Rising costs for inflation-indexed loans in Iceland

Rising Costs for Inflation-Indexed Loans in Iceland

According to the CEO of Íslandsbanki, interest rates on inflation-indexed loans need to increase due to a significant disparity between the Central Bank’s rates and inflation levels. The bank has absorbed billions in costs related to these loans.

Following a recent reduction in the Central Bank’s base rate, which dropped by 0.5 percentage points earlier this week to 8.5%, Íslandsbanki announced an increase in interest rates on inflation-indexed loans by 0.2 to 0.3 percentage points. Similarly, Arion Bank has also raised its inflation-indexed mortgage rates by 0.4 percentage points.

Despite the Central Bank’s rate cuts, inflation remains prevalent, recorded at 5.1% last month. The bank’s CEO noted that there has not been a proportional reduction in interest rates correlating with declining inflation rates, which has led to substantial costs for banks. As a result, many borrowers have switched to inflation-indexed loans over the past year.

Emphasizing the bank’s challenges, the CEO explained that should the bank issue short-term bonds to finance these loans, interest rates would need to range between 5% and 6%. Although they’ve raised current mortgage rates to around 5%, the bank finds itself in a position with little to no interest spread, and possibly negative spreads, which signifies that much of the financial impact is being absorbed by the bank.

The CEO also highlighted that there are essentially two different currencies in the country—indexed and unindexed—and banks are largely covering the imbalance between them. The so-called indexing imbalance has increased significantly, leading banks to fund inflation-indexed loans through unindexed debt.

Further details from other banks regarding rate adjustments are still pending.