How Prime Rate and Inflation Affect the Monthly Payment
One of the reasons financing in general, and mortgages in particular, are so deeply unpopular is that it feels as if everything was done to make the subject as complicated as possible. Why are there several types of loans? Why can't you just pick one simple option and be done with it?
We'll say more about the different loan types later on, but for now, having already covered inflation and the prime rate, let's take the next step and explain how these "abstract" topics tie directly into your loans.
With the exception of one loan — the fixed unlinked loan (KALATZ) — the monthly payment on every loan depends on, and changes with, an external, objective economic index that you have no control over whatsoever.
That index might be the Bank of Israel interest rate, the Consumer Price Index (CPI), the yield on Israeli Government bonds, and so on.
The aim of this article is to explain how the monthly payment changes when this economic index rises or falls.
The monthly payment can change for two reasons:
- A change in the interest rate — this is the profit the bank earns each month from granting the loan
- A change in the principal — this is the amount of debt you took on
The way the payment changes differs depending on whether it's driven by an interest rate change or by growth in the principal.
How does a change in the interest rate affect the monthly payment?
To set the stage: the vast majority of loans on offer carry a variable interest rate. In fact, the only loans whose payment doesn't change as a result of an interest rate change are:
- A fixed-rate loan linked to the Consumer Price Index (note! the payment will still change every month due to changes in the principal)
- A fixed-rate loan that is not linked to the Consumer Price Index
We should also stress that although the interest rate can change, it doesn't always change in practice. With the prime-linked loan, for example, the Monetary Committee meets to discuss, set, and adjust the Bank of Israel interest rate eight times a year, but the rate won't necessarily change at every one of those meetings.
But what happens when the interest rate does change? In that case, the monthly payment has to be recalculated to apply from that point on. This is done by recalculating the amortization schedule.
Example: interest rate change from 4% to 5%
You borrowed a sum of money in a variable-rate loan on an annuity amortization schedule. The outstanding principal balance stood at 100,000 NIS, with 50 payments remaining. The previous interest rate was 4%, and you've just been notified that it's now changing to 5%.
You can calculate the monthly payment using the PMT function in Excel:
Before the change: the payment was at 1,177 NIS per month.
PMT(4/1200, 50, -100000) = 1,177 ₪
After the change: the payment is at 1,228 NIS per month.
PMT(5/1200, 50, -100000) = 1,228 ₪
What happens to the monthly payment if the interest rate falls?
When the interest rate drops, you come out ahead — your monthly payment drops too. So if you expect rates to fall in the near future, you can increase your exposure to variable-rate loans and enjoy a lower payment and smaller interest costs.
Note that the interest rate can't fall below zero. In other words, you'll never reach a point where the bank "pays" you on your loan.
How does a change in the principal affect the monthly payment?
First, let us emphasize that the only reason our monthly payment will change as a result of a change in the principal amount is if our loan is exposed to the Consumer Price Index (CPI) (unless it is a loan on a linear payments schedule).
The loans exposed to the Consumer Price Index are:
- Fixed CPI-linked loan
- Government-subsidized mortgage (Zakaot)
- All variable-rate loans that are also CPI-linked
The payment on these loans changes every month, when the Central Bureau of Statistics (CBS) publishes the Consumer Price Index. How does it change? If, say, the Consumer Price Index rose this month by a certain rate, the outstanding principal balance on the loans above rises by that same rate. The monthly payment then grows by exactly that amount to make up for the increase.
Example: a CPI rise of 0.2%
You borrowed a sum of money in a CPI-linked loan on an annuity amortization schedule. The outstanding principal balance stood at 100,000 NIS, with 50 payments remaining. The previous interest rate was 4%. As we saw above, the monthly payment is 1,177 NIS.
If the Consumer Price Index rose this month by 0.2%, then the debt grew, and the 100,000 NIS became 100,000 NIS plus 200 NIS (which is 0.2% of the outstanding principal balance).
If the principal grew by 200 NIS, we open a new, small sub-loan of 200 NIS, on exactly the same terms as the original loan.
The payment on this loan is 2.36 NIS per month, which is exactly 0.2% of the original payment:
PMT(4/1200, 50, -200) = 2.36 ₪
So starting next month, the payment will no longer be 1,177 NIS but 1,179.36 NIS — from here on out.
The biggest risk in CPI-linked loans
You need to understand the single most important mechanism in CPI-linked loans: if the index rises another 0.2% next month, a further sub-loan is opened — 0.2% of the main loan plus 0.2% of the sub-loan created the previous month.
What happens if the Consumer Price Index falls?
In that case, the principal decreases and your monthly payment falls. So if you expect inflation to fall in the future, you should increase your exposure to CPI-linked loans. You're taking a risk, yes, but you also get the chance to lock in a lower interest rate and pay less in interest.
It is important to emphasize: the principal cannot fall below its original value.
Good luck!