Managing Your Mortgage

Part II:  Selecting a Mortgage and When to Refinance

Professor Matthew Spiegel

September 19, 2006

In order to understand what type of mortgage you should try to get, or when you should refinance it, you need to understand something about how interest rates work.  The graph below displays the difference between the 10 year and 1 year treasury rates going back to 1953.

While the line jumps around a lot, the important thing to note is that it is almost always above zero. That means in a typical month a 10 year government bond pays a higher rate of interest than a 1 year government bond. The only significant exception to this rule takes place between 1978 and 1982.  The box contains a brief explanation as to what happened.  But, the bottom line is that it is unlikely to happen again any time soon.

In general, long term interest rates are higher than short term rates because the lender takes on additional risk.  With a short term loan the lender receives the current interest rate, whatever it may be. With a long term loan the rate is fixed and cannot take advantage of that.  The problem is inflation, or potential inflation.  If inflation rises then lenders will want a higher interest rate in order to generate a positive real return on their loan.  For example, suppose you lend money out at 3% and inflation is 6%.  Then after you get your money back, with interest, your funds will have less in the way of purchasing power than when you started.  Most lenders are obviously not going to tolerate that.  Thus, long term interest rates tend to be higher than short term rates in order to provide the lenders with a premium for taking on the risk that inflation will wipe out the profits on their investment.

What does all of this have to do with your mortgage?  Quite a lot actually.  Mortgage rates are based upon government bond rates.  Which one depends on the type of mortgage.  A 3/1 ARM will initially depend on the three year rate and once it resets the one year rate.  In contrast, a 30 year mortgage is generally based upon the 10 year government rate. That means you will, typically, have a lower initial interest rate if you take out an ARM than a 30 year fixed rate loan.

At this point most articles now switch into “yes but” mode.  The “yes but” has to do with what may happen in the future.  With a fixed rate loan you know that whatever happens your monthly mortgage payments will not increase.  But with an ARM they may.  While that is true some perspective is needed.  First, how long do you plan to stay in your current house?  One year, three years, five years, or as long as ten years?  The average house turns over about once every seven years.  So are you sure you will be buried in the back yard of that house you are looking at?  In real life people change jobs, get divorced, get married, have more or fewer children than they expected, and experience other surprises that lead them to move.

Suppose then, that I think family is typical and will live in the house for seven years. In this case a 30 year fixed rate mortgage provides absolutely no advantage over a 7/1 ARM.  At the end of seven years moving forces you to pay off whichever mortgage you take out in full.   That means the fact that the ARM will reset after seven years is irrelevant to you since you will not borrow the money for that long.  So the only thing you need to know is which mortgage costs less right now. The answer will inevitably be the 7/1 ARM.  Those planning to move in less than seven years can save even more (again without taking on any more risk) by purchasing their home with an ARM that has an even shorter initial term.

Alas, most of us do not know exactly when we will move out of our house.  It may be two years, ten years, or thirty years.  What then?  If this is the situation you are in then you need to be realistic about the chances you will remain where you are over various periods of time.  If you are pretty sure that you will be moving within the next seven years then you certainly want to look at an ARM of some sort. If you might stay put for over seven years then you need to consider how much risk you are willing to take on for the potential rewards.

We already know that 30 year fixed rate mortgages typically start off at a higher interest rate than an ARM.  But, is the lower initial ARM rate worth the risk that interest rates will rise if you want to remain in your house over a long period of time?  To answer that question you need to answer several others.  Can you afford the interest payments on a 7/1 ARM?  If the answer to this question is no you are probably trying to buy a house that is beyond your financial reach.  Your only choice in this case will be a shorter term ARM, or one of the new variants like an interest only or option mortgage.  But, if interest rates rise you will be forced out of your house.  That seems like a very poor position to put yourself into.  How financially disciplined are you?  An ARM will save you money initially.  Will you spend your savings or put them away in the event interest rates rise and you need the funds later on?  If you are simply going to spend them will you be able to pay the mortgage if interest rates go up two or three percent?  If you can, the go ahead, take a trip with your savings!  If not, and if you cannot get yourself to save the funds then again you might be better off with a long term mortgage.

Assuming you can afford to remain in your house if you take out an ARM and if interest rates go up a percent or two should you go with the ARM?  If you should take out an ARM what term is best?  To answer these questions you need to have some idea of how volatile interest rates really are.  The graph below displays the 10 year and 3 year treasury rates in real terms; that is with inflation’s impact removed.

The first thing you should notice is that outside of the 1970’s and early to mid 1980’s the rates generally lie between about two and four percent.  In fact, if you leave out the 1970’s and 1980’s the real 3 year rate never went above 4.98% and the real 10 year rate never exceeded 5.22%.  Is it fair to remove 20 years of data?  There is no good way to answer this.  In my view, it seems unlikely that the economic policies that lead to the high inflation 1970’s and then to the high interest rates in the first half of the 1980’s (to bring the inflation rate back down) are unlikely to occur again in the foreseeable future.  But, I have been wrong about what the future will bring before. So, ultimately you have to answer this question yourself.

Assuming you think my having removed the 1970’s and 1980’s from the data provides a better picture of what might lie ahead, the case for why it often pays to take out a 3/1 or 5/1 ARM instead of a 30 year fixed rate loan becomes clear.  Real interest rates are pretty stable.  That means if you take out an ARM and interest rates really do rise it will be because inflation has as well.  But, if inflation rises then, generally, so do wages.  Thus, you will be able to afford a somewhat higher mortgage payment should that come to pass.  Better yet, if inflation stays at its currently modest pace of two to four percent then today’s interest rates are likely to be very close to those you will see going forward. 

Now, take a look at today’s rates.  According to the web site of a local mortgage broker today you can get a 5/1 ARM with no points for 6.125% or a 30 year fixed rate loan for 6.5%, also with no points. Which should you take?  Given how close these figures are the answer is not apparent.  With the 5/1 ARM you will save 0.375% per year for at least the next five years. In dollar terms that means for every $100,000 you borrow the 5/1 ARM will cost you $607.61 per month, while the 30 year fixed rate loan will cost $632.07 per month. If interest rates either remain stable or decline then the 5/1 ARM will be the better deal for sure.  Not only will you save $24.46 for every $100,000 you borrow for the next five years, but beyond that as well. 

So far we know that for the 30 year loan to dominate a 5/1 ARM interest rates have to go up.  But by how much? Well, by quite a bit more than 0.375%. Suppose that in five years 5/1 ARMs remain 0.375% below 30 year fixed rate loans. If rates go up only 0.375% then you can continue to take out another 5/1 ARM and pay no more than your neighbor who took out a 30 year fixed rate loan today.  Thus, you will (in total) be ahead of your neighbor for at least ten years. For the first five you are ahead and for the next five no worse off.  So rates have to go up by even more than 0.375% for you to lose with the 5/1 ARM and you have to stay in your house for more than five years.  The first is certainly not certain, and for most families neither is the second. 

But wait!  We are not done yet.  Remember that the 0.375% you save you do so over the next five years. Suppose we take those savings and invest them in tax free municipal bonds that currently pay about 3.8%.  At the end of five years you now have your savings plus interest, which at today’s rates will leave you with $1,613.32 per $100,000 borrowed.  If rates go up by 2×0.375% or 0.75% you can still use your savings to offset the additional interest payments and have something left over to boot!  After five years you will owe $93,196.95 for every $100,000 you borrowed.  If you take out a new 5/1 ARM with a 25 year term for $93,196.95 you will have to pay $651.28 per month per $100,000 borrowed.  (I am using a 25 year term to be “fair” since the 30 year mortgage only has 25 years to go and I want to compare loans with similar payoff dates.) This new payment is $19.22 per month more than the 30 year loan’s cost.  But remember you have $1,613.32 in savings.  How long will it last?  Well, if interest rates increased the cost of your mortgage they also increased the return on your savings.  Let us assume that municipal bond rates go up by 0.5% to 4.3%.  In this case your savings will pay off the additional interest for 73 months.  Wait! That is more than another 5 years! Yes, even if interest rates go up by 0.75% then one 5/1 ARM followed by another 5/1 ARM will cost you less than a 30 year fixed rate loan over the next ten years.

So what should you do? Today’s real interest rates are about one to one and a half percent below their historical averages.  That probably means either the inflation rate will come down or interest rates will continue to climb.  While an increase in interest rates of 0.75% in five years is not enough to make a 30 year fixed rate loan more attractive than two 5/1 ARMs over the next ten years, an increase of much more than that is.  Personally, I am betting inflation will come down and interest rates will not climb much more than 0.75%.  But, as I warned you earlier, my economic forecasts have not always panned out.

When to Refinance

For consumers a mortgage’s best feature is that you can always pay off your current loan and take out a new one.  This process known as refinancing allows you to exploit declining interest rates to your advantage.

The key to refinancing is to keep your closing costs and the points you pay as low as possible!  This cannot be over emphasized.  If your mortgage is large enough so that you can obtain no point, no closing cost loans do it.  A no point, no closing cost loan allows you to take advantage of every single downtick in interest rates.  This offers you potentially tremendous savings and takes the guesswork out of when to refinance.  Basically, you want to refinance whenever you can obtain the same loan that you currently have at a lower interest rate.  Thus, if your loan is currently at 6% and you find one for 5.95% you can and should refinance into the lower rate.  If you have an ARM the advantages are twofold.  First, as with a 30 or 15 year fixed rate loan you get the lower rate.  Second, with the ARM you extend the period over which you loan’s initial rate is fixed. For example, suppose you have a 5/1 ARM that you took out two years ago.  That loan now has only three to go at the initial rate before it begins adjusting annually.  But, if you refinance into a new 5/1 ARM you will have five years before its rate adjusts annually.  So, not only do you have a lower interest rate but it will extend further into the future.  What a deal!

If you cannot find a no point, no closing cost loan the refinancing decision becomes somewhat more complicated.  Now you have to balance out the fixed costs you will incur from refinancing against the potential interest savings.  Worse, closing costs are not tax deductible.  That means you have to save even more in interest each year to make refinancing worthwhile.  To see why suppose that between the federal and state governments you are in the 30% tax bracket.  In this case, for every dollar you pay in interest the government reduces your taxable income by one dollar, and thus your taxes by 30 cents.   Reversing this, if you reduce your interest payments by one dollar (via refinancing) then you will need to pay an additional thirty cents in taxes.  Suppose your closing costs come to $1,000 how much in interest do you need to save to offset this cost?  The answer is $1,000/(1−.3) or $1,428.57.  What is happening is that if you reduce your interest payments by $1,428.57 the government will view that as an increase in your taxable income.  They will thus demand you pay 30% of that in additional taxes, or $428.57 leaving you with only $1,000 in savings.  One way to make all of this less painful is to convince your lender to exchange points for closing costs.  As noted in Part I of this article, unlike closing costs, points are tax deductible and thus make refinancing more profitable.

If you have to pay closing costs or points to refinance then you need to determine if the savings are worth the up front fees.  This is not a simple calculation.  The interest you will save comes over time while the fees must be paid now.  Also, these savings come to an end whenever you move or refinance yet again.  Assuming you plan to stay in your current house for at least two years, a good rule of thumb is that you should wait to refinance until the interest savings will cover the fixed costs of doing so in two years or less.  This way if you do move you will not lose that much. Conversely, if do not move and interest rates continue to fall you will be able to take advantage of them without seeing your savings sucked away by your lender’s fees.

Timing the Mortgage Market

Lenders and real estate agents often warn their clients to lock in a mortgage now before rates go up! One imagines that rates are always about to go up.  That seems hard to believe.  After all, interest rates have to go down more or less as often as they go up, given they stay within a fairly narrow range.  Otherwise they would drift off to positive or negative infinity.  But, maybe your real estate or mortgage broker knows if rates are going up or down right now?  I have news for you the government bond traders at investment banks and other major institutions make a lot more than real estate or mortgage brokers! If professional bond traders thought for one second that interest rates were sure to go up or down they would jump on it.  There actions would then move interest rates to the point where even they had no idea which way rates would go next.  In economics this is called an equilibrium.  In equilibrium traders are no more inclined to buy than sell.  It is the common state of the world.  (Otherwise making money would take no talent, effort, or skill.)  Have no fear, your real estate agent or mortgage broker has no better idea if rates are soon going up or down than I do; which is to say absolutely no idea.

So is there anything to the idea that you should lock in a mortgage rate today?  If you can do so at no cost, yes.  It is a free option.  If rates go down you can get a new loan commitment at the new lower rate.  If rates go up, you are protected.  On the other hand, this protection is on average not worth paying very much for.  You are as likely to obtain a mortgage at a lower rate by waiting as you are to be forced into one with a higher rate.  So if it is free go for it, if not take a pass.

A Final Note:  Competition is Your Friend

When looking for a mortgage call around!  Mortgage brokers and banks can be fiercely competitive, but only if you make them compete.  If you have fewer than three quotes you have not been shopping hard enough. Even if you have three quotes call back one of the current losers.  See if they will drop the loan rate to get your business.  Remember, they did not give you a quote to begin with because they like you.  They did because they thought they would profit from your business.  You should have the same attitude.  Your goal is to find out who in fact will give you a loan at the lowest possible rate.  You owe them nothing.  Get the best quote you can and then take it.

If you need help either setting up an investment plan or advice concerning how much risk is associated with various choices feel free to contact us Alpha Investment Opportunities.

© Matthew Spiegel