Rates Depend Both On our Risk and Interest Rate Market Risk
Interest rates both address individual risk and interest rate expectations, and both fixed and variable rates involve considering both fully. Our individual circumstances set our individual risk, where lenders assess a given amount of risk with all other things being equal. We can call this our base risk, and then this gets adjusted according to the outlook for the interest rate market.
The base risk sets the rate with a fixed rate loan, and it is expressed in the spread with a variable rate loan. Circumstances can change though and this is why our spread is subject to change, which often happens when variable rates go too low and the lender wishes to extract a greater premium over the benchmark, causing the spread to go up.
With a fixed rate loan, the future outlook for interest rates gets priced in, where the lender bears this additional risk for a price. We might get offered the choice between a fixed rate of 7% and a variable rate of 6.5%, and this is based upon the risk to the lender of rates moving up beyond their projections as well as a risk premium component.
When rates go up, a fixed rate loan will benefit because their rate becomes relatively cheaper versus variable rates as well as in general. A variable rate loan will get more expensive as rates increase. When rates go down, fixed rates become more expensive and variable rates become less so. These rates aren’t just set in isolation without a view of the future though, and knowing where the rates are trending won’t help you much because what is known about this, the best knowledge about it in fact, is already factored in.
At best, we can just make educated guesses as far as where interest rates are going, and while these guesses are usually pretty good ones, there’s always a chance that we are wrong. Just setting the rates to the break-even point is not enough though, as whenever a lender takes on risk, there has to be an additional benefit to do it, otherwise there is no incentive. This is why an additional amount gets added in to make it worth the lender’s while to take on this risk as opposed to just assigning it to us with a variable rate.
We will always pay a premium over time for a fixed rate, even though this does not mean that we won’t ever come out ahead with a fixed rate. It really depends on how the interest rate market moves during the term of the loan that the fixed rate is applied to, but overall, fixed rates do benefit lenders and it is because they need to be benefited to want to do this.
A lot of people think of this as a proposition of equal expected value, and then wonder whether they want to gamble with rates or hedge their bets so to speak, with a similar expectation of value. This is not the case at all though, and we’ll come out on the short end of this more times than not, and by a meaningful amount as well.
Fixed Rates Have a Lower Expected Value Overall
We’re basically buying peace of mind with fixed rates, much like we get with insurance, and we may prefer this peace of mind enough to want to pay a price for it, but this requires that we realize that there is a cost to this for us to make a meaningful decision about this.
Given that the price of both types is usually not that far apart, the difference between them isn’t that large, and the cost isn’t that expensive, but a percentage point on a loan can add up to quite a bit.
When the rates are closer together, this actually indicates that the expectation is for rates to go down not up, and sometimes we can even see fixed rates lower than variable rates, because the variable rates are expected to decline in the near term at least.
We can get a quick and surprisingly accurate view of where a lender thinks that interest rates are going by just looking at the spread between fixed and variable rates, and you can bet that there is a lot of analysis behind this, of a much better quality than borrowers can aspire to since their knowledge of such things is so casual.
Looking at trends in bond yields can also add some insight, and banks pay very close attention to the bond market when they set their rates.
If we think that we are going to take what limited knowledge we have and look to outwit banks with it, we require a reality check here, and the numbers that the banks use aren’t arrived at with little or no analysis, as there is so much money on the line that they cannot afford to be less than very diligent here.
A lot of people don’t realize this though and think that this is something that we can apply our cursory judgement with and conclude which option is best overall in terms of expected value, but that’s a rather foolish view, as popular as it might be. If we think that we can out-speculate banks on interest rates, we need to better examine what basis we think we can do this on and it isn’t expertise. Perhaps we have a working crystal ball or some special powers to see the future, or perhaps have done this for a living and are an actual expert, but if not, we’re out of our league here.
The correct approach here is to just assume that the bank knows what they are doing and have priced their fixed rates to their advantage overall, and use that as a reference point. We then will recognize that it will cost us more with a fixed rate overall and then decide whether this extra cost is worth it to us.
Perhaps the psychological component is enough to justify this, and for a lot of people who choose the higher cost of fixed rates, this is why they choose them. However, they usually do so without realizing the difference in cost, thinking that this may be either deciding between outcomes of a similar value or even think that this isn’t something that can be known so one choice may be as good as another on that basis.
Variable Rates Are Preferable Unless We Really Do Need to Fix Rates
Much of this psychological benefit arises from a lack of proper understanding of the two options, which leads us to become too risk averse in this situation. As long as the consequences of taking on the risk of interest rate fluctuations does not have any material effect on our ability to repay or to afford other things we may need, this isn’t a risk that we even need to account for and therefore should prefer variable loans and not pay extra for a hedge we don’t need.
Sometimes it might make a difference though, and deciding whether or not it will or could is what we really need to be focused on. If our financial situation is tight for instance and we can afford the payments on the loan at the fixed rate but cannot go much beyond that rate without some sort of hardship being created, now we’ve got something to think about.
This is a real risk though, and we want to focus on real risks, not some general and undefined level of discomfort from taking on risk. There’s always risks of various degrees, but it’s only the effects of the risks that matter, what changes they can cause in our situation, in this case our financial situation.
Lenders may offer the opportunity to switch from a variable rate to a fixed one should the borrower reach a point where they are no longer comfortable with a variable rate, and such an option does very often influence a borrower’s willingness to accept the risk, whether or not this is a good approach or not.
If we go variable and rates go up, and then lock in the loan at a fixed rate, you can bet that these changes that caused fixed rates to go up will be priced into the fixed rate when we have an opportunity to choose them later. Once again, not understanding that risk is always priced in accordingly with fixed rates clouds our thinking, and there is no benefit to locking in a fixed rate later actually because whatever trouble that may have happened or what may be on the horizon is accounted for.
To view this as an escape hatch is therefore an illusion, but an illusion that many people like. This is not an escape at all though, it is more like entering the fire when it is burning even hotter and with the cost of switching going up not down overall.
Once again though, our circumstances may still make switching a wise choice, if once again, we are reaching our capacity and cannot bear the risk of exceeding it. These choices, whether to go fixed or variable initially or whether we should switch this up later, will all depend on our own circumstances and should not be a matter of our trying to scoop the interest rate market, where what little knowledge we may have becomes well tainted with the emotion of fear.
The interest rate market among lenders is a huge one though, and banks and other large institutions do use this a lot to mostly hedge their risks but also to speculate on it. When you get a lot of hedging, this can provide opportunities to speculate as the hedgers are not driven primarily by expected value but by risk mitigation. This is similar to what futures traders do, where the big participants are driven by other forces such as business needs and the traders can then take advantage of trends that develop out of this without being encumbered by anything other than profit from the trade.
Individual borrowers, who are much more like a deer in headlights when it comes to deciding whether to go fixed or variable, aren’t really in a position to do any speculating really, even though some do think that they can outwit their banks on this point. Expected value might not even be the priority with some borrowers, as they may be happy to pay more not to worry about any of this, and if such things cause them stress, spending extra to make this go away can certainly be a wise choice.
As long as we are aware that there is an additional cost here, and then ensure that the benefits we perceive from it make sense, we will be on the right track at least. This at least beats being off the track and seeing where we pin the tail on this donkey with our blindfold on, which sometimes can be our own behind if we don’t understand things well enough.