Question

With a Fixed Rate Mortgage, who holds the interest rate risk? Do they hold all the risk or is it spread out? How could the groups who holds the most risk, spread the risk? What is the biggest advantage and disadvantage of fixed rate mortgages?

Answer 1

With a Fixed Rate Mortgage both borrower and lender holds the interest rate risk.

The risk is spread out between borrower and lender. When interest rate in market goes below then it is a loss for borrower as he can he can loan at cheaper interest rate. When interest rate in market goes up then it is a loss for lender as he can lend the money at higher interest rate.

Both parties can swap his/her risk by going into swap contract with a third party in exchange for a floating rate debt security.

Advantage:

No matter what the interest rate is prevailing in the market, the borrower will pay the same interest rate and lender will get the same interest rate.

Disadvantage:

For Borrower , if the interest rate goes down in the market, he can't enjoy the lower interest expense.

For Lender, if the interest rate goes up in the market, he can't enjoy the higher interest income.