> This exposure could help you, or hurt you, but I would hardly call it a bad thing.
The problem is the amount it can help you and the amount it can hurt you are disproportionate; if the rates fall enough to significantly help you, you could likely have a similar reduction by refinancing a fixed rate mortgage. But, if rates go up, you can't refinance to get a better rate, and you may have trouble selling as you may have planned, because higher interest rates put downward pressure on prices.
For me, it seemed like the risk was not worth the reward; especially given I was borrowing in 2009, and rates had significantly more room to go up than to go down. In the 1980s 20+% interest rate climate, I may have chosen differently.
Can you really just refinance a fixed rate mortgage that's now priced at an above-market interest rate? Surely the bank has you on the hook to pay that higher interest rate for the remainder of your loan term, they're not going to accept an early termination without some kind of penalty. After all, they've presumably backed your loan with some kind of equally long-term security.
> After all, they've presumably backed your loan with some kind of equally long-term security.
See, this is what banks are explicitly NOT in the business of doing. They are in the business of borrowing short and lending long, with a rate spread to make money in the process.
I have had a number of mortgages in the last 10 years in the US (refinanced multiple times), and none of them had any prepayment penalties. I suspect if I looked for one that does I might find it and it might have a slightly lower rate. Maybe. That depends on whether the bank planned to keep it on the books or sell it on; it's easier to sell on standardized mortgages into an MBS than weird ones with bespoke terms.
They are in the business of borrowing short and lending long, with a rate spread to make money in the process.
See that makes sense with variable rates. However if you offer a 30-year fixed rate at 4% because you know that you can currently borrow short at 2.5%, what happens in 20 years time when no-one is willing to lend short to you for less than 6%?
1) The loan is still on your books. In that case, you are in the same situation as an individual who has invested money in a 4% bond and can't withdraw it from there while at the same time paying 6% on a car (or house, or whatever) loan. It's annoying, for sure, but whether it's a serious problem depends on your net assets (which you might draw down to make up the difference) and your net income at that point (which will depend on whether you are still managing to make loans at higher than 6%). Also, 20 * 1.5 - 10 * 2 = 10, so I think you you still come out positive in this scenario, subject to some _really_ simplifying assumptions like the rates being 2.5 and 4 for 2 years and then jumping to 6 and 4, and ignoring the fact that money now is more valuable than money later, etc. But yes, if you keep the loan on your books you do run the risk that rates will go up and the money will not be optimally invested; you presumably try to model that risk and price it into your rates.
2) You sold the loan on to investors in the form of bonds. In that case you really don't care that much, as the loan originator. The investors who bought a 3.25% (or whatever; some loan management fees come off the top) bond now have the problem of having a bond that is paying likely below-inflation rates, and can't be sold, except at a loss, because of that. If the question is why investors would buy such a bond now, it's because they need something to invest in and pickings are pretty slim if they want a risk profile better than stocks (and we can argue whether morgage-backed securities give you that) and they are betting rates won't go up that much.
Now you could ask why people generally buy fixed-yield bonds at all, which is really the same question. My guess would be that partly this is a bet that rates won't rise (partly driven by central banks' commitment to macro stability and therefore not having too-large changes in interest rates). And maybe partly an issue of what time horizon the bond purchasers are operating on...
fixed yield bonds/mortgages also provide an interesting hedge in the current climate against
1) Recession
2) Negative interest rates.
in theory one could make a bet that a recession will occur in X months forcing a rate cut/stock decline and use leverage on fixed rate investments to make an above average return.
You might have to pay a fee to close out the loan early, but mostly the fees are reasonable. If your loan was originated after 2014, prepayment penalties are very limited [1]
My lender had a program where you paid a nominal amount (originally $500, but later $1000) and they'll adjust your rate to their then current rate. If you do a full refi, my understanding is that's going to cost in the neighborhood of $3000, although many lenders will roll that into the loan, or otherwise hide it.
That still feels sleazy and racketish. I can understand doing that when you take on a new customer, but charging you thousands of dollars just to change the exact same loan to one with a different rate? [1]
Reminds me of the time I bought a package at a pawn shop, but didn't want one of the items in it. They said that to get a discount, I'd have to buy the whole thing as is then pawn back the unwanted item. So far, so good, but then I had to give my ID and attest that I didn't steal that one item ... even though they knew it never came from me to begin with!
[1] The way you said it, thousands sound like the typical case and $500 is a special deal.
If you do a full re-fi; the new lender is going to run your credit, do an appraisal of your home, record the new loan on the title, do a title search, purchase title insurance, pay the broker's commission, etc; that all costs money, and that's where the thousands come from.
Just adjusting the rate in their systems certainly doesn't cost the lender nearly $500 or $1000, but it was still a win-win. They got some money to offset the lower rate, and got to keep servicing the loan, and I got to pay less interest, it's been a while, but I seem to recall my break even was about 3 years each time. I would certainly consider the availability and price of rate modification when considering lenders in the future.
So since it seems like under this system, the lender carries most of the downside risk on interest rate movements while the borrower gets the upside, the lenders must be covering this with a greater spread between their cost of borrowing and the fixed interest rates they charge?
Usually yes; the rate for fixed mortgages tend to be higher than adjustable. Looking at rates today, I'm seeing about 3.75% for a 30-year fixed; 3.125% for 15-year fixed, and 4.25% for a 5/1 ARM; but it's more typical in my experience for an ARM to come in near or below the 15-year fixed rates.
If your original lender were to refuse you could refinance with a different one. Your lender knows this and therefore will let you refinance to keep your business (I'm actually doing this now).
You do have to pay loan original fees again though which can be 1-2% of the balance of the loan so you have to compute when it actually pays off for you and whether it's worth it.
The problem is the amount it can help you and the amount it can hurt you are disproportionate; if the rates fall enough to significantly help you, you could likely have a similar reduction by refinancing a fixed rate mortgage. But, if rates go up, you can't refinance to get a better rate, and you may have trouble selling as you may have planned, because higher interest rates put downward pressure on prices.
For me, it seemed like the risk was not worth the reward; especially given I was borrowing in 2009, and rates had significantly more room to go up than to go down. In the 1980s 20+% interest rate climate, I may have chosen differently.