Variable-rate Mortgage - Pricing

Pricing

Adjustable rate mortgages are typically, but not always, less expensive than fixed-rate mortgages. Due to the inherent interest rate risk, long-term fixed rates will tend to be higher than short-term rates (which are the basis for variable-rate loans and mortgages). The difference in interest rates between short and long-term loans is known as the yield curve, which generally slopes upward (longer terms are more expensive). The opposite circumstance is known as an inverted yield curve and is relatively infrequent.

The fact that an adjustable rate mortgage has a lower starting interest rate does not indicate what the future cost of borrowing will be (when rates change). If rates rise, the cost will be higher; if rates go down, cost will be lower. In effect, the borrower has agreed to take the interest rate risk. Some studies have shown that on average, the majority of borrowers with adjustable rate mortgages save money in the long term.

The actual pricing and rate analysis of adjustable rate mortgage in the finance industry is done through various computer simulation methodologies like Monte Carlo method or Sobol sequences. In these techniques, by using an assumed probability distribution of future interest rates, numerous (10,000–100,000 or even 1,000,000) possible interest rate scenarios are explored, mortgage cash flows calculated under each, and aggregate parameters like fair value and effective interest rate over the life of the mortgage are estimated. Having these at hand, lending analysts determine whether offering a particular mortgage would be profitable, and if it would represent tolerable risk to the bank.