If I borrow 200k from a bank or building society to buy a house in say 2018, why is the interest rate on that loan variable for the next 25 years? Shouldn’t it be the internet rate when the bank loans the money to me.
If the bank has loaned me money when interest rates are low, then interest rates go up, aren’t they just creaming off a whole load of profit from me?
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You can get what is known as a fixed rate mortgage, where the interest rate is guaranteed for a number of years, the problem is that rate is generally higher then the variable rate and if interest rates fall you may much more than people on a variable rate.
No. The bank has to pay out interest usually near the current interest rate to borrow money in the short term and it pays interest to depositors at a variable rate too. So the cost of lending you the money varies with time.
The bank offers a variable interest rate loan to balance out the interest it receives and what it pays. If it offered you a fixed interest loan, then it will charge a higher interest rate because the bank won’t know the future interest rate it has to pay.
Remember the bank takes deposits and makes loans.
Rates vary with the market. Rates are how they make money off of you. They want the highest rate possible while not losing business because people can get better rates elsewhere.
In an adjustable rate mortgage, you may start out with a lower rate. This means they are making less money on you. The rate adjusts with the market. So while you may start out with a lower rate, it can (and usually does) increase.
In a fixed rate mortgage, you agree on a set rate and that’s it. For that particular mortgage, your rate is set and will not change. It’s much more stable for both parties. Because of that, your rate will likely be higher than the starting rate of an adjustable rate mortgage.
Say an adjustable rate mortgage starts at 1.5% and is capped at a possible 1% rate increase per year up to say 7%. Year 1 you’re paying 1.5%, year 2 2.5%, year 3 3.5%, and so on.
If you could get a fixed rate mortgage at 1.5%, you would never consider an adjustable rate and the mortgage company wouldn’t make nearly as much money off you. Instead you may have a 4% fixed rate. So you’re paying more in interest the first few years but you’re protected if rates go up in the future.
TLDR: Adjustable rate mortgages are basically a discount in the first several years of your mortgage in order to secure business for the mortgage company with a good likelihood of making the money back up on the later part of the loan.
Because the bank’s borrowing costs are also variable (their depositors expect a rate that moves with short term rates), and you don’t have an entity with government backing to buy long term fixed rate mortgages from the banks.
The bank gets money from their depositors and loans it to you at a marked up interest rate, so their costs are usually rising with their revenues when your loan rate goes up.
The technical answer is, because you agreed to it.
The practical answer is, because the way the system is set up means that the cost of the bank incurs for lending money varies with time, and the bank itself has to keep their investment viable. That variance is due to many factors, the most well-known being the rate at which the central bank is lending. That’s the “interest rate” you hear about in the news so often.
The alternative answer is, you don’t have to agree to a variable rate. The bank will be more than happy to offer you a fixed-rate loan, but that rate will be higher to compensate.
Your mortgage rate is based on the prime lending rate which is in turn based on the federal interest rate. As the federal interest rate changes so do all those other rates which can make your mortgage more or less expensive.
I guess it depends on where you live how mortgages work. Here in the US, the most common mortgage is a 30-year, fixed interest rate mortgage. Other countries might have variable ones due to higher degree of fluctuation of interest rates and currency valuation, etc.
But when banks raise interest rates on customers, they’re typically doing so in lockstep with the Federal Reserve or Central Bank raising rates that banks must pay to meet reserve requirements.
The bank is committing that money to you for the entire duration of the loan. The problem is, their cost over that period changes depending on market interest rates. If they hadn’t tied up the money in your house, they could have gotten the overnight rate every day (or given someone else a mortgage at a higher rate), so if rates go up to 7% they’re losing money on your 2% mortgage. They have three basic ways of setting a price for that.
One way is to pass on the actual cost of that money to you with a variable rate. So you pay whatever the interest rate is at the time. They know that whatever happens, their profit from your mortgage will be consistent over time, so that’s nice for them.
A second way is to charge you a fixed interest rate for the duration of the loan. The bank can, if it chooses, hedge against those instruments to mitigate its risk. You might prefer a fixed rate because your payments are more predictable, and the bank might not want you to default on your mortgage if interest rates spike. There is a market rate for 25 years, and it represents what people think is fair compensation for the possibility that interest rates could change.
A third way is to give you a fixed interest rate for a shorter term like five years, and then you get a new market rate for the next five years on the remaining balance. That’s kind of a middle ground.
It’s really a question of whether you or the bank should take on the risk of something unexpected happening. Plus you might even pay a little extra for the security of knowing your payments won’t change and you’ll continue to be able to afford your house.
The bank has all the power in the relationship because it’s their money, and they don’t like risk, so they can offer only variable rates if they want, or they can set the price of the fixed rate where they feel fairly compensated.
Ideally, banks would be competing with each other for your business, and that would make them offer fair rates and a variety of rate structures to appeal to different borrowers.
Well, banks don’t get their money at a fixed rate for 25 years so neither do you. They borrow and lend to you, plus extra for their work.
So it all depends on what the current rates are and trying to predict the future if you want to do a variable rate mortgage or a fixed rate mortgage
When we got our mortgage it was 2.4% , I got a fixed rate since I didn’t really foresee mortgage rates dropping to like 1% after a year or two which they ended up doing
But at the same time now rates are 7% so I didn’t get totally screwed by the rates rising like someone with a variable rate did
Most major banks will let you choose or have a different amortization period or maximum amount allowed to be paid off. A variable rate mortgage you may be allowed to pay off larger chunks at once but for my fixed rate I’m allowed at most 10% a year this way the bank always ensures it gets its money
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