A penny drops about mortgage rates

ken writes:

On the wireless this morning commentators were discussing the recent decision by the Permanent TSB building society (or is it a bank?) to raise interest rates on their mortgage loans by 0.5%. This has been criticised by the Irish unions who say financial institutions benefitting from the Irish government’s blanket debt guarantee owe it to the people of Ireland to keep rates low. The minister of finance has said that these matters will be left to the discretion of the individual banks, and the commentators I heard this morning all supported that policy. They explained that because of the fees the banks were paying the government to provide the guarantee, and because of the costs of sourcing money to provide loans in the first place, it was just not profitable for the banks not to increase their rates. Now, I didn’t really understand (so I cannot fully remember) all the details of the explanation, but the underlying point seemed to be this: that to lend money to ordinary people, banks had to borrow it from somebody else, so the interest rate they lend to ordinary people at must cover the interest they themselves will be paying for that money in the first place.

Actually now, thinking about it slowly as I write this, I might have just understood this explanation. I’ve been puzzled about it for a while. It seemed odd to me that mortgage interest rates were subject to change over the length of a mortgage at all. How should wider conditions in the market affect a deal made between the bank and the person some time ago? Assuming you pay the loan back, the bank should just forget about that money and give no further thought to it. The bank could have put all that money to other uses, but instead chose an interest rate based on how much they would like to profit from lending it to you, and lent it to you at that rate. There is nothing further the bank needs to do regarding that loan but sit back and count the payments as they come in. The transaction between you and the bank should be insulated from whatever else is going on in the market. The bank lends you money at the start of your mortgage in one big lump. They’ve already taken all that risk associated with the loan up front. Provided you’re doing your part in paying it back, the bank should just leave the whole thing alone.

And yet, that is not what happens at all. Banks are constantly meddling with their arrangements with people, changing the mortgage rate and even offering mortgage rates that track the central bank base rate, which from the perspective I’ve just offered is completely irrelevant. The fact that the bank has to borrow money to provide the mortgage is irrelevant because they’ve already done that, and at the time priced the cost of procuring that money for you into the interest rate.

But I see now that the fact that the banks borrow the money is indeed relevant. Just as the customer is having to pay off the loan to the bank each month, the bank has to pay bank what it borrowed each month as well. So if the bank is suddenly being asked to pay more in respect of what it borrowed in the past to lend to you, it will have to meddle with what it asks in interest from you to preserve its profit on the arrangement. This is what makes mortgage rates connected to wider goings on. If banks could borrow at a fixed rate for the length of the mortgage, or if they only lent money that was actually theirs in the first place, then they could profit from mortgages with rates fixed for the life of the mortgage. Maybe central banks, should consider this when they end to commercial banks.

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3 thoughts on “A penny drops about mortgage rates

  1. laura

    Surely they were talking about tacking on an additional 0.5% for new mortgages, no? I believe you are correct that the contract with the borrower must remain at the rate agreed upon for the duration of the original mortgage. In the US, at least, changing the rates affects only new mortages and re-fi’s (which are happening all the time). Well, I’ll see if I can find something about this online to get the details.

  2. laura

    An article at “independent.ie” indicates that the increase will be on “variable rate” mortgages, as opposed the the fixed rate variety where you lock in for the duration. I assumed both types were available and the higher rate would likely go to those who don’t want to risk market fluctuations.

  3. In the UK fixed rate mortgages have relatively short terms compared to the life of the loan: 1, 2, 3, 5, 10 years. The longest my bank offers is 10 years and the interest rates on a 10 year fixed rate mortgage are much higher than on a tracker or short-term product. So unless you believe rates are going to go very high, most people are better off with short-term fixed or tracker mortgages. In fact, with housing prices so ridiculously inflated, many people would struggle to pay the cost of a long-term fixed-rate mortgage each month. They may lose their home if their two-year rate runs out at a time when rates have gone up to ten percent, but rates might not go that high. How can anyone be expected to make that call?

    The thing is, Ken, your scenario makes sense, but the practices of the financial sector don’t. The money borrowed and lended isn’t ring-fenced, just as it doesn’t correspond to actual printed cash, just as printed cash doesn’t correspond to gold or other actual wealth — it’s part of the dynamic daily ebb and flow of what is essentially electronic information between financial institutions and individuals. It’s all fake.

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