Mortgages: Why Irish borrowers will remain exposed to interest rate swings

The bulk of new mortgages being taken out now are fixed-rate products. Most borrowers are fixing for relatively short periods of time, though there are also now offers and new competition for longer-term fixed rate loans of up to ten years.

However, a new Central Bank paper has raised questions about whether the cost of these longer-term fixed-rate homeloans may in future have to rise. This is important, as it is about whether we will ever be able to move away from our current mortgage model which leaves borrowers exposed to most of the risk.

In many other EU countries, borrowers can fix relatively cheaply for long periods, sometimes for the length of the loan. Here, we are a long way from this. These are the reasons.

1. The facts: The use of fixed rate mortgages has risen sharply over recent years. A new Central Bank paper on the topic – Fixed-rate mortgages:building resilience or generating risk? – by economists Jane Kelly and Samantha Myers points out that the proportion of new mortgages issued on a fixed rate rose from 20 per cent in late 2014 to around 75 per cent in 2018.

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However, crucially,the vast bulk of these are short-term fixed rates – for five years or less – which now represent around 20 per cent of the outstanding stock of mortgages.

Longer-term fixed rate offers are now starting to become more widely available, but only for terms of up to 10 years. They are much more common in other markets – notably the US and Denmark. Removing the exposure to interest rate swings over long periods takes a lot of risk away from from mortgage borrowers. But we are still a long way from a Continental style mortgage model here.

2. The teaser offers: The Central Bank paper underlines one important point – short-term fixed rates are better considered as "teaser" products through which banks compete for customers. Unlike long-term fixed rate products, they do not remove much risk from the household, which in fact is likely to be exposed to a higher variable rate when their fixed term ends. What they can do, given the low level of current teaser offers which are generally below variable rates, is to allow households to pay a bit less in the first few years, when finances are often very tight.

As the researchers point out, this can be a benefit, but is not something which will improve the financial resilience of households over the term of the mortgage. Variable rates are currently around one and a half times teaser rates, the researchers point out. Around 40 per cent of fixed rate loans originating last year will automatically switch to the bank’s standard variable rate in 2021 and another 32 per cent in 2023. So a lot of borrowers will soon enough face higher repayments that they do now.

If ECB rates have gone up by then,the gap between what they pay now and what they will pay will be higher again. But as shorter- term fixed rates are lower than variable ones now – and break fees to get out of a fixed contract are often now low o rnon-existent – many new borrowers are opting for these deals. to get them a few years into their mortgage at a relatively low cost.With the outlook for interest rate rises still moderate, this may still work out fine for many.

3. The move to long-term fixed rates: We are in a post-crisis period of super-low borrowing costs,but who knows what the world will look like in, say, five or seven years time.

Unlike short-term fixed rates, longer-term products could help to improve the stability of household finances by moving the risk of higher interest rates away from borrowers to banks. And longer-term fixed rates are slowly becoming more common.The Central Bank paper says fixed terms of five years plus now account for 5 per cent of the market – and it has been clear in recent months that more offers and some competition is entering this segment.

4. 'Going European': So is Ireland finally "going European" – following the trend in many big EU markets where consumers typically fix for long periods? Certainly 10-year rates at just over 3 per cent in some cases will attract some borrowers. Are they willing to pay more now for the peace of mind of fixing in at a time of extraordinarily low interest rates ? Fixed rate products can also be less flexible, for example if you want to change your repayments.

But the Central Bank paper raises a couple of other vital points in relation to the future of longer-term fixed rates in Ireland. It points out, first, that a whole range of institutional and legal factors influence how mortgage markets have developed in different countries. In Denmark, for example, interest rates have fallen to close to 1 per cent for 30-year loans. But if you don’t make your repayments, banks get an automatic right to repossess your home, often within six months and recourse to your future income and other assets.

In Germany part of a house purchase is typically funded via non-secured savings, meaning the loan to value on the main mortgage is lower.Markets vary in terms of rules on how mortgage rates can be altered and on a range of other factors – and in some cases, like the US,the cost of fixing in the long-term can be high.

However there are other issues, too, which the Central Bank paper warns are likely to make longer-term fixed rates more expensive here in the years ahead. In other markets where such loans are common, banks typically find a way to raise long-term funds and also sometimes pass on some of the risk of default, via selling off some of the loans, or raising money through the issuance of special bonds, sometimes with elements of government support.

In Denmark there is a large market for mortgage bonds – even though the default risk remains with the bank – while in the Netherlands the government supports a mortgage guarantee programme.

5. Banks rely on deposits: In Ireland, however, banks rely on deposits – most of them short-term – for 80 per cent of funding. They are using short-term funding for long-term loans, an obvious risk if the cost of funding rises. We saw, during the crisis, the pickle the banks got in with their tracker mortgage books as the interest rate charged to borrowers fell well below the cost of raising money.

Here, banks do raise some funds on the market, but there is no developed mortgage bond market as in Denmark to raise long-term funding and no government- backed securitisation of insurance scheme to lower this risk to the banks of default. So the Central Bank paper warns that if longer-term fixed rate lending rises, banks will have to find a way to hedge their risk through specialised trading strategies ( such as interest rate swaps, a kind of hedge) and ensure they have enough capital to account for losses. This means they need more cash in their balance sheet, or other assets which can be used to absorb losses which emerge.

“These additional costs will likely result in households paying higher mortgage rates., reflecting the benefits they obtain from being insured against bank funding cost risk,” the paper says. In other words, if you want the security of fixing for a long period, you will have to pay up.

6. Serious structural problems: The bottom line is that there are barriers here to the development of the kind of longer-term fixed rates here at affordable cost which would remove as lot of risk from borrowers. Low long-term bond interest rates are keeping some of these rates – for seven and ten-year loans, for example – relatively low for the moment by historical standards. However, they remain above shorter term fixed rates and we have no products available for more than 10 years.

Now the Central Bank is warning that funding and regulatory pressures could lead to a rise in longer-term fixed rates in future. Once the inflation cycle turns, market trends may also push these rates higher.

The Danish model of long-term fixed costs for borrowers at rock-bottom rates is not one which will be made available to Irish borrowers. And we already know that Irish borrowers pay well above the EU average for standard variable loans, in which they take the risk of changing rates.

Interest rates are low now, for sure. But serious structural problems remain in the Irish mortgage market and consumers will continue to pay the price.

Smart Money is a weekly online column which looks at the big economic trends and what they mean for you.