One widely used mortgage model is the LIBOR-based mortgage. In this type of mortgage, your rates are variable and change in keeping with fluctuations in LIBOR base rates. When you take out a LIBOR-based mortgage, you benefit when rates go down, but pay more when rates go up.
So-called receiver swaps can be purchased to protect you from the risk of rates rising. In what’s known as a payer swap, the mortgagor exchanges a fixed rate for a variable rate, such as a LIBOR-based rate. In this arrangement the bank acts as the «receiver» (learn more about interest rate swaps here).
Here’s an example of a possible scenario based on positive LIBOR interest rates:
Cost of a LIBOR-based mortgage: 0.05% (LIBOR) + 0.5% (bank markup) = 0.55%
Costs of an interest rate swap (payer swap): 1% (fixed mortgage rate) - 0.05% (LIBOR) = 0.95%
Final costs paid by the mortgagor with a LIBOR-based mortgage and an interest rate swap: 0.55% + 0.95% plus 1% + 0.5% = 1.5%
The basic principle is this: The higher the LIBOR rates, the more an interest rate swap that compensates you for variations in LIBOR rates pays off. If the variable rates of the rate swap offer match the LIBOR base rates, your rates will remain constant over time, as they would if you got a fixed rate mortgage.
Compared to fixed rate mortgages, the combination of LIBOR-based mortgages and rate swaps has been a good bet, because the interest rates usually ended up lower. Other options you get with swap mortgages are the possibility of a long mortgage term (this may exceed 30 years on some offers) and lower costs if you exit your mortgage agreement early, compared to fixed rate mortgages.
Swiss LIBOR-based mortgages and negative interest rates
Under the current negative interest rate regimen imposed by the Swiss National Bank, a 3 month CHF-LIBOR will fluctuate between -1.25 and -0.25. As it stands, Swiss franc LIBORs are deep in the minus for all mortgage terms.
Many mortgagors didn’t count on negative interest rates, or weren’t aware of the fact that negative interest rates aren’t passed on the borrower under Swiss LIBOR mortgage contracts. Most often, rates have a 0 percent floor, plus an additional markup (or markdown in this case) making up the bank’s profit margin.
Instead of receiving money for mortgaging their home using a LIBOR mortgage, borrowers continually pay interest rates as per the bank’s margin.
LIBOR mortgages with rate swaps and negative interest rates
When negative interest rates are imposed, holding a LIBOR mortgage with a rate swap puts you in a hazardous position. Banks continue to calculate the same fixed rates for the swap, but add to that the negative interest rate. However, negative rates are not applied to the LIBOR-mortgage.
An example of a rate swap using a LIBOR mortgage and negative interest rates:
Costs of LIBOR mortgage: 0% (interest rate floor) + 0.5% (bank markup) = 0.5%
Costs of an interest rate swap (payer swap): 1% (fixed interest rate) + 0.8% (minus -0.8% LIBOR) = 1.8%
Total borrower costs of a LIBOR mortgage with a rate swap: 0.5% + 1.8% = 2.3%
The costs of LIBOR swap mortgages are remarkably high at this point in time. Among the hardest hit are large institutional borrowers such as cooperatives and owners of properties with a value of several million francs or more.
But increased costs also indirectly influence renters. Because many cooperatives opted for LIBOR swap mortgages, some of them have been forced to compensate for higher interest payments by passing the cost on to renters in the form of rent increases. With no obvious signs of an upcoming change in interest rates, it’s fair to say that these circumstances could continue for several years.