Just like mortgage lenders are constantly issuing new mortgages and having others repaid at the same, so too are they constantly borrowing and repaying loans from central banks.

So, every time a lender agrees to give you a new fixed-rate mortgage, they’re placing a bet: a bet that, over the next two or five years (or however long), they’ll still make a profit on your mortgage, regardless of what happens to interest rates in the future – remembering that they, too, are repaying interest back to the central banks.

As a result, mortgage lenders are constantly looking at what they think interest rates are going to be over the period of your mortgage (be it 10 years or 30), and planning for them. But life is unpredictable, and lenders hate unpredictability; interest rate swaps are how they protect themselves against this unknown.

Think of interest rate swaps as insurance for the lender. The lender agrees to swap their unfixed, unpredictable interest rate with another party, who guarantees a fixed rate – but charges the lender for the privilege. The swap lasts for an agreed period – often two or five years.

Interest rate swaps are good business for both the lender and the second party. The lender gets a degree of extra certainty about future interest rates, and the other party makes a small profit from the charge. 

The lender doesn’t get to decide how much it’s willing to pay for this ‘insurance’; there is a whole marketplace of second parties willing to make these swaps with lenders, and the charges go up and down based on good old-fashioned supply and demand. It’s these charges that we know as swap rates. 

As you’ve probably guessed, the lender passes these charges onto you as part of your fixed-rate mortgage. So, swap rates have a direct impact on the costs associated with this kind of mortgage. 

During times when interest rates are steady and nobody expects a change in the status quo, swap rates are low. But when interest rates are in flux – as they have been over the past couple of years – swap rates go up.

After all, insurance – no matter what you’re insuring, whether it’s a car or an interest rate – is about measuring and mitigating risk. Risk is just another name for uncertainty. And the higher the risk, the higher the insurance premium. 

In the recent past, when interest rates were at historically low levels, swap rates were cheaper over two years than they were over five.

It reflected that, ultimately, there wasn’t anywhere for interest rates to go but up. It was just a question of… when? And it’s why, at the time, a 5-year fixed-rate mortgage attracted a higher rate than a 2-year equivalent.

Now, of course, interest rates have increased. Today, the situation is inverted, and 5-year fixes are being offered at a lower rate than 2-year fixes. Why?

Again, it’s because of predictions around risk. It’s an indication that the market is expecting the next few years to be more volatile, but they will be calmer – or, you might say, more predictable – in the longer term. 

It’s why lenders are willing to offer you a lower interest rate on a longer fixed-rate mortgage if you agree with what the market is predicting – but includes an Early Repayment Charge, as an added layer of protection for itself, in case the predictions are wrong and you’d be better off bailing out before the agreed fixed-rate period is over.

Of course, you might disagree and opt for a higher rate over a shorter fixed-rate period, and take the chance that rates will be lower in two years’ time than they are now.

The choice, ultimately, is yours; your financial adviser can give you advice about which lender and product is right for you, but the details of your specific application – like the length of the fixed-rate period, the overall term of the mortgage, and the amount you borrow – are for you to decide.