Everybody with a ARM needs to refinance now. It seems like banks are manipulating LIBOR again, the main index Adjustable Rate Mortgages are tied to. Given the Fed raised rates in December 2015 by only 25 basis points, it is difficult to accept why LIBOR rates have risen by ~60 basis points. Since that time, the US stock market has corrected by 10%, the 10-year bond yield has declined by 45 basis points, and it is now highly unlikely the Fed will raise rates again this year.
LIBOR rates should be closer to 25 basis points higher instead of 60 basis points higher. We’re seeing signs of deflation around the world for goodness sake. If LIBOR does not decline soon, expect to see another investigation into the banks that make markets for LIBOR. Between another potential Ponzi scheme and LIBOR interest rate manipulation, let’s all hope for the best and also take action.
FREE 0% MORTGAGE
I try to share with readers in real time what I’m doing with my money so others may benefit. After shopping around for various mortgage refinance rates when the 10-year bond yield collapsed to 1.6%, I locked in a 5/1 ARM at 2.375% with -0.125 points compared to my existing 2.625% rate. If my ARM resets today, my ARM would jump to 3.4% due to LIBOR, which is what I’m really hedging against by refinancing now.
A 2.375% 5/1 ARM essentially means I have a mortgage that is basically FREE every month because I can invest my money in a 5-year CD at 2.42% risk-free according to my Rate Brain widget on my homepage up above. Currently, Melrose Credit Union and E-LOAN both have 5-year CD rates at 2.4%+. For example, with a $1M mortgage, I’m paying $23,750 a year in interest but would earn $24,200 a year in interest if I locked in a 5-year CD with the same principal borrowing amount today. In other words, my effective mortgage interest rate is negative.
Not everybody will have the capital to conduct such an arbitrage. That’s fine as it takes time to save a bed of cash. What’s more important as a borrower is to RECOGNIZE the existing arbitrage so that at the very least, you know you are getting a fantastic deal when such dislocations occur.
EXPLAINING THE TERMS OF AN ADJUSTABLE RATE MORTGAGE
The below chart is a snapshot of my actual Adjustable Rate Mortgage (ARM) terms.
This 5/1 ARM is tied to the one year LIBOR rate + a margin of 2.25%. At a total interest rate of 2.375% for the first five years, the bank only makes a margin of about 1.24% above LIBOR. The initial fixed rate periods of an ARM (1,3,5,7,10) are subsidized rates, which you should take advantage of before the ARM adjusts. It’s similar to using a credit card to buy things for a 30-day interest free loan, just not as bad if you don’t pay your bill because credit card interest rates are usuriously high, while ARM mortgage rates are capped.
In the sixth year, the bank can raise my interest rate by as much as 2% to 4.375% fixed for the rest of the year, if LIBOR rises to 2.125%. My interest rate can rise by another 2% to 6.375% in year seven if LIBOR rises to 4.125%. The maximum interest rate the bank can charge me is 7.375% starting in year 8 – 30, which is equivalent to LIBOR at 5.125% (5.125% + 2.25% margin = 7.375%).
As an ARM holder, you’ve really got to take a view on where short term interest rates (LIBOR, Fed Funds rate) and long term interest rates (10-year bond yield) are heading. With evidence of deflation around the world, I do not see Central Bankers raising their overnight borrowing rates aggressively. Perhaps LIBOR could rise from 1.14% today to 2.125% in five years, but that would indicate healthy inflation, which would also portend to a healthy increase in property values. A mortgage interest rate of 4.375% is not that much at all.
Besides my belief that interest rates will continue to stay low for longer, another reason why I’m very sanguine about refinancing into another ARM is because in five years, my principal will be about 12% less if I don’t pay down extra principal. Therefore, I’ve got another buffer if rates do rise.
WHY SO MANY DIFFERENT INTEREST RATES?
The reason different financial institutions have different CD and deposit interest rates is because financial institutions all have different capital needs. Banks make money by attracting deposits, paying an interest rate on those deposits, and lending your money at a higher interest rate to make a spread.
My 2.375% 5/1 ARM is with Citibank. But when I go to see Citibank’s 5-year CD interest rate page, they show only 0.5%. This means Citibank is flush with cash and is in no need to attract more capital. They are probably over-capitalized and need to find ways to deploy their deposits to boost their earnings.
If you are a financial sector investor, an easy due diligence is to simply check the latest deposit and CD rates of various financial institutions. The higher the financial institution is paying, perhaps the more balance sheet risk there is. For example, before Washington Mutual got acquired for pennies on the dollar, they were offering 4-4.5%, 5-year CD rates even though the overall market averaged closer to 2%.
LIVE FOR FREE
Your mission as a Financial Samurai is to BORROW from over-capitalized banks and LEND to under-capitalized banks.
Whenever you see CD interest rates pay more than mortgage rates with the same duration, you must take action by refinancing your debt. There’s no clearer sign that you are getting the best mortgage rate possible at the time.
With rates this low now, I wouldn’t be in a rush to pay down your mortgage unless you have tremendous excess liquidity or debt levels far beyond a comfortable level. Develop a system where a percentage of each dollar is used to build your risk-free fund, invest in the stock market, and pay down your highest interest rate debts.
With my latest mortgage refinance, I plan to live in my house mortgage payment fee by tethering my CD interest income of ~3.6% towards my new mortgage interest rate of 2.375%. Who said living in a city like San Francisco is expensive?
If you can wipe away your living costs, you can now free up a tremendous amount of cash flow to invest or do whatever your big heart desires. Now I’ve got to figure out how to eat well for free. Any suggestions?
If you’re looking for a mortgage, go online to a site like LendingTree. As soon as you fill out a no obligation form, lenders will e-mail or call you within 24 hours with their rates. If you don’t like their rates, use their e-mail evidence as a way to get your current bank to match or beat their rate. That’s what I’ve always done and it ensures that I always get the lowest rate at the time. It really is about shopping around and making banks compete for your business!