Avoiding residual debt risk when interest rates rise

Experts are certain that a trend reversal in construction financing interest rates has begun. This also increases the residual debt risk. Construction interest rates have been rising since the beginning of the year. This means that the highest level since mid-2019 has been reached in january. In the meantime, interest rates have been well below this limit. Some borrowers with good credit ratings have had to pay interest of only o.5 percent. Currently, interest rates on 20-year fixed-rate loans average 1.4 percent. In a decade-by-decade comparison, this is still favorable. But there are increasing signs that further interest rate hikes are on the way. In order to limit the monthly burden, some prospective borrowers are considering lowering the repayment rate for this reason. But this is a good idea?

An indicator of the turnaround in interest rates: the yield on ten-year federal bonds

Mortgage interest rates are closely linked to the interest rates for mortgage bonds. These, in turn, develop in parallel with the yield of the federal bond. Rising bond yields therefore usually also lead to higher construction interest rates. As a guideline, the interest rate for a loan with a ten-year term develops parallel to the yield of the ten-year federal bond – plus 1 percent. As crestfinanz reports in its latest newsletter, last week was the first time in almost two years that the ten-year federal bond traded with a positive interest rate. At the peak, the bond rose to 0.0006%.

As we explained in our 2022 interest rate comparison commentary, interest rates are expected to rise in the coming months. However, this is no reason to make a hasty and ill-considered decision, because the expected increase in interest rates will most likely still be moderate. Interest rates for a construction loan with a ten-year fixed interest rate are expected to rise to between 1.5 and 1.75 percent over the course of the year. However, the level remains low by historical standards, as ten years ago interest rates of more than 3 percent were common – and were already considered very favorable at that time.

The residual debt risk if interest rates continue to rise

If construction interest rates remain relatively favorable and the cost of buying real estate continues to be high, the temptation to realize the dream of owning one's own four walls with a relatively low monthly charge is obvious. But the monthly charge is a deceptive value. Much more important is how quickly the loan can be repaid. Here, it is advisable not to skimp on repayment in order to keep monthly bank rates as low as possible. In times of potentially rising interest rates, it is much more important to set repayments high in order to keep the residual debt remaining at the end of the term of the interest-linked construction loan as low as possible.

The residual debt always shows the amount that has to be re-closed with the follow-on financing at the end of the initial financing. This is why the contractual structure of the initial financing is particularly important. In addition to many contractual components that need to be considered, such as flexible adjustments and special repayment options, there are two factors in particular that minimize your residual debt risk in times of rising interest rates:

  1. Interest-linked term of the contract: it makes sense to plan the interest-linked term of the contract as long as possible. Financing for at least 15 years is strongly recommended; even longer terms (20 – 30 years) are also possible, depending on the amount of equity you can contribute to the real estate purchase. It is important to know that banks charge low interest premiums for particularly long-term contracts.
  2. The initial repayment should be set as high as possible. Repayment determines how much residual debt remains at the end of the interest-linked term and then has to be refinanced with follow-up financing. If the interest rates rise, the interest rate for the follow-up financing will also become much more expensive. Then it can pay off not to have used the maximum amount for repayment and thus for debt reduction in the low-interest phase. And the residual debt risk then becomes a real danger.

How new financiers and follow-on financiers can now keep residual debt risk low

  1. If you already have a current short-term construction financing contract with a low repayment rate, the only way to get out is as quickly as possible without having to pay money to the bank in the form of an early repayment penalty. You can take out a forward loan during the interest-linked term of the initial contract (usually up to 3 years before the initial contract expires), which secures you the currently favorable interest rates for the follow-up financing. In this forward loan, however, you can then set the repayment as high as possible and the term as long as possible.
  2. When concluding an initial financing, it is advisable to conclude the highest possible repayment (5 percent) with the longest possible term (20 years). This reduces the residual debt risk for the follow-up financing. Of course, you should make sure that the monthly charges remain within your budget. A maximum of 40 percent of the monthly net household income available is regarded as a safe benchmark.

A repayment schedule informs you about your residual debt risk

A repayment plan is the basis for secure construction financing. At each point in time of the financing, it not only provides direct information about the monthly installments to be paid to the bank, but also shows the current status of the remaining debt at that point in time. The residual debt, in turn, is the most important value for subsequent financing. Because it gives information about the amount that must be continued to be financed after the initial financing is completed. With an annuity loan, not only the monthly interest and repayment installments change over time, but also the residual debt amount.

You receive the repayment schedule from the bank at the start of the financing process. You should already request this with the initial offer from the bank. But even before you contact a bank, you can calculate the options available to minimize your residual debt risk. The higher they z. B. Set the repayment rate, the faster you'll be debt-free. And the longer the fixed interest rate, the more secure your financing. Calculate various repayment amounts and terms in advance with the help of online repayment calculators. This not only shows the effect of a higher repayment on the interest costs and on the remaining debt. This is how you research your perfect balance between the fastest possible repayment and a financially justifiable monthly rate beforehand. This applies to the initial as well as the subsequent financing. To get this overview, we recommend the accedo repayment calculator (>link).

Independent advice from banks is important

For understandable reasons, banks are interested in keeping their own risk as low as possible when granting loans. That's why they prefer shorter terms and lower repayment rates. For your secure financing in a rising interest rate market, however, the opposite is true: longer interest rate-linked terms, high repayment and the shortest possible total term of the financing. We therefore recommend that you contact a reputable construction financing broker who is independent of any bank and who can offer you secure financing tailored to your life planning. In addition, they have daily access to the offers of more than 450 banks and can thus find the bank that can make the best offer for you as a lender, both in terms of term, flexible contract modules and rapid freedom from debt.

The residual debt risk primarily affects first-time financiers. However, there are ways and means that you should know in order to keep this risk as low as possible.

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