The challenge of setting mortgage rates fairly

Thu, 22 Nov 2018

I’ve been thinking a lot recently about different ways to manage market uncertainty.  Most of my research is on electricity price volatility, but it got me thinking about another example of  market uncertainty: mortgage rates. (Please note that this post is intended to be illustrative, and shouldn’t be taken as financial advice.)

When you buy a house, you typically borrow under a mortgage.  Generally, your mortgage is guaranteed for 20-40 years (so long as your keep up your repayments).  However, the interest rate that you pay generally won’t be fixed for the whole period.

One possible option is a floating or adjustable rate, which allows the mortgage provider to adjust the rate every month, in line with general market interest rates.  In some cases the bank gets to set them, in other cases they’ll be a fixed margin to a centrally set benchmark (eg the Bank of England base rate). But either way, if you have a floating rate mortgage, you have a risk that rates will rise, perhaps very considerably.

In some countries, you can get mortgages where the rate is fixed for the life of the mortgage.  This avoids the risk of rates rising (though correspondingly, you lose the benefit if rates fall).  The fixed rate you are charged will generally reflect how market participants expect the floating interest rate to change - they usually expect it to rise over time.  But longer term fixed rates tend also to be biased up compared with expected short term rates, perhaps because there are generally more fixed rate borrowers than lenders.  There is an argument that this bias is unfair on borrowers who are less able to handle the interest rate volatility, who are therefore forced to use a fixed term rate.

One significant difficulty of long term fixed rates is that they may charge a significant penalty if borrowers want to repay early (for example, if they sell the house, receive an inheritance, or receive a pay rise).  This isn’t just borrowers being greedy - they’ve generally hedged these interest rates, and incur significant costs, especially if market rates have fallen. In the UK, these early repayment fees have tended to be so high that borrowers have avoided the products, and most borrowers only fix for 3-5 years at a time.

In the US, because the bulk of mortgages were financed by a government (the Federal National Mortgage Association, commonly known as Fannie Mae), early repayment fees aren’t charged.  This may seem like the kindest thing to do, and means that the majority borrow at a fixed rate for the full term of the loan. But the fact is, lenders will definitely include the expected cost of repayments when setting the fixed rates, so borrowers are still paying.  In addition, financially savvier customers, and wealthier ones are more likely to repay early, especially when rates drop, meaning those worse off are paying a higher rate for a benefit they are less likely to take advantage of. I suppose you could charge a smaller premium for people that you knew were less likely to strategically repay early, and you could offer a discount for people prepared to waive their right to repay early, but these choices bring their own risks.

In conclusion, I don’t think there’s a straightforward way to make things fair.  In this case, I believe that forcing everyone to use the one approach would lead to significant suboptimality, reduce borrowers’ abilities to manage their risk, and wouldn’t even make things substantially fairer.  But I still believe fairness is an important factor to be aware of when designing and regulating markets.

A few links: