March 2020 was the beginning of utter madness, in so many ways.
For the financial markets, it meant unprecedented intervention from governments and central banks to keep the global economy from imploding.
As a result of their policy decisions, we all experienced the severe side effect of 40-year high inflation in 2022.
No one likes inflation, especially the bond market.
Bond investors were some of the first to sniff-out the potential of red-hot inflation and as a result sold bonds at a record pace.
This led to over 7% fixed mortgage rates in 2022 as the price of US mortgage bonds dictates mortgage rates: lower bond price = higher rates (yield).
Although, it felt like the Fed rate hike decisions were to blame, the big moves in mortgage rates were in response to inflation data (CPI) and came before Fed rate hikes.
The Fed raised their overnight lending rate (Fed Funds) aggressively to tackle the inflation problem, but the bond market was always a few steps ahead of them.
The attempt by investors to predict Fed actions, and the impact of their policy decisions, is easy to see based on yield curve inversions.
The inverted yield curve means longer term rates are lower than shorter-term rates. It also suggests the market expects the Fed to overtighten (raise rates too high) and will be forced to cut rates in the not-so-distant future (2024) as the economy sours.
Currently, an investor will collect more interest from a 2-year US Bond than from a 10-year US Bond. This is counterintuitive since longer-duration means greater risk, therefore investors should require higher yields (rates).
However, when market participants think an economic crisis is looming, they prefer protecting against those risks in longer-duration bonds, instead of being exposed to market volatility when a shorter-duration bond expires mid-crisis.
Why is this important?
In the rest of this article, I’m going to show how the phenomenon of yield curve inversion benefits property owners who strategically chose a higher mortgage rate in 2020-21, instead of paying points to get the lowest rate available at the time.
This approach, which I refer to as “Mortgage Rate Arbitrage” can be implemented in any market environment and is something I have mastered in my 17-years of mortgage finance.
However, as you will read below, it becomes a critical strategy when interest rate reach extreme levels (highs and lows).
We are at a pivotal point right now, what I believe to be the top in mortgage rates for the current Fed hiking cycle.
Therefore, implementing a mortgage arbitrage strategy today is crucial in order for borrowers to maximize their home equity, so they can still qualify for a lower rate later even after home values have declined.
IMPORTANT CONCEPTS TO LEARN
One of my favorite articles, and my most popular, is “Game of Loans”.
One of the most important, is my “Law of Recuperation” article
In Game of Loans I discuss how margins (profits) influence the rate options lenders offer you.
I also warn about chasing rate and why this usually results in paying for a rate that doesn’t save the borrower any money.
In Law of Recuperation I further breakdown why low rate does not always equate to a better mortgage, and the woes of chasing rate.
I highly recommend you read these articles. They will give you a stronger understanding of the ideas I share next.
Mortgage rates at the peak of 2020-21, as a result of central bank bond buying, had artificially reached an all-time record low.
30-year fixed mortgage rates for government loans, like FHA and VA, were even briefly in the high 1% range.
Sure, it sounds sexy to say you have a 1.75% interest rate, but what you had to pay for that rate versus just a half-percent higher (2.25%) made the lower rate option foolish.
Let’s explore this further.
If your mortgage balance was $500,000 and you decided to “chase rate” by paying 2-points (2%) for the lower rate it would have cost $10,000 in discount fees (points).
This does not include all the other transaction costs, like escrow fees, title insurance, appraisal, etc. These together can easily reach another 2-points.
So, that slightly lower rate would cost $20,000 or more.
Meanwhile, because of how certain mortgage rates are packaged into different mortgage bond coupons (please read “Game of Loans”), the merely half-percent higher rate of 2.25% would not only have ZERO discount fees, but it would offer a rebate large enough to offset all the transactional costs.
This means the loan would in essence be FREE.
The payment on the 1.75% loan would be $1,786.
The 2.25% loan would have a payment of $1,912.
A difference of $126.
It would take 158 months to recuperate the $20,000 costs from the lower rate (20,000 / 158).
This means compared to the 2.25%, you would not experience any true savings with the 1.75% until the 13th year, after the $20,000 costs have been fully recuperated.
Read “Law of Recuperation” for a broader explanation.
THE CONSEQUENCE OF CHASING RATE
However, that’s not the end of the pain for “rate chasers”.
The 2-year US Bond is paying over 4%.
Most of the curve, all the way out to 30-years is somewhere between 3.75 – 4.50%.
Let’s take the US 20-year bond at 4.25%.
Instead of chasing rate in 2020, if you took the $20,000 and purchased a US Bond, which is considered the “safest” asset, you could receive a 4.25% return.
The annualized return on $20k at 4.25% = $850 or $71 per month.
This means the savings ($158) of the lower 1.75% mortgage rate are nearly cut-in-half (158 – 71 = 87) by opting to invest the $20k into a bond.
Assuming you actually stayed in the same loan for the full 13-year recuperation, you would have only just recovered your $20,000.
Meanwhile, the bond would have paid you $11,000.
MORTGAGE RATE ARBITRAGE
Chasing rate becomes truly detrimental when borrowers refinance before full recuperation.
Although it seems hard to believe, given that mortgage rates peaked at 7% in 2022, the odds are good that bonds (and mortgage rates) revert to back to their long-term trendline.
This means we may have yet to reach the record low in mortgage rates, and at the very least we re-test the lows of 2020-21.
It is also likely that this happens within the next 5 – 10 years, or less.
Investing the $20,000 into a shorter-duration bond, perhaps the 5-year Treasury Bill, would mean you get your $20k back and $4,000 in cash-flow.
You now have $24,000 and the opportunity to get a new record low rate at “no cost” or with less money out of pocket because you didn’t chase rate and your patience paid you an additional $4k to use towards a better loan on the next cycle lower in mortgage rates.
Short term, this is good news for property owners who did not chase rate and are positioned to take advantage of both high-yielding government bonds today and lower mortgage rates in the future.
However, significantly lower mortgage rates (higher bond PRICE) are typically a warning and consequence of economic crisis’.
Unfortunately, this seems to be in the crystal ball of most economists, and probably occurs within the next two-years.
This also means falling home prices, which is already happening.
MISSING: HOME EQUITY
Typically, borrowers will finance loan costs into the loan balance which cuts into home equity.
Depending on how quick or how deep home prices drop, the $20,000 in closing costs from the earlier example could eliminate some borrowers from qualifying for a refinance if/when mortgages are lower.
As you can see, making a savvy mortgage decision is not just about what rates are today, but understanding potential future outcomes, and structuring your mortgage in a manner that benefits you both today and down the road as market conditions change.
This is even more true today, as borrowers struggle with the sticker shock of higher mortgage rates and look for ways to consolidate adjustable-rate debt from HELOC mortgages and high-interest credit cards.
Please, before you chase rate and make a bad decision today, contact me so we can take a holistic approach to refinancing and I can design a strategic refinance option that will be win/win for you regardless the financial conditions.
The “other guys” are going to sell you rate of the day and push closing costs down your throat to help make the payment more tolerable in the short term.
Yet, long-term this approach will only cost you money without true savings, destroy equity, and eventually lock you out of refinancing later as home prices continue to drop.
More on the unfolding housing price declines in the next post coming soon…
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