Fixed
interest rates
A fixed interest rate mortgage provides the borrower with the comfort of a stable repayment schedule over the fixed rate term. In America fixed rate terms of 30 years are commonplace, whereas over here we are lucky to find a ten year fixed rate although a few lenders are starting to offer long term fixed rates. In most cases a fixed rate is only for a set period of a few years years, typically two to five years, with a redemption fee for early settlement.
The main attraction is the fixed payment schedule rather than an attempt to get better value-for-money. Most UK lenders combine the fixed rate offering with a discount as well, so the true underlying fixed rate is often camouflaged. But you should expect to pay a little more for the added benefit of stable payments. There is another way of stabilising payments, which we will look at later, and where there are no early redemption fees.
Fixed
rate schemes cost money
Most lenders raise money from short
term, variable rate depositors. A
lender offering a fixed rate to a borrower and matching it with a variable rate
depositor is clearly taking a risk. Interest
rates could rise, increasing the payout to depositors with no corresponding
increase from the borrowers who have been promised no change: lenders could be
seriously out of pocket and even go bust if the mismatch was bad. This actually happened in the USA during the last century
forcing the government to step in with massive rescue schemes.
These days, the risk taken by lenders offering fixed rate loans is hedged. That is to say, they buy a financial instrument called a swap, which effectively passes the risk on to a speculator, usually a large institution like a bank. The speculators take a professional gamble on future interest rates. If rates move as they think, they will win out – and they lose if not. On the whole, as professionals, they win more than they lose. So if a lender offers a fixed rate of say 6% (ignoring incentive discounts), the professionals think that rates on average will be lower than 6% over the term in question.
This means that most underlying fixed rates usually turn out more expensive than accepting the fluctuating series of variable rates over the same period. In other words the IRR for a fixed rate scheme will usually turn out to be higher. But in return, the borrower is enjoying the comfort of a fixed, stable payment schedule, which must be worth something.
In the USA fixed rates are the norm and borrowers expect them to be more expensive than ARMs – Adjustable Rate Mortgages as they call them. If you want something extra, it usually costs money and fixed rates provide security – and security costs. But it may still be worth it, depending on your attitude.
The
professional probably knows best
To hope that a humble borrower
will outsmart the professional speculator requires an element of immodesty.
That is not to say it never happens.
Some fixed rates have turned out to be winners for the borrower.
But on average they turn out to be winners for the speculator.
The speculator is not necessarily the same as the lender who has paid
someone else to lay off the bet. But
if you as a borrower want to come out of a fixed rate contract early, be
prepared to pay a fee, which reflects the additional cost to the lender of
breaking his contract. It is not a
case of the lender profiteering from a penalty but compensating from a real
cost, at least in most cases it is.
Whenever the press reports rising interest rates, borrowers think they should now fix their rates. But, the lenders will already have adjusted the rate they offer to match the expectation. Only if a lender happens to have an old tranche of funds, hedged when rates were perceived to be lower, is it possibly a value-for-money exercise.
In summary, choose a fixed rate more for its payment stability rather than an attempt to beat the City at its own game. Those with a conservative attitude towards investment might well be candidates for a fixed rate repayment mortgage. But do not expect a fixed rate scheme to deliver better value-for-money: there is a cost to pay for fixed, stable payments.
Interest rates quoted for both fixed and
variable rates themselves change daily. An
example of what fixed rate was possible on 2^{nd} June 2000 is shown in
the table following, when 3 month LIBOR was 6.26% pa.
LIBOR stands for the London
Interbank Offered Rate and is the lowest rate banks can borrow at – often
called the wholesale cost of money - for a set period.
Wholesale lenders will be able to borrow at this rate plus a small
margin, and then lend out at the same rate plus a bigger margin and call it the
Standard Variable Rate. Fixed rates
are obtained in a similar way but most lenders then apply a discount incentive
as seen in the table below, assuming a margin of 1.25% and an incentive discount
of about 5% in year one.
Term
in years |
Fixed
rate base cost |
Typical
full fixed rate |
Typical
fixed discounted rate |
1 |
6.68
% pa |
7.93
% pa |
3.00%
pa |
2 |
6.65
% pa |
7.90
% pa |
5.50%
pa |
3 |
6.67 % pa |
7.92 % pa |
6.25% pa |
4 |
6.63 % pa |
7.88 % pa |
6.50% pa |
5 |
6.57 % pa |
7.82 % pa |
6.75% pa |
10 |
6.33 % pa |
7.58 % pa |
6.95% pa |
Caps, floors and collars
There are many different financial
instruments available to creative lenders to enable them to offer special
products. The fixed rate product is
funded with swaps. But it is also
possible to obtain a capped rate using a similar instrument. To the borrower, this means that the interest rate charged
couldn’t exceed the capped rate over whatever term it is capped for, but it
can fall if interest rates generally fall.
On the face of it, it seems an excellent idea to the borrower – a
safety margin if things go bad, without losing the option of lower rates if they
occur, although there is an early redemption fee.
However, like the fixed rate, there is always an extra cost whenever extra security is built in. A capped rate would normally be higher than a fixed rate since the speculator behind it has less opportunity to make a profit. If it is security and stability you need, a capped rate is unnecessary since the fixed rate provides it more cheaply.
But when you look at floors, things become more interesting. A floor is when the interest rate can go no lower than a prescribed rate. A lender would pay you if you agreed to a floor. If you wanted a cap and a floor, the cost of the two might even cancel out, depending on the rate range you chose. Such an arrangement is called a collar. It is like a fixed rate scheme but which can move in a preset range – like a snake in a tunnel.
However, the most desirable collars, which provide the best protection against perceived rate rises, but some comfort when rates fall, are still usually available at a net cost. They may be attractive to some people: it is always best to calculate the IRR and NPV as described earlier to compare the scheme with other products and to identify just what you are paying for the security privileges. Only then can you judge if the facilities are worthwhile. Use the “Loan Comparator” spreadsheet for this purpose.