Mortgages: fixed vs variable rates

[DrClaude]

I don't know how things are changing globally, but over here the bank rates are slowly going up. In conjunction, I've been reading articles from my bank that say that it would be a good time to go from a variable-rate mortgage (where the rate is adjusted every 3 months) to a fixed-rate mortgage (with a term of anywhere from 1 to 8 years).

While I understand the stability argument for a fixed-rate mortgage (one knows exactly how much one will have to pay over a long period), I don't see any valid argument from the point of view of personal economy.

The way I see it is that the bank itself, when setting the long-term rate, is using models of how the bank rate will evolve, so that they don't end up in the situation where they are offering rates that are too low. Knowing banks, I assume they must be quite conservative in their assessment, meaning they will leave a large margin for error, so that they don't lose any money. Therefore, they only way for a consumer to gain from a fixed-term mortgage is if the bank strongly underestimated the increase of the bank rate.

In other words, I think that going to a fixed-rate mortgage is equivalent to betting that the bank erred in their prediction of the evolution of the bank rate. Is this wrong?

 

[PeroK]

I don't know how things are changing globally, but over here the bank rates are slowly going up. In conjunction, I've been reading articles from my bank that say that it would be a good time to go from a variable-rate mortgage (where the rate is adjusted every 3 months) to a fixed-rate mortgage (with a term of anywhere from 1 to 8 years).

While I understand the stability argument for a fixed-rate mortgage (one knows exactly how much one will have to pay over a long period), I don't see any valid argument from the point of view of personal economy.

The way I see it is that the bank itself, when setting the long-term rate, is using models of how the bank rate will evolve, so that they don't end up in the situation where they are offering rates that are too low. Knowing banks, I assume they must be quite conservative in their assessment, meaning they will leave a large margin for error, so that they don't lose any money. Therefore, they only way for a consumer to gain from a fixed-term mortgage is if the bank strongly underestimated the increase of the bank rate.

In other words, I think that going to a fixed-rate mortgage is equivalent to betting that the bank erred in their prediction of the evolution of the bank rate. Is this wrong?

I imagine that there is extra contingency in a fixed-rate deal, so as you say you are likely to pay more. But, a key factor may be a worst-case scenario. Averages are not the whole story. One approach to personal finance is to ensure the worst-case scenario is manageable. In other words, the thing you most want to avoid is getting into financial difficulties. A fixed-rate mortgage might ensure that. And that might be worth paying for on average.

 

[StoneTemplePython]

In other words, I think that going to a fixed-rate mortgage is equivalent to betting that the bank erred in their prediction of the evolution of the bank rate. Is this wrong?

You're wise to be suspicious of the products being sold. And with interest rates it gets extra complicated to think about how it looks internally for a bank because of the mixture of funding sources that banks use...

But this is basically wrong. The way to think about it is banks (roughly) run a matched book. So when they sell, in effect, swap to fixed contracts to you, they are marketing swap to floating to someone else. That someone else may be other retail customers like you or interest rate derivatives to large corporate clients or governments or...

In a sense this isn't a fundamental valuation viewpoint, but asset arbitrage viewpoint. What their models say may have an impact on credit risk assessments (is having retail borrowers on floating rate debt riskier? I suppose so), but mostly they try not to rely on longterm interest rate forecasts and lay off the interest rate risk -- i.e. the positions net aka the matched book.

Banks sit in the middle and collect a spread / fee -- some of it for bearing credit risk and some of it as income for being a middleman. In general their goal is to have lots of activity so they can collect more fees for intermediating. Vanilla interest rates swaps are a pretty commoditized product and their aren't particularly high spreads here.

 

[BWV]

I don't know how things are changing globally, but over here the bank rates are slowly going up. In conjunction, I've been reading articles from my bank that say that it would be a good time to go from a variable-rate mortgage (where the rate is adjusted every 3 months) to a fixed-rate mortgage (with a term of anywhere from 1 to 8 years).

While I understand the stability argument for a fixed-rate mortgage (one knows exactly how much one will have to pay over a long period), I don't see any valid argument from the point of view of personal economy.

The way I see it is that the bank itself, when setting the long-term rate, is using models of how the bank rate will evolve, so that they don't end up in the situation where they are offering rates that are too low. Knowing banks, I assume they must be quite conservative in their assessment, meaning they will leave a large margin for error, so that they don't lose any money. Therefore, they only way for a consumer to gain from a fixed-term mortgage is if the bank strongly underestimated the increase of the bank rate.

In other words, I think that going to a fixed-rate mortgage is equivalent to betting that the bank erred in their prediction of the evolution of the bank rate. Is this wrong?

No, this is all wrong. Banks in the US do not take the interest rate risk, nor do they generally hold mortgages. Banks earn a fee for underwriting the mortgage and then they get packaged into a securitized pool. Your bank wants you to change your mortgage because they will earn a fee. The floating rate vs fixed rate is not set by the bank, it is tied to the market for other interest-bearing instruments such as Treasury Bonds. The fixed-vs-floating spread depends on this, not what the bank thinks future interest rates will be.

 

[phyzguy]

As PeroK said, a lot of this is protecting yourself from risk. Below is the history of the Fed funds rate in the US. What happens to your variable rate loan if interest rates spike back up to 20%, like they did in the 1980s? Can you afford that scenario?

 

[Vanadium 50]

The discussion about banks being in many (but not all) cases middlemen doesn't really change the argument. Replace the word "bank" with "lender" and there you go. Similarly, it doesn't really matter if rates are set algorithmically or by some guy wearing green eyeshades. They are what they are.

Dr. Claude, you are right that the banks..er...lenders try to set up their loan pricing so that they get their share - ideally, the same present value for equivalent risk. And you are right that they have table after table produced by model after model to try and do this. However, these are all based on averages. The average borrower pays the minimum: if you pay more than that, one product may be better than another. Usually, that will be one with a lower initial rate. The average mortgage is in force for something like seven or eight years before the owners move or refinance. You might know your own case is shorter or longer than this, and again, one product may be better than another.

 

[Evo]

I got a 30 year fixed mortgage at 3.56% a little over a year ago. I feel very good about it. Sure at one point the rates dipped a fraction of a point for a month, but then went back up and continue to go up. @BWV, is correct, banks underwrite the mortgage, but the loan was from another source, and was sold to a mortgage company a week after closing (I knew this would be happening as neither my bank or the loan source held mortgages).

Of course, some banks do hold mortgages, I have had those in the past and was not happy. I am very happy with the professional mortgage company I have now.

 

[BWV]

I got a 30 year fixed mortgage at 3.56% a little over a year ago. I feel very good about it. Sure at one point the rates dipped a fraction of a point for a month, but then went back up and continue to go up. BWV, is correct, banks underwrite the mortgage, but the loan is from another source, and was sold to a mortgage company a week after closing (I knew this would be happening as neither my bank or the loan source held mortgages).

Likely it was the servicing rights that were sold, not the mortgage. Conforming mortgages are packaged into pools by the government entities Freddy Mac or FNMA and securitized with a government guarantee to make whole any credit losses from the pool. My mortgage has changed servicers several times while the actual mortgage is held within a mortgage backed security.

 

[Evo]

Likely it was the servicing rights that were sold, not the mortgage. Conforming mortgages are packaged into pools by the government entities Freddy Mac or FNMA and securitized with a government guarantee to make whole any credit losses from the pool. My mortgage has changed servicers several times while the actual mortgage is held within a mortgage backed security.

You're probably right, I'm not sure, mine was a rather new type of mortgage, most people hadn't even heard of it, my banker hadn't. I hadn't, my realtor hadn't. But if you can get it, it's AWESOME.