Mortgages vs. gilts

A question from Yahoo! Answers:

Why are banks giving mortgages for 5% when they could invest that money in gilts for 5.1%?

First of all, let’s get the facts straight. A quick look at Bloomberg’s interest rates page for the UK:

http://www.bloomberg.com/markets/rates/u…

shows that 5% yield to maturity can be had only in gilts with durations shorter than three years. 20-year gilts yield 4.35%, 30-year gilts, 4.05%. So a 30-year mortgage underwritten at 5% will carry a 0.95% yield premium over a 30-year gilt. Additionally, 5% is not the market average, but rather the lower edge of the band, the high edge being closer to 6%:

http://moneycentral.moneyextra.com/compa…
http://moneycentral.moneyextra.com/compa…

Also, in the UK, fixed-rate mortgages are somewhat of a misnomer. Fixed rate only applies during the specified initial period (which could be as short as two years and as long as 20 years), after which it may revert to a higher rate.

Then, mortgages, unlike gilts, pay fees. A typical closing fee may be as high as 0.5% of the mortgage, payable upfront. Also, in the UK, it is legal to charge prepayment penalties on home mortgages, which many banks do.

Finally, duration. A 30-year mortgage has a much shorter duration compared to a 30-year gilt…

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