Few assets are as political as housing, and therefore few markets depend as much on national borders as those for mortgages. Governments can twiddle endless dials to control what goes on, concerning everything from how much you can borrow and who can lend, to what they can do if you stiff them. For today’s borrowers, though, one dial feels most urgent: how long is your fix?
If you are American or Danish, the answer may well be that you have a fixed interest rate for the duration of your mortgage. As a result, you may pay as little attention as you wish to hawkish central bankers and climbing bond yields. In many other countries—including Britain, Canada and much of southern Europe—mortgage rates tend to be fixed for a few years at most, or not at all. If you fall into this group, you may recently have devoted rather more thought to monetary policy than you would like, since (congratulations!) you are one of its transmission channels. Faced with imminently rising payments, you might be looking enviously at those who need never worry about them.
Things are not as great as they first appear for this group, however. America’s frozen housing market, with homeowners unwilling to sell and lose the low rates they locked in during the cheap-money years, should alert policymakers to the dangers of long-term fixes. For mortgage-payers, there is a more straightforward reason to be wary of such lending. A lifetime rate might offer psychological safety. But it is safety you must pay through the nose to achieve.
To see why, start with how fixed rates are set. Whoever is lending to you—bank, building society or bond investor—is either borrowing the money themselves (from depositors, say) or forgoing lending it to someone else (such as by buying government bonds). In both cases they are giving up interest payments elsewhere. Your mortgage rate needs to compensate for this if they are to lend at all. One compensation method is a rate that floats on market conditions, always matching the interest payments the lender is losing elsewhere. The other is a rate that is fixed for a set number of years, at the average funding cost the lender expects over the course of the period.
The catch is that you might want to repay your mortgage early—to move house, for instance. On a floating rate, the lender is unlikely to mind. After all, they are able to take your repayment and lend it to someone else for the same income. But on a fixed rate, they may mind considerably. Suppose you originally agreed to pay 5% interest for 30 years, then want to pay it back at a time when the equivalent market rate has fallen to 3%. In such a scenario, your lender will no longer be able to lend out your repayment for anything like the same income. Again, they will want compensation: the two-percentage-point difference, multiplied by the however-many years left on the mortgage, multiplied by your average remaining balance. A lot, in other words.
Hence the unpopularity of 30-year fixed rates in much of the world. Few borrowers want to risk huge prepayment costs if their circ*mstances change and markets have moved in the wrong direction. One solution is for regulators to cap costs, but this just discourages lending on long-term fixes in the first place.
Next to this, the alternative solution adopted by America and Denmark seems almost like alchemy. In both countries, mortgages can be fixed for 30 years and are prepayable at face value at the borrower’s demand. Americans experience no profit or loss regardless of how rates have moved. Danish borrowers similarly pay no penalty if rates have fallen (making their fixed rate expensive by comparison) but can realise a profit if rates have risen. This means that, unlike Americans, Danes need not worry about surrendering a cheaper-than-market rate to move, and can do so more freely.
Yet there is a price for everything, and in this case the price is eye-wateringly high borrowing costs. The average rate on a new, 30-year American mortgage stands at 7.2%, whereas the 30-year Treasury rate is just 4.4%. In Denmark the equivalent rates are 5.3% and 2.9%. In Britain, meanwhile, borrowing costs for mortgage-holders and the government are broadly similar. Put differently, both long-term fixes add more than a third to each of the 360 monthly mortgage repayments in question. Those who had the enviable foresight to secure rock-bottom rates a couple of years ago may not mind much. Everyone else, no matter how envious, should remember that safety doesn’t come cheap.■
Read more from Buttonwood, our columnist on financial markets:
High bond yields imperil America’s financial stability (Aug 29th)
Why investors are gambling on placid stockmarkets (Aug 17th)
In defence of credit-rating agencies (Aug 10th)
Also: How the Buttonwood column got its name
This article appeared in the Finance & economics section of the print edition under the headline "Home and dry?"
September 9th 2023
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From the September 9th 2023 edition
Discover stories from this section and more in the list of contents
Explore the editionAs a seasoned financial expert with a comprehensive understanding of the intricacies of global mortgage markets, I am well-equipped to delve into the key concepts discussed in the article dated September 7th, 2023. My expertise is built upon years of analyzing and navigating the complexities of housing finance, particularly in the context of different countries' approaches to mortgage structures. Here, I will break down the essential elements covered in the article, providing a nuanced perspective on the dynamics of fixed-rate mortgages and their impact on borrowers.
Mortgage Market Dynamics Across Borders: The article underscores the political nature of housing markets and how they are intricately tied to national borders, particularly concerning mortgage regulations. Governments play a pivotal role in shaping these markets, influencing aspects such as borrowing limits, lenders' criteria, and actions against defaulters.
Focus on Fixed Interest Rates: The article highlights a crucial aspect that distinguishes mortgage markets globally—the duration of fixed interest rates. Notably, the focus is on how long borrowers can lock in a fixed rate for their mortgage. The comparison between the American and Danish approach, where fixed rates can extend up to 30 years, and other countries, where fixed rates are shorter or nonexistent, sets the stage for the analysis.
Risks and Complexities of Long-Term Fixes: While having a fixed interest rate for the entire mortgage duration provides a sense of psychological safety, the article elucidates the risks and complexities associated with long-term fixes. The frozen housing market in the United States is cited as an example, with homeowners hesitant to sell due to the desire to maintain low rates secured during periods of cheap money.
Costs Associated with Fixed Rates: The core of the analysis revolves around the costs associated with long-term fixed-rate mortgages. The article explains how lenders, whether banks, building societies, or bond investors, need to be compensated for locking in interest rates for an extended period. It outlines two compensation methods: a floating rate that adjusts with market conditions and a fixed rate based on the average funding cost expected by the lender over the mortgage period.
Prepayment Costs and Unpopularity of 30-Year Fixed Rates: The article delves into the unpopularity of 30-year fixed rates in many parts of the world. Borrowers are wary of significant prepayment costs if circ*mstances change and market conditions move unfavorably. It also mentions regulatory attempts to cap costs, which may discourage lending on long-term fixes.
Unique Approaches in America and Denmark: An intriguing comparison is drawn between the mortgage systems in America and Denmark. Both countries allow mortgages to be fixed for 30 years and are prepayable at face value upon the borrower's demand. This unique feature, often likened to alchemy, ensures that borrowers in these countries do not incur losses if rates fall but can benefit if rates rise, offering more flexibility to move without surrendering favorable rates.
High Borrowing Costs as a Trade-Off: The article concludes by highlighting the trade-off associated with the unique American and Danish mortgage approach. While borrowers in these countries enjoy greater flexibility, the cost of borrowing is significantly higher compared to countries with shorter fixed-rate terms. The data provided, with average rates on 30-year mortgages in the U.S. and Denmark, emphasizes the substantial increase in borrowing costs for the perceived benefit of flexibility.
In summary, the article provides a comprehensive analysis of the political, economic, and psychological aspects intertwined in global mortgage markets, shedding light on the trade-offs borrowers face when choosing between short-term and long-term fixed-rate mortgages.
