Fixed-rate mortgages have been a mainstay of home-buying ever since the US Federal Housing Authority came up with the idea in 1934.

But if locking in the interest rate on your mortgage for a chunk — or the whole — of its term is great for you as a customer, it creates considerable risk for banks. Which is why fixed-rate mortgages as we know them today wouldn’t be possible if it weren’t for a little known hedging instrument called an interest rate swap.

Here’s how hedging makes fixed-rate mortgages possible and home-ownership more affordable.

Mo’ money, no problems

Before we dive in, it’s worth noting that fixed-rate mortgages are themselves a type of hedging instrument, because they help you make sure you don’t lose too much money if things go wrong.

Your mortgage repayment is split into two parts:

• The principal, that is, the amount you’ve borrowed to pay for your home
• Interest. This is the price of your mortgage. What you pay the bank for lending you money

While the principal decreases as you repay your mortgage, interest can increase and decrease, depending on interest rate fluctuations.

Interest rates fluctuate for many complex, interconnected economic reasons, including the state of the property market and changes in the cost of living.

But here’s the bottom line.

If you have a mortgage with a variable interest rate, changes to the economy and, in turn, interest rate fluctuations, can increase your mortgage repayments. And if they rise too steeply, your mortgage repayments could become unaffordable.

By contrast, fixing your mortgage for five, 10, or even 30 years means your mortgage’s interest rate and monthly repayments will stay the same, regardless of what happens to the economy.

Of course, interest rates don’t always go up. They could also go down, which could mean lower monthly repayments. A Danish bank, for instance, made headlines in 2019 for offering mortgages with negative interest rates — mortgages that literally pay you interest instead of the other way round.

That said, negative interest rates are a rarity; a once-in-a-generation phenomenon. And while scientists have created complex mathematical models for forecasting fluctuations, the reality is that nobody can be 100% certain about whether interest rates will go up or down, when they will do so, and for how long.

Seeing as your mortgage is probably your biggest monthly outgoing — in the UK, for instance, mortgage repayments can add up to an eye-watering 45% of the average household’s income — it makes sense not to take your chances.

Yes, getting a fixed-rate mortgage means you could lose out on an excellent deal if interest rates do take a nosedive. The trade-off is that you’ll get peace of mind and an easier time staying on budget.

A win for you, a risk for your bank

While a fixed-rate mortgage means less risk for you, it creates more risk for the bank. Put simply, because the bank has locked your interest rate for a long period of time, it will have to take the hit if the interest rate spikes.

But let’s back up for a second.

Banks get the money for their mortgage products from two main sources. One is customer deposits. And the other is from borrowing money themselves, typically from other banks or by issuing bonds.

Just as you pay interest on your mortgage (and on any other loan, for that matter), banks also pay interest on the money they borrow.

Customers earn interest on certain deposits like savings accounts and fixed-term deposits. Similarly, investors who buy bonds don’t do so out of the goodness of their hearts. They do it in order to earn interest and grow their wealth.

The bank earns money by charging you a higher interest rate on your mortgage than it pays to customers and bond-holders. The difference between the interest the bank pays and the interest you pay is the bank’s profit.

This is what makes fixed-rate mortgages risky.

If interest rates rise, your bank will have to pay depositors and bondholders more money. But if you’ve fixed your mortgage’s interest rate, they can’t make up what they’ve paid extra by passing the increase on to you. Which means they’ll either make less money or end up losing it.

How banks swap their way out of interest rate risk

The risk in fixed-rate mortgages puts banks between, well, a boundary wall and a hard place – especially given the size of interest income relative to other sources of income.

On the one hand, because they make repayments predictable and ensure they stay affordable, fixed-rate mortgages are hugely popular. According to the Bank of England’s latest data, for instance, most mortgages issued in the UK are fixed.

The flipside is that, the more fixed-rate mortgages banks issue, the more money they stand to lose when interest rates go up.

That’s where a hedging instrument called an interest rate swap comes in.

An interest rate swap is an agreement in which two parties agree to swap the income from future interest payments on a financial contract with the income from future interest payments from another financial contract.

Typically income from fixed interest is exchanged for income from a variable interest rate. So, the bank can give its income from fixed-rate mortgages to another party. And in exchange, the other party gives the bank its income from a variable, but usually higher rate of interest.

This benefits everyone. The other party gets the certainty of a stable income from a fixed interest rate. Meanwhile, the bank has mitigated its fixed interest rate risk on its mortgage portfolio, which allows them to keep offering you a fixed-rate mortgage.

Hedging makes home-ownership happen

Buying a house is a big decision. And with property prices soaring, it’s also a huge, long-term financial commitment.

The silver lining is that the fixed-rate mortgage makes it possible to lock in your interest rate, keep your repayments stable, and your home more affordable.

And it’s all down to hedging.

So next time you’re tempted to dismiss hedging as wonkish and boring, think again.

Not only does it have far-reaching impacts in the real world…

It’s ensuring that, no matter whether the economy tanks or soars, you can continue owning your own home.

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