I’ve had mortgages in two countries, the UK and Australia. They work very similarly, you can generally get a ‘tracker’ mortgage, which is a little above the central bank rate and tracks the central bank rate, so your repayments vary over time, or you can get a fixed rate.
Fixed rates are usually more expensive, and the longer you fix (typically 1,2,3 or 5 years, though you do see 8) the more of a premium you pay over the tracker rate. When your fixed period expires you usually refinance based around whatever new rates are available at that point, and you are usually constrained from refinancing during that period (exit fees).
But in the US I understand that people usually fix the rate for the whole term of the loan? And I imagine that makes refinancing quite rare?
Is this not quite risky for banks? Not that banks taking a risk is bad, but it seems a very long bet for them.
What sort of interest rate premium over the base rate is common?
In the UK or here AFAICT it’s usually about 1.2-1.5% over base rate for the better value trackers and goes up from there for fixed, depending on your loan to value ratio as well. IIRC I had a five year fixed at about 2.5% over base in the UK, though memory is fuzzy.
The US and Denmark are the two well known jurisdictions with fixed rates for the loan term (typically 30 years in the US).
Refinancing happens when rates go down.
Yes, this does mean lenders take a lot of interest rate risk. The whole US government mortgage securitization and insurance infrastructure exists to help transfer this risk to people who want it.
I find the non-US model weird... What are you supposed to do if 3 years into owning a house the rate goes way up? At that point you will have almost no equity and extending the term isn't going to help much.
People actually do refinance frequently if rates go down. If they go up naturally they'll keep their lower rate.
This does create issues when rates go up a lot like they just did, because it makes it harder for people to move.
Fixed rate mortgages do create risk for banks, and some banks have run into trouble recently, although a lot of mortgages are resold by banks and packaged into bonds, either by investment banks or by the "Government Sponsored Entities", Fannie Mae and Freddie Mac.
You’re supposed to be able to afford it if the rate goes up, and build that into your risk model, and rein in your spending.
This then means that central bank interest rises have an immediate effect on the spare cash for a wide swathe of the population.
You’re also supposed to have at least 20% equity at the get-go in Australia, or you end up having to pay extra for some sort of loss of value insurance (I haven’t looked into this much as it’s not my situation). This is making it hard for young folks to get started in an environment of elevated prices.
From my perspective it would be a pretty sweet deal if I could fix my loan for 25 years and only ever revise the rate down!
That’s why I was asking - what sort of rates do you actually end up paying, vs the central bank rate at the time?
Here in Australia, the regulator requires banks to assess your ability to make repayments at an interest rate three percentage points higher than the actual rate. A few years ago it was a floor of 7% rather than a buffer, and they'll probably go back to something like a 2% buffer and a 7% floor (rates increased by more than 3 percentage points in recent times, so looks like a three percent buffer alone isn't enough).
But yeah, mostly what happens if rates go up is that you begrudgingly pay it, because most in that situation can afford it (those who have changed circumstances may not be able to, but most can).
Edit: also, the fact that mortgage holders are more sensitive to rate increases means (it is thought that) the central bank doesn't need to change rates by as much to get the same effect. If there would be widespread mortgage defaults given a certain sized rate increase, then that probably means the central bank can stop short of an increase that large.
So the problem is sort of self-limiting. Rate hikes are designed to induce financial strain, but too much isn't desirable, so central banks don't hike too much on purpose (they sometimes do by accident).
> Is this not quite risky for banks? Not that banks taking a risk is bad, but it seems a very long bet for them.
It is and it isn’t I think. They rebundle those into securities and sell them on so that other banks and investment firms convert capital into cash flow and it acts like an investment portfolio (then others leverage those securities with derivatives). So the bank isn’t holding the loan directly typically. Of course, as we found out in 2008, the amount of exposure to risk is generally poorly understood even by the players. That being said, I believe similar things happen abroad, so I’m not so sure why 30 year fixed exists in America as an anomaly that you don’t see in other countries and what specific regulation / law encourages it to be this way.
I have no knowledge of Australia or the uk mortgage markets but in America mortgages get packaged up in securities and sold to investors in the market or big agencies/government programs. Most banks don’t hold mortgages on their books for long before selling them off. Some banks retain servicing but don’t hold the debt on their books. It’s all very complicated and feels like a shell game but mortgage markets have only blown up once in memory whereas I’ve stopped counting recessions.
Except the model was flawed and carried much higher tail risks. Risks that the ratings agencies failed to catch when they gave them AAA ratings in the debt market.
And a lot of conforming mortgages are held by government-sponsored enterprises like Fanny Mae. Key point those asset holding companies don't have to deal with profit and losses like ordinary investment businesses.
People in the US refinance all of the time. Usually either because the mortgage rates are now low enough to lower their payment significantly or to take some equity out as cash (for renovations, another down payment or other reasons). I bought my current home 8 years ago and have refinanced twice.
> Is this not quite risky for banks? Not that banks taking a risk is bad, but it seems a very long bet for them.
Not really. Mortgages are (mostly) bundled and on-sold to investors which assume the risk of default and interest rate changes. The originating bank collects are premium for the loan and moves on to the next one.
US mortgages are unique I believe. Canada does 5 year fixed and you refinance at the current rate.
I believe the US mortgages work because of Fannie Mae/Mac and a market in mortgage backed securities ( MBOs? I thought they caused the 2008 crisis but I think they are still a thing with better risk management, I dunno?).
It was auction-rate mortgage backed securities that triggered everything. If you see those start showing up again, know we're heading for an awful place.
I’ve had mortgages in two countries, the UK and Australia. They work very similarly, you can generally get a ‘tracker’ mortgage, which is a little above the central bank rate and tracks the central bank rate, so your repayments vary over time, or you can get a fixed rate.
Fixed rates are usually more expensive, and the longer you fix (typically 1,2,3 or 5 years, though you do see 8) the more of a premium you pay over the tracker rate. When your fixed period expires you usually refinance based around whatever new rates are available at that point, and you are usually constrained from refinancing during that period (exit fees).
But in the US I understand that people usually fix the rate for the whole term of the loan? And I imagine that makes refinancing quite rare?
Is this not quite risky for banks? Not that banks taking a risk is bad, but it seems a very long bet for them.
What sort of interest rate premium over the base rate is common?
In the UK or here AFAICT it’s usually about 1.2-1.5% over base rate for the better value trackers and goes up from there for fixed, depending on your loan to value ratio as well. IIRC I had a five year fixed at about 2.5% over base in the UK, though memory is fuzzy.