Historically low level of interest rates triggered a discussion about loans with a fixed interest rate. They would be better suited to the needs and possibilities of households than variable rate loans. There are even proposals to introduce regulations preferentially treating this market segment.
Fixed-rate loans would, in particular, protect customers against interest rates – and therefore credit installments – in the future. A closer look at the current and expected market conditions, as well as the construction of such loans, however, indicates that the arguments about the need to popularize or even favor such loans are not very convincing. And the formation of the product offer of banks in this case is best left to the market forces, while ensuring that the client receives full and comprehensible information about the characteristics of the product.
A loan for a fixed rate, or what
Reflecting on the promotion of loans with a fixed interest rate, you first need to sort out the concepts and specify exactly what the product is about. From a theoretical point of view, a loan with a fixed interest rate is a loan whose interest rate is fixed over the entire maturity of the loan – i.e. in the case of mortgage loans, for example, 20 or even 30 years. The archetype of such a loan is the American prime mortgages, whose development was related to the establishment in the 1970s of government agencies buying loan portfolios from banks and issuing securities secured with them.
However, the credit market in the United States is atypical in many respects and apart from it credit agreements with a fixed rate throughout the maturity period are quite rare. In European countries mortgage loans are generally hybrid – ie their interest rate remains constant only for a certain initial period, and then changes the formula into variable (eg the interbank market rate increased by a fixed margin) or is set at a new level for the next several years period.
Only in France and Belgium, loans with a fixed rate for more than 10 years constitute a clear majority. In the Netherlands, the mortgage market is almost evenly divided into loans with a variable rate (20%), a fixed one in 1-5 years (30%) and a fixed loan in 5-10 years (40%). The Czech Republic and Slovakia are dominated by loans with a fixed rate in the period of 1-5 years. In Poland, however, virtually only mortgage loans with variable rates are granted.
An international comparison indicates that, theoretically, there is space to diversify the product offer of domestic banks to mortgage loans with a fixed rate. As in most European countries, also in Poland, a fixed rate loan would probably have a hybrid character – with a fixed rate of no more than 5 or at most 10 years.
Granting a loan with a fixed interest rate is connected with a double risk for the bank. First of all – interest rates may change, and secondly – the loan may be repaid before maturity (so-called prepayment), which will force the bank to grant new loans on less favorable terms or to close the hedging transactions when they the valuation is unfavorable.
Theoretically, the bank may hedge the interest rate risk by acquiring long-term fixed rate financing (eg by issuing mortgage bonds) or by concluding a relevant transaction in the Interest Rate Swap market (IRS). In practice, however, it is not so easy. The mortgage bond market is still underdeveloped and unavailable to commercial banks, as these securities can only be issued by specialized mortgage banks – their scale of operation is very limited, which results, among others, in from high regulatory requirements for loans securing mortgage bonds. Some commercial banks may obtain refinancing for granted loans by selling loans granted to mortgage banks, which in turn will issue covered bonds on the basis of purchased portfolios.
Available data indicate that the global market for IRS contracts denominated in PLN is currently only liquid for transactions with tenors (maturities) up to 5 years, and therefore it is possible to effectively protect the interest rate risk by a maximum of that date. The emergence of demand from domestic banks for PLN IRS with a longer maturity may contribute to the development of the market for these instruments, but at least in the initial years, these transactions would be expensive.
These problems are aggravated by the second source of risk, ie the option of prepayment included implicitly in the fixed rate loan. Because the customer can pay off the loan almost at any time, the valuation of the prepayment option is a complex theoretical issue. The market for IRS PLN options is even less liquid than the IRS market alone, and Bermuda or American options – i.e. with a risk profile closest to the appropriate prepayment option – are not quoted at all. This means that even if the domestic bank found a counterparty willing to issue such an option, the cost for the bank and ultimately for the client would be significant. How big? In the absence of a developed interest rate derivatives market in Poland, the valuation of the prepayment option is subject to considerable uncertainty.
A certain approximation of the fair value of such an option can be obtained by constructing the prices of missing derivative instruments necessary for the calibration based on back-testing of the delta hedging strategy. Then, by calibrating the appropriate model of the forward interest rate structure to the prices thus obtained, an approximation of the price of the prepayment option may be obtained, conditioned by the past volatility of interest rates on a given market.
The estimated premium for the prepayment option included in the interest rate of a 20-year fixed-rate loan over the entire maturity would be approx. 180 bp. As a result, the interest rate on a fixed rate loan would be significantly higher than that offered in the variable rate loan (by approx. 370 bps as per new sales data for January 2017).
The above estimation of the impact of the prepayment option on the loan interest rate assumes that the bank does not charge an additional fee for prepayment of the loan (in other words, all bank costs related to the prepayment are included in the loan interest rate). The Mortgage Loan Act allows the bank to charge for early repayment during the period of fixed interest. However, if the bank decides to construct a loan agreement in which prepayment costs will be charged to the customer in the form of fees charged at the time of repayment, the effects of these fees at the level of the entire loan portfolio will be economically equivalent to a higher interest rate on loans.
Loans with a “rarely variable” rate – comparative simulation
A closer look at the market conditions indicates, therefore, that the only type of fixed rate loan that can realistically be discussed in the case of Poland is simply a loan with a “rarely variable” interest rate, or a relatively short period of constant interest rate (2-5 years). The risk profile of such a loan, however, does not differ significantly from the risk profile of widespread variable-rate loans in Poland.
To illustrate this, you can simulate installments for two types of loans, i.e .:
- Interest bearing loan at Jabank 3M + fixed margin of 150 bps, change of interest rate every 3 months (further ARM3M);
- Interest-bearing loan at 5-year swap rate + fixed margin of 190 bps, change of interest rate every 5 years with the possibility of refinancing and prepayment (hereinafter FRM5Y); The FRM5Y loan margin is higher than for the ARM loan, because it takes into account the cost of the prepayment option included implicit in the loan. This cost can be estimated at around 40-50 bp.
For simulation purposes, we assume that in both cases the loan amount is PLN 300,000. PLN and maturity at the time of awarding 25 years. We analyze the paths of ARM3M and FRM5Y loan installments granted every month from January 2003 to December 2016, which gives a total of 168 cohorts of loans. In order to include in the analysis the period of both downward and upward trend in interest rates, we create a hypothetical scenario for the evolution of Jabank 3M and IRS 5Y rates until 2041.
Initially, i.e. in January 2003 – June 2017, the scenario is based on actual market data. Then “missing” interest rates by 2031 are supplemented on the basis of data from 2003-2017 in reverse chronology, after which for the years 2031-2041 we re-use data from the years 2003-2012, this time in the correct order (see diagram opposite).
This creates a hypothetical time series covering the years 2003-2041 and various phases of the interest rate cycle (downward trend, upward trend and stabilization), allowing to compare the costs of both types of loans in all cohorts, i.e. taking into account the moment of the cycle in which they were granted. Analysis of simulation results leads to several conclusions.
First of all, the average cost of the FRM5Y loan is systematically higher than the ARM loan. Only in the case of several FRM5Y loans with a 40 bps margin granted at the turn of 2014/2015, the installments calculated based on Jabank 3M were slightly less favorable. In other cases, the average installment is higher in a fixed-rate loan of about 5%.
In other words, in the long run, the borrower taking out a loan with a fixed interest rate of 300,000. PLN would have to pay on average almost PLN 100 a month more than if he had taken a loan for a variable rate. The difference in the average size of installments is revealed despite the analysis of the upward trend in interest rates and results mainly from the term premium included in IRS 5Y rates and the cost of prepayment options included in the loan interest rate (for the prepayment cost of 100bp the installment in the FRM5Y loan is on average 10% higher than in ARM).
Secondly, the significant difference between both types of loans is not so much the scale of changes in the size of loan installments in the loan horizon, as for the “leap” of these changes. In other words, the simulation indicates that a customer taking out a fixed rate loan (fixed at 5 years) should experience a similar scale of market interest rates in the long run as the customer taking out a loan at a variable rate, but in the first case the increase in loan installments will be more accumulated time. The effect related to the rapid increase in interest rates is so strong that, in the end, prevailing benefits resulting from the repayment of the nominal value at lower rates and the possibility of prepayment of the loan.
To sum up, a loan with a fixed interest rate – in the form that would have a chance to develop in Poland – would not significantly differ in terms of risk profile and costs from variable-rate loans in Poland. A customer taking a loan with a fixed rate would benefit from the possibility of paying lower interest rates with a strong upward trend in interest rates, but in the entire loan service period he would have to pay so much for the privilege that it would be comparable or even better to take a loan with a variable rate. Such a conclusion leads to two main conclusions.
Firstly, a fixed rate loan with a relatively short period of guaranteed interest rate – i.e. one that would have a chance to develop in Poland in the near future – there is no clear advantage over a traditional variable rate loan. Hence, it does not seem justified to stimulate the development of fixed-rate loans by means of supervisory intervention or regulation.
Secondly, even if the average costs of both types of loans are similar, in a fixed-rate loan, adjusting service costs to changes in market interest rates is, on average, more of a jump. Such a sudden increase in loan installments can be perceived by borrowers as unfair and create reputational and legal risk for banks.
In conclusion, it is best to leave the formation of the product offer in the field of mortgage loans to market forces. Nothing precludes banks from offering loans to customers with a fixed rate as an alternative to loans with an interest rate indexed to Jabank 3M. However, it is important that customers are aware of the long-term costs and benefits associated with each type of loans, and that the sellers take into account primarily the needs of customers, not the ad hoc interest of banks seeking to increase profitability in low interest rates. In this regard, financial supervision activities and institutions responsible for consumer protection may be helpful, aimed at developing an effective standard of information provided to clients making a decision to take out a loan with a fixed or variable interest rate.