Bet on rising interest rates? That sounds like a pretty shady and risky financial gamble. But the practice is quite common among home builders – and completely legal. Forward loans are the name of the game: a form of follow-up financing in which you secure the current interest rates for a building loan that you won’t need for several years. Granted: there is a risk involved, but there are benefits. The clarifiers explain how it works and what you should pay attention to.
What is a forward loan?
It is well known that one man’s joy is another man’s misery – and that also applies to low interest rates. If you are thinking about buying a house or an apartment, you will be happy to have low interest rates for real estate financing. Those who already live in their own home and are still paying off their building loan are annoyed: they may have to pay significantly higher interest rates for their old financing. And by the time it is time for follow-up financing, the low interest rates may already be over.
The forward loan was invented for such situations: A real estate financing, which one closes quasi in advance to secure favorable interest rates. But before you get the idea to take out such a loan in advance because you want to build in a few years: Unfortunately, that’s not possible. A forward loan is only available as follow-up financing. So you must already have a current property financing that will not be paid off by the end of the fixed-interest period.
Simply explained: Fixed interest rate for real estate financing
When you take out a real estate loan, you agree with the bank on a fixed interest rate for a certain term, for example for ten years. This is how long the interest rate for your loan is fixed. You pay exactly the percentage you agreed when you took out the loan, even if interest rates rise in the meantime. However, this also applies if interest rates have fallen in the meantime.
At the end of the fixed-interest period, a building loan is often not paid off in full. You will then have to renegotiate the loan conditions with the bank for the outstanding amount. Or you can pay off the remaining amount with another loan.
At the end of the fixed-interest period, homeowners then have to decide: Either you continue the financing with the previous lender – this is also called prolongation – or you look for a new mortgage lender with better conditions. And this is possible with the forward loan up to three years before the first financing expires – both with the old bank and with another provider. With some mortgage lenders it is even possible to take out a loan five years in advance.
How does a forward loan work?
In principle, a forward loan does not expire any differently than a normal follow-up financing. The only difference is that it is concluded years before the end of the current building loan. During the forward period – the period between the conclusion of the loan agreement and the start of its term – there are no costs for the new financing.
So you simply pay the instalment for your old building loan every month as usual. When it expires, the term of the forward loan that was concluded long ago begins:
- The money is paid out.
- You thus pay off the remaining debt from the old construction loan on time and
- will then pay the monthly loan installment agreed upon when the contract was concluded.
When is such a loan worthwhile in advance?
The interest rate for a forward loan is based on the construction interest rate at the time the contract is concluded. If construction money is available at a favourable rate, you can also take out a forward loan with similarly low interest rates. A forward loan is therefore always worthwhile if you expect interest rates to rise until the end of your fixed-interest period.
The risk here is that instead of rising, interest rates may fall until the end of your fixed-interest period. In this case, you will still have to pay the higher interest rate that you agreed when you took out your forward loan. Because a contract is a contract. You can read more about this below in the section on disadvantages.
Price for the security: the interest rate premium
Of course, the banks do not give the interest guarantee out of pure kindness. The bottom line is that a forward loan is always slightly more expensive than a normal construction loan with the same interest rate. This is because the banks demand a so-called interest surcharge for the waiting period until the disbursement. You do not pay anything during the period between the conclusion and disbursement of the forward loan. However, a small surcharge is due for each month until disbursement, but only later increases the actual interest rate.
You should keep this in mind when you consider whether a forward loan is worthwhile for you or not. If the interest rate does not change until the end of the old fixed-interest period, you will get off cheaper with a conventional construction loan.
What does the interest guarantee cost me?
To calculate the cost of a forward loan, you need to know these three factors:
- the interest rate (also called debit interest)
- the interest mark-up
- the lead time until disbursement
The interest mark-up is a value set by the bank, usually between 0.01 and 0.05 percent, which is added to the debit interest for each month until disbursement. The longer the lead time, the higher the surcharge.
An example calculation:
If the interest premium is 0.02 percent, for example, 0.48 percentage points (24 x 0.02) would be added to the debit interest for a 24-month forward period. With a debit interest rate of 2 percent, the final interest rate would therefore be 2.48 percent.
If you take out a forward loan of 50,000 euros with a term of 10 years at the conditions described above, interest costs of 6,431.75 euros would be incurred.
For a comparable normal building loan with the same interest rate of 2 percent, where no interest surcharge is due for a forward loan, the interest costs would be 5,159.44 euros.
Advantages and disadvantages of the forward loan
The advantage of the forward loan is clear: if the interest rates are favourable, you can secure them for your follow-up financing, even though this is not due for a few years. The point at which a forward loan can be taken out depends on the respective provider. Some providers allow up to five years in advance. The latest date for concluding a forward loan is one year before the fixed interest period of the old real estate financing ends.
However, the advantage of planning security can be reversed to the disadvantage if interest rates do not rise or even fall further until disbursement. In that case, the forward loan costs you more than if you had simply waited with the follow-up financing.
Because: If you have taken out a forward loan, you must accept it. And you must accept it at the agreed conditions. If you do not do so, the bank will demand a high compensation – even if it takes years until the payout date. Unless you have clairvoyant abilities, you should therefore definitely consider the interest rate development before you take out a forward loan. And even then, there is still a certain risk that interest rates will develop differently than expected. You should be aware of this.