Wednesday, September 12, 2007

Term Deposits (10) - Borrowers Perspective

The person borrowing from a bank that lends long and borrows short also faces uncertainty. They have agreed to a mortgage with at twenty year term, with a bank that has only organised the finance for the first six months of the loan. The bank presumes that it will continue to be able obtain the money as it is needed. This is probably true, but the bank does not know what rate of interest rate it will have to pay to obtain the money in the future. That is why most banks will generally not hold mortgage interest rates fixed for more then about two years. They do not know how the interest rates will move in the future, so they pass the risk on to the borrower.

The adjustable or floating rate mortgage is the solution to this problem. The adjustable rate mortgage is really a series of short-term loans. The bank is implicitly saying to the borrower, I can only loan you this money for a couple of years. At then end of that term, I will renew the loan, but I do not know what the interest rate will be. I will always be able to borrow some money, but I cannot control the interest rate. I will have to adjust the interest rate that you pay to allow for this. So really an adjustable rate mortgage is really a series of short term loans with different interest rates, but with the same security remaining in place.

If the borrower is willing to take the risk of committing to a twenty or thirty year mortgage, without know what the interest rate will be, that is their business. However, taking on an unknown risk in this way is not very wise. The Bible suggests that we should not make commitments beyond five years. Making a commitment to make payments in thirty years time is serious enough. The fact that you do not know what the amount you have to be, makes the uncertainty even worse.

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