substantially lower the interest calculated in later years.
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Interest Rate Comparison: A flat rate is only superior if the percentage offered is significantly lower than comparable reducing rate mortgages.
Conclusion: When deciding on a mortgage, it's crucial to understand not only the interest rate but also how the interest is calculated. Terms like flat rate and reducing rate can significantly impact the overall cost of your mortgage over its lifespan. A reducing rate mortgage is typically more favorable, especially for long-term loans, as it reduces interest over time.