Are There 5% Loans in Mexico? Dual Index Mortgages

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September 21, 1998

"A friend from Mexico says she has a home loan with an interest rate of only 5%, even though the inflation rate there is much higher than that. Is there any way she can be right?"

Mexico is one of a number of countries suffering from inflation that have experimented with some off-beat types of mortgages such as the PLAM ("price level adjusted mortgage") and the DIM ("dual index mortgage"). Your friend could have either type but it is probably a DIM because that has become the most widely used instrument in Mexico in recent years.

The interest rate on the DIM is not really 5%, as you suspect, but much higher – consistent with market rates in Mexico. Further, the rate earned by the lender is adjusted periodically (it is "indexed") in line with changes in market rates. From the standpoint of the lender, the DIM is much like an adjustable rate mortgage (ARM) as we know it here.

From the standpoint of the borrower, however, the DIM is nothing like an ARM. The initial payment is relatively low, consistent with what the borrower can afford. For example, it might be calculated at 5% as noted by your friend. But while the payment may be calculated at 5%, the rate due the lender could be 25% or more, the difference being made up by "negative amortization" -- increases in the loan balance. Typically the loan balance on a DIM will rise for many years before it begins to decline.

Meantime, the payment made by the borrower changes every month in line with changes in an index of wages and salaries. Having the borrower’s payment tied to a wage and salary index and the lender’s income tied to an interest rate index is what makes it a "dual index mortgage".

The expectation is that the borrower's payment will eventually rise to the point where it fully covers the interest and the balance will begin to decline. There is only one "minor" problem. If wages and salaries in Mexico don’t keep up with inflation, the payments made by borrowers aren’t going to rise fast enough for this to happen. At the end of the terms, there will be unpaid balances. While lenders in Mexico have written some DIMs on which they accept this risk, in most cases they have insurance from the Mexican government, which stands to take the loss.