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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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.
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