You might have heard the term 'swap rates' when people talk about the price of fixed rate mortgages, but what are they, and how do they actually work?
Here's what you need to know.
What are swap rates?
Swap rates seem complicated but are actually quite straight forward, you just need to get your head around the jargon. In short, an interest rate 'swap' happens when two parties exchange one stream of interest payments for another, where one party swaps a fixed rate with another party's variable rate.
In the below example, a bank is going to go into a swap rate agreement - after an interest rate increase - in an attempt to maximise profits:
A bank offer savers a variable interest rate of 1.5%. It is borrowing funds from savers, and paying them that 1.5% in return. The bank then lends that borrowed money in the form of a mortgage to a house-buyer, but at a fixed rate of 3% over five years. This allows the bank to pay back the borrower and still make a profit.
An interest rate rise occurs. The bank matches the new rate of 2.5% to stop savers going to a different bank. This will decrease the bank's profits because they are having to pay their savers more, but are not able to charge more on their 3% fixed rate mortgage.
So the bank started out receiving 3% from the mortgage holder and paying out 1.5% to the saver, which left 1.5% profit. But when the interest rate increased they now pay out 2.5% to the saver, so the profit shrinks to just 0.5%.
This is where the swap rate comes in.
To protect itself from the risk of lower profits, the bank agrees with another financial institution (known as a counterparty) to replace the variable cost of its funds (the 2.5% it is paying to savers) with a fixed one that the counterparty owns (2%).
The counterparty is looking to do the opposite, by replacing a fixed cost of funds with a variable one, hence the 'swap'.
By agreeing to the swap, both parties are placing a bet on the future movements of the interest rate, with each party trying to make money off the other's rate.
The bank, which is replacing a variable rate with a fixed rate, wants interest rates to go up. By exchanging the 2.5% variable cost with the fixed cost of 2%, the bank will make less profit in the immediate future but will benefit if interest rates go up again, because it can maintain the 2% repayment without needing to respond to another interest rate increase. Meanwhile, the counterparty inherited a variable rate so will need to pay the bank that higher interest rate as part of the swap.
Therefore, the counterparty has higher risk; it will need to match a rate rise to keep its customers, therefore losing the profit it would have made if it had just kept the fixed rate and not given it to the bank.
If the counterparty is lucky, the interest rate will stay the same and it will therefore not need to adjust its interest payments.
Why would this affect your own mortgage?
Swap rates give lenders an indication of what people think will happen to the interest rate. By checking the swap rate, you will gain an important insight into whether a fixed rate mortgage will cost more than a variable rate mortgage.
In brief, a high swap rate means you'd prefer a fixed mortgage, and a low rate means you'd prefer a variable mortgage. This reflects market sentiment and the amount of swaps, and a counterparty will only take a swap if their risk is low.
However, although swap rates have a bearing on fixed rate mortgages, there are lots of other factors (many of them very technical) which also influence what level of fixed rates a lender can offer. So there isn't necessarily a direct link between swap rates and mortgage rates, but they often give a good indication of what might happen.
What changes the swap rate?
The level of the swap rate is, very basically, a best guess of what might happen to interest rates over the next few years. If the market expects an increase in the base rate, counterparties will be taking on more risk and will therefore charge more for a swap rate.
So if the swap rate - the cost of swapping your variable cost for a fix cost - goes up, it means the market thinks interest rates will increase sooner rather than later.
When a base rate rise is expected, for example, the counterparty faces a greater risk of increases. So the bank has to pay a bit more, meaning the 'swap rate' tends to go up. In turn that means the bank needs to increase the cost of fixed rate mortgage deals to ensure it still makes a profit.
Swap rates have been gradually increasing
Swap rates have been gradually increasing recently, which has prompted some commentators to suggest that a rise in rates could be imminent. Importantly, though, the swap rates are anticipating what might happen. So an increase in swap rates can drive up the price of mortgages, even if the Bank of England doesn't increase base rate.
On the other hand, sometimes even when the cost of swaps increases, mortgage rates don't always go up by the same amount. That's due to competition between lenders who are keen to attract business, which benefits borrowers because it means there are currently still plenty of low rate fixed mortgage deals to choose from.
Well, there you have it. Swaps are complicated on the surface but make sense once you know why people enter into them. As always, getting your knowledge from the experts is the best route when discussing your finances. Fortunately, we have partnered up with London & Country, the UK's biggest fee-free mortgage advisor, to give you the help you need when it comes to money.
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