Who carries the risk when a mortgage rate can move?

When a bank lends money for a house, interest rates can change during the many years of the loan. Someone has to carry that risk, and the choice between a fixed and a variable rate decides who. In a fixed-rate mortgage, the interest rate remains the same through the whole term. In an adjustable-rate mortgage, the rate is periodically adjusted based on an index that reflects the cost to the lender of borrowing on the credit markets. Often the rate is that index plus a margin, written into the contract and fixed for the life of the loan.

The key idea is that adjustable rates transfer part of the interest rate risk from the lender to the borrower. If rates fall, the borrower benefits; if they rise, the borrower loses. Adjustable-rate loans usually charge lower interest rates than fixed ones, the other side of that trade. Inflation adds a twist. Someone with a fixed rate is better off if inflation turns out unexpectedly high, because it lowers the real value of the repayments, and worse off if inflation falls and pulls interest rates down.

Lenders have their own reasons. Banks funded by deposits, which have much shorter terms than mortgages, would face a mismatch if they offered lots of fixed-rate mortgages. Some argue this contributed to the US savings and loan crisis, when Paul Volcker raised interest rates in the early 1980s. Banks offer adjustable-rate mortgages because they reduce risk and match their sources of funding.

Countries differ. Fixed-rate mortgages are the norm in France, Belgium, Germany, the Netherlands and Denmark, while Austria, Greece, Italy, Portugal, Spain and Sweden favour adjustable rates. In the UK, variable-rate mortgages are more common than in the United States.