Rate risk is the amount of potential present for sustaining a loss in the event there is a shift in the prevailing interest rate. Banks often look very closely at this type of risk when structuring loans that carry a floating or variable rate of interest. In like manner, investors who acquire bonds and other financial instruments with a varying interest rate will also assess the rate risk before making a decision to purchase the bond issue.
Lenders are often acutely aware of rate risk. This is because in situations where the prevailing interest rate drops, and remains at a lower level for an extended period of time, the lender will generate considerably less return on each loan underwritten with a floating interest rate. For this reason, some lenders are likely to recommend fixed rate mortgages and business loans when there is some expectation of interest rates falling well below the current rate, and remaining there for some time. During periods where projections indicate the prevailing rate is likely to increase and remain in place for an extended time, those same lenders my urge potential clients to go for a fixed rate loan, locking in that rate no matter what happens in the future.
Lenders also assess rate risk and attempt to project the degree of impact that the change in interest rate would have on their ability to service all types of loans, including those with fixed interest rates. Should interest rates go up, this means that the cost of funding all loans, in particular those carrying fixed rates of interest, will increase. While the increased rates applied to loans with variable rates of interest help to offset the increase, they may or may not completely compensate for the lost revenue from the fixed-rate loans. For this reason, lenders will attempt to maintain some balance, thus reducing the risk of losses no matter what the prevailing interest rate does.
Rate risk is also an important consideration for the consumer. An individual wishing to secure a home mortgage may consider both fixed rate and variable rate mortgage packages. When weighing the pros and cons associated with each approach, the borrower will want to obtain professional opinions as to what type of shifts are likely to take place over most of the life of the loan. While a number of unanticipated factors can occur and affect the rate adversely, it is usually a simple process to accurately project whether interest rates will be stable or volatile at least over the next decade. Armed with this type of information, the borrower can make an informed decision of what type of mortgage to apply for, and be reasonably comfortable that he or she is saving money in the long term.
