Variable rate gambling can be costly
Sunday, August 15, 2010 By Kathleen Barrington Now that the banks are pushing up variable mortgage rates for borrowers, it is time to ask yet again why our government has persistently failed to encourage long-term fixed-rate mortgages which might have protected borrowers from the impact of rising rates.
The price hikes being imposed on Irish borrowers will, for the moment, only affect variable rate mortgage holders who do not have tracker mortgages.
The recent hikes by AIB, Bank of Ireland, Permanent TSB,E BS and KBC will push up the cost of those variable mortgages for Irish borrowers even though the ECB has held rates at historically low levels. In the case of Bank of Ireland, f or instance, the increase will push up the cost of servicing a €300,000 mortgage by about €74 a month.
But all variable rate mortgage holders will ultimately be affected when the European Central Bank (ECB) eventually pushes up its own rates.
The impact of increasing interest rates hits particularly hard in Ireland, given that about 67 per cent of Irish mortgages are on variable rates compared with an average of just 43 per cent on variable rate mortgages in the euro area as a whole.*
In Belgium, Germany, France and the Netherlands, which represent about 65 per cent of all euro area housing loans, a long-term fixed period is the norm, with fixed rate periods of at least ten years or more.
Many European consumers who are on variable rates are also much less exposed to the risk of rising interest rates than Irish consumers. That’s because in many European countries there is a cap set - either by law or by contract - on the extent to which banks can increase rates. The idea is to protect borrowers from excessively large swings in household interest repayments. The result is that the Irish household sector faces an unusual degree of uncertainty about future monthly mortgage repayments, compared with many other eurozone countries.
The preponderance of variable rate mortgages here also begs the question of whether house prices soared partly due to the very low interest rates that applied in the aftermath of the dotcom bubble bursting at the beginning of the decade, only to start falling when the ECB doubled interest rates in the middle of the decade and eventually crash when the credit crunch hit.
Irish policymakers have paid little attention to this problem. But the British government examined the issue a few years ago when it commissioned Professor David Miles to report on the role of long-term fixed rate mortgages in protecting borrowers from the kind of boom-bust cycles that have characterised the British housing market.
Miles, who is also a member of the board of the Bank of England, found that generally speaking ‘‘most householders would be better off with the very long-term fixed-rate mortgages at any loan-to-income ratio above about three, and the fixed-rate mortgage results in a very substantial gain for those with ratios much above 3.75.”
Miles also found that the more you borrowed relative to your income, t he more attractive long-term fixed-rate mortgages were. He said that when householders had a substantial risk of unemployment or a big fall in income, a long-term, fixed-rate mortgage was preferable.
He concluded that a significant proportion of households - though probably not a majority - might be expected to find that the advantages of very long-term fixed rate mortgages make them attractive.
But the problem is that most borrowers make their decision based on the cost of current monthly payments. Matters are not helped by the fact that many lenders offer low, introductory offers to first-time buyers for a period of, say, two years.
This makes the initial payment on variable rate mortgages an awful lot cheaper than for long-term fixed-rate mortgages, giving the consumer yet another reason to choose the variable rate mortgage.
Miles found that more than a half of the two-year introductory mortgage rates on offer in Britain during 2003 and 2004 were priced beneath the cost of funds to the bank, but the banks made up for this by loading charges on to the standard variable rate mortgages of older customers.
‘‘This structure of mortgage pricing is only possible because of a degree of cross-subsidisation between different groups of borrowers who have variable rate mortgages,” he said. ‘‘In recent years those paying standard variable rate have been paying up to 200 basis points more on their mortgages than those who have the cheapest variable rates.
‘‘This cross-subsidisation has, as a side effect, meant that fixed-rate mortgages look very expensive to borrowers who focus on the initial rate on a mortgage,” Miles explained.
The Irish banks have long protested that there is no demand for long-term, fixed-rate mortgages in Ireland.
But Miles found that in Britain, where the mortgage market closely resembles our own, the pricing strategies used by many lenders and the tendency for advisers not to focus on the risk of interest rate movements were the most likely factors behind the lack of demand.
In short, the introductory rates are deceptive and mask the true cost of the mortgage over its full term, a cost which may be better captured by the monthly payments on a fixed-rate mortgage which is based on the expected price of the mortgage over the full term.
Those who were seduced by low introductory offers can suddenly find themselves struggling when rates rise, especially if the rate rise happens when, as is the case in Ireland, unemployment and taxes are rising while wages are falling in many areas.
Not only does this pile pressure on the consumer, it also fuels the vicious cycle in the economy by taking more money out of the consumer’s pocket at the very time that businesses most need the consumer euro.
The Miles analysis is even more relevant in Ireland than in Britain as we do not have control over our own interest rates due to our membership of the eurozone.
But our politicians, bankers and regulators didn’t take measures to protect consumers from ECB rates that were out of kilter with local market conditions when we joined the euro a decade ago; they wouldn’t heed the Miles report when times were good; and now that times are bad, they are so busy fighting fires that they have all but forgotten about fire prevention.
* Housing Finance in the eurozone. ECB working paper. March 2009
* Miles D (2004).The UK Mortgage Market: Final Report and Recommendations, HM Treasury
* Miles D (2005) Incentives information and efficiency in the UK mortgage market, The Economic Journal