Due to a history of persistent inflation and high interest rates, Iceland adopted a mortgage (housing loan) system largely based on so-called indexed loans.
Lately, as interest rates have fallen to historically low levels, non-indexed loans have increased in popularity but indexed loans are still a major part of Icelandic mortgages. What is this indexation and how does is differ from more traditional non-indexed loans?
Overall prices in the country are measured each month by the Icelandic statistics office (Statistics Iceland / Hagstofan). The price of food, clothing, heating, rent, travel and all other comsumption is measured and changes are added to the so called Consumer price index. Indexed loans are fixed to this index. In addition to paying interests on the loan you will pay whatever the change of inflation is in each month.
Let‘s look at how this works.
Indexed and non-indexed loans
Paying off a traditional non-indexed loan is fairly simple. You pay a part of the remaining principal as well as interests. As you pay the remainder of the loan decreases.
Indexed loans are vastly different and far more complicated. Each month you pay your regular payment of the remaining principal and your interests. But as monthly inflation numbers are published the increase in the consumer price index (usually a fraction of a percent) is added to every payment remaining of your loan. As this addition to the remainder of the loan can possibly outweigh the payments you are making there is a change that despite paying down the loan the remainder of the total loan amount increases.
Because of this indexation the interest rate is usually quite lower on indexed loans.
Pros and cons
Why do people still apply for indexed loans given the danger of increased inflation eating into their equity? First of all indexed loans usually offer lower payments to begin with, as interests are lower and the effects of years of inflation have yet to be added to the loans. This makes it easier to qualify for a loan and buy your first apartment or purchase a more expensive property.
Secondly there are ways of paying off the mortgage at a quicker rate by increasing monthly payments such as utilising the temporary option of tax-free private pension payments directly to the remaining amount.
As non-indexed interest rates have gone down those loans have become a more realistic option in Iceland and a record number of home owners have refinanced from indexed to non-indexed loans.