(The following is an excerpt of a morning presentation to the American Women's Club of Dublin on the day of an ECB interest rate announcement. For more details please go to Money Skill BuildingTM's website for upcoming workshops and presentation as well as classes in your area.)
We have all heard the terms "fixed", "variable", and "tracker" when it comes to mortgages and, more importantly, determining your mortgage payments. We all know that the difference between a fixed rate mortgage and both a variable and tracker rate is that the amount of the payment generally doesn't fluctuate with a fixed rate mortgage and is set over a number of years. With a variable or tracker mortgage the mortgage repayment amount generally fluctuates in accordance with a rate set by the bank or in the case of a tracker loan, rate set by the ECB. If that rate set by the bank increases, then the amount of the monthly repayment increases.
That is why some borrowers choose a fixed rate loan. Even though they pay a higher rate at first and their monthly payments are higher they prefer to know that their payment will be fixed. Of course, now with a low interest rate environment borrowers may conclude that choosing a higher fixed rate doesn't make sense. Some borrowers decide that to pay a higher payment just to "lock - in" a good rate isn't worth the extra money paid out every month. They feel that money could be better used elsewhere. And perhaps they are right.
On the other hand, if variable rates and tracker rates go up, those borrowers on trackers and variable rates will see their monthly payments go up and risk default if they don't have the cash to pay the higher amount.
So do we really understand the differences between each interest rate? How do they impact our wallet and our long term financial health?
First, while the type of rate impacts our monthly payments, the rate also impacts the bank, because there is a cost to the bank in making loans. This cost is more than the points you pay or the legal costs to close the loan and file the necessary documents. There is an ongoing cost of funds that pretty much dictates the costs to the bank and eventually the cost to the borrower.
The cost of funds is at the heart of the global financial crisis. However, Money Skill BuildingTM will focused on how the cost of funds not only impact the banks but also the borrower. It's the reason why anyone on a variable rate or tracker should know who Ben Bernanke is and why the ECB open market operations matter...but more on that later. (See below for further details)
For now we need to focus on where the banks get their funding and how they in turn make loans.
In the old days, before all the fancy financing that made the financial crisis happen, banks used to lend depositers' money. They would pay you, say, 5% on your deposit (laughable nowadays, but just an example) and then lend out the money you put on deposit at, say 10%. The difference between the cost of funds (5%) and the interest charge to you to borrow (10%) is called the interest margin and that amount went to the bank. Very straightforward.
Then the banks started to loan money that wasn't depositors'. They went to the capital markets (basically a huge market place where companies, banks and even countries go, with the help of investment companies, to advertise the fact that they have money to lend).
Banks now started to borrow money to lend money. So they could make more loans and increase revenues. They weren't confined to the deposit pool of funds. They could borrow more! Revenues could increase because they could make more loans. If they wanted to make a 20 year mortgage to Joe they went and borrowed the money in the capital markets using a 20 year bond. They knew they would be paying say 5% for borrowing the €300,000 but receiving 10% from Joe Bloggs for borrowing it. Brilliant stuff. More people could get mortgages.
But that wasn't enough. They could access another source of funding that was even cheaper.
For reasons I will discuss in class, generally the shorter the term bond the cheaper the cost to borrow. For example, if I wanted to borrow say €500,000 from the capital markets and lend it for 20 years I could borrow for 20 years and pay say 5% to do so. But if I only wanted to borrow for say 5 years I could pay only 2%. More interest margin for the bank. But I would have to go back and borrow another €500,000 in 5 years time and again in 10 and again in 15 years time in order to have funds to match all the banks lending.
Now if the bank wanted to decrease the cost of borrowing further they could borrow for 2 years at an even lower rate of, say, 0.5%. More loans and even cheaper costs of funds make for healthy profits.
What the banks then did was match the rate they were being charged to the rate that they were charging you the borrower. For example, loan on a mortgage could go from being say 10% for all 20 years to say 5 percent for 5 years, 7 percent for 5 years, and 8.5% for 10 years.
As long as the cost to borrow money for the banks was significantly less than what they charged the borrower, the banks could make money. And your rate was set according to the cost of borrowing for the bank. And if they needed to, banks could borrow from each other over night to cover any funding gap. And the rates charged to each other were so small, because they all knew each other each other's business models because they were all doing the same thing, right. What's a few hundred million among friends?
Oh dear....Well as we all know those few hundred million were really a trillion (or more) and the business models that gave everyone low variable rates and even lower tracker rates were built on a house of financial cards.
The crisis came when there was so little faith in financial institutions' ability to pay back even overnight loans. The ECB increased the banks costs of funding further by increasing the rate they charged banks. Tracker mortgages began to be more expensive. People found it harder to repay and defaults increased making lending to banks even more expensive. Regulators began asking why banks had too few deposits and so many loans that weren't being paid back. Then to make matter worse, depositors started to take money out. Paying off credit cards, a very expensive form of short term debt that the banks relied on to generate interest margin, were being paid down or off.
Finally the ECB started to lower interest rates charged to banks. However, these rates weren't being passed on to borrowers. Variable rate borrowers didn't see their rates go down. Only those on tracker mortgages. While variable rate borrowers had been paying a lower rate in the past the cost to borrow funds on the market still remain high today. So no savings. The tracker borrowers, however, remained tied to the original agreement to charge the borrower a rate that reflected the ECB's rate at the time. Regardless of the cost of borrowing.
So there you have it. A business model that promised to supply more people with more mortgages at a rate they could afford effectively blew up with the fall of Lehman Brothers and Northern Rock. As borrowers, we were left trying to figure out how a deal that seemed so financially sound could turn out to be such drain on our financial future.
That's why it is so important that while we spend locally we have to be able to look globally at our financial future. It seems that with bailouts and monetary policy driving the lending and borrowing conditions we now face, knowing how our cost of borrowing is determined is essential to planning for our future financial health.
If you want to learn more about the cost of borrowing or would just like to learn more about finance in today's world look at Money Skill Building's TM website for more information. MSBTM doesn't sell products. MSBTM just provide education and knowledge about economics and finance that relates to our world today. We look forward to hearing from you.
Money Skill BuildingTM does not represent or sell retail products or endorse any specific provider of such products. MSBTM earns no remuneration, commission, fee or other reward as a result of any particular decision, by anyone attending such event and arising out of such attendance, to use any particular retail financial product or any specific provider of such products. MSBTM strongly suggests that participants seek out the advice of a qualified financial professional in putting together their individual financial plan.
Look for us on twitter @moneyskillbld
Search for us on Facebook Money Skill Building
