Mortgage interest rates considerations Part 1 Borrowers: “The lower, the better”?

When dealing with interest rates, borrowers could potentially argue that no matter what, “the lower, the better” always holds true. Whereas this might in general be a good consideration in the short term, there are numerous other parameters to be considered while taking a conscious decision with regard to (probably) one of the most important financial decisions in everyone’s life. This article focuses on basic considerations from a borrower’s perspective around interest rates risks, risk profiles, trade-offs in the choice of the financing instruments and lenders.

1.????What risks related to mortgage interest rates should borrowers consider?

In general when a borrower enters into a mortgage agreement the following interest rates related risks must be kept in mind:

1.????Rate risk: mortgage products have different tenors while the mortgage rate / costs for the borrower are kept fixed (e.g. 0.5% or CHF 200/month for 3 months). Therefore depending on the tenor of the mortgage an increase of the underlying interest rates might have a direct impact on the mortgage costs borne by the borrower (particularly for short-term products, like SARON mortgages where a rate resetting might for example take place every 3 months);

2.????Refinancing risk: even if with long-term mortgages (where the mortgage rate / costs are kept fixed, e.g. 1% or CHF 400/month for 10 years) the rate risk can be mitigated, this hedge is only temporarily valid: at some point in time in the future the mortgage will come to maturity and shall be prolonged at the then valid interest rates (e.g. in 2032); and

3.????Pre-payment risk: like with a mobile phone subscription, also with a fixed-rate mortgage the conditions are set for a pre-defined tenor (e.g. for 10 years at 1%). In case the borrower might want to repay or change the mortgage prior to the maturity (e.g. because he/she sells the property) an early termination penalty might apply[1] like the one applied for mobile phone subscriptions.

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2.????How can borrowers treat these risks?

Since decades a very good practice has been established for investment decisions: a persons “investment profile” in order to determine the most suitable investment strategy. In general terms, the investment profile is determined by the person’s risk appetite (how much money am I ready to lose on my investment?); and the person’s risk capacity (how much money can I afford to lose?).

Not as broadly known as the investment profile, the mortgage profile of a borrower is also of paramount importance as it refers to one of the most important financial decision and is based on a similar approach composed by:

The borrower’s risk appetite (do I accept changes in interest rates, or do I want to know how much I will pay for a defined period of time?); and

The borrower’s risk capacity (can I afford to pay higher interests, and if yes how much or would these be a burden for my private financial situation?).

The combination of the risk appetite and risk capacity has an impact on mortgage trade-off among the borrower’s main needs: pricing, security, and flexibility. A 15 year mortgage will satisfy my need with regard to security (I will know the cost of my mortgage for the next 15 years), but reduce my flexibility to repay the mortgage and comes in a normal environment with a higher pricing.

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Figure 1 – borrower’s trade-off

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3.????What mortgage instruments are available for retail borrowers?

Now that the mortgage rate related risks and their treatment have been introduced, let’s show the instruments at disposal:

4.????What does “forward” mean?

Both mortgage instruments shown in chapter 3 can be purchased with an immediate pay-out date (I close the mortgage today, the amount is paid out in two days), or with a so called forward period (I close the mortgage and fix its conditions today (e.g. 1% for 10 years), the amount is paid out in six months). Particularly for fixed-rate mortgage, retail clients can lock-in rates up to 18-24 months in advance of the pay-out of the mortgage amount. The usage of forwards imply in general a higher security (I fix the rate in advance), however also a higher pricing (the so called forward spread of e.g., 0.20% will be added to the fixed-rate mortgage rate) and a lower flexibility (adjustments lead in general to costs).

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5.????Should a borrower split the mortgage amount in different tranches?

In general: good idea! Splitting the mortgage amount in different tranches (e.g., overall mortgage amount CHF 1’000’000, covered by a 3-year mortgage of CHF 400’000 and a 10-year mortgage of CHF 600’000), is an easy way for borrowers to reduce the refinancing risk (explained in chapter 1): the risk of having to refinance the entire mortgage amount at once at higher rates is diversified over two different points in time (e.g., in 3 years and in 10 years).

However, this diversification comes with a point to be considered: lower flexibility. The guarantees given to the lender for financing (i.e. the old good mortgage certificates) don’t consider the mortgage tranches (e.g. existing mortgage certificates of CHF 200’000 and CHF 800’000, covering the above mentioned CHF 1’000’000 mortgage amount), at the time of the prolongation of the first tranche, the borrower will in general not be able to switch to another mortgage provider for free. Why? Because bank A which is financing the two tranches, will not be willing to hand over the mortgage certificates to any other bank B the borrower might want to choose (given bank A has still an outstanding mortgage of CHF 600’000 coming to maturity in 7 years). Solutions to this deadlock are available (e.g., the prepayment or the second tranche, the splitting of the mortgage certificates, or issuance of bank guarantees), but these come with a price tag.

An exception to the above situation worth mentioning occurs when the time between the two tranches does not exceed 18-months (e.g. overall mortgage amount CHF 1’000’000, covered by a 3-year mortgage of CHF 400’000 and a 4.5-year mortgage of CHF 600’000). In general lenders in the Swiss market agree in such cases to hand over the mortgage certificates against a so-called promissory note (unwiederrufliches Zahlungsversprechen) from the new lender, allowing the borrower to switch.

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6.????Can a borrower combine offers from different lenders?

In recent years certain mortgage providers even allow borrowers to combine different lenders for the financing of the same property (e.g. overall mortgage amount CHF 1’000’000, covered by a 3-year mortgage of CHF 400’000 from bank A and a 10-year mortgage of CHF 600’000 from bank B). This approach is particularly beneficial because it allows to take advantage of complementary offers: that one lender (e.g., a bank) might have more attractive SARON and short-term offers, whereas another lender (e.g., a pension fund) might have more attractive rates on long-term mortgages. A second advantage is that at every refinancing the borrower can still switch to other mortgage providers.

Figure 2 – example of offering among lenders

The actors currently providing the borrowers with this option do it in very different ways. For example certain providers do it showing every offer available, whereas others do it in the background. In any case the set-up of the offering should be thoughtfully understood, as these options come normally at a lower flexibility (e.g., for mortgage increases).

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7.????What should borrowers also consider in the choice of the lender?

As previously outlined in the article “The changing credit market in Switzerland” there are cyclical and structural factors that led – among others – to an increased heterogeneity of lenders in the mortgage business: pension funds, insurances, fonds and investment foundations (re-)entered or increased their activity in the last few years. A higher heterogeneity is beneficial for borrowers as it increases competition among lenders and also enriches the offering (e.g., with the possibility of fixing rates longer than 10-years).

Besides the choice of the right instrument as presented above, borrowers are therefore increasingly confronted with a broader optionality related to the choice of lenders and following questions should be considered:

Am I willing to enter a close partnership with this particular lender? How might be the lender willing and capable to perform any increase of the mortgage amount in years from now I might need? How can I expect the lender to react to challenging situations which might arise during the lifetime of the mortgage?

The mortgage business is generally speaking a long-term relationship between a borrower and a lender based on trust and reliance. It is therefore very important for borrowers to also assess the lender suitability as a financing partner, particularly for the long maturities nowadays available in the market.

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[1] Many discussions and articles have been dedicated to the mortgage early termination topic. In general the early termination is calculated as the difference between the sum of outstanding interest rate payments until the initially agreed maturity and the reinvestment rate of the lender. This difference might be negative or positive, whereas the payment of any negative different is subject to the mortgage agreement. Given the potential financial impact of any repayment, a look at the contractual clauses is definitely worth the time.

Disclaimer: The opinions expressed above are solely our own and do not express the views of UBS. The opinions expressed above do not constitute and shall not be intended as any investment or financial advice.