Those who’ve been waiting to refinance for the past 12 months have missed the boat with the US 10-year treasury yield surging to 2.15% as of 5/31/2013 vs. a low of 1.4% in July, 2012. Everything from 5/1 adjustable rate mortgages to 30-year fixed rate mortgages have all moved higher by similar, but not exact magnitudes due to durational differences.
Now that it’s 1/20/2015, the 10-year yield has
climbed even higher to 2.6% fallen back down to 1.82% due to volatility in the stock markets, oil prices going down, the Swiss abandoning the peg, and Russia in limbo.
I recommend refinancing as many times as possible if existing rates are at least 0.5% lower and you can break even on the refinance costs within 24 months. Not refinancing due to laziness or fear is quite stupid. It’s interesting to note that the larger your mortgage to refinance, the lower your explicit refinance costs. Given I believe the ideal mortgage amount is $1 million dollars (if you can afford it) for tax purposes, my refinance costs are often “no cost” with fees simply embedded in the new lower rate. There is no free lunch, but it sure feels that way when a bank says do you want a 0.5% lower rate that will cost you nothing out of pocket!
SO WHAT IS A HOMEOWNER SUPPOSED TO DO?
It’s all about perspective in finances. Although you may have missed the refinance window for the past 12 months, let’s take a look at a two year window to see where 2.15% or higher stacks up.
As you can see from the chart, the two year high for the 10-year yield is 3.2%. Going from 2.15% to 3.2% is a huge 50% move higher which should scare the bejesus out of bond holders who will lose a lot of money since principal price moves in reverse of yields.
As a mortgage holder, you are actually also a bond investor. Let’s say you refinance $100,000 to 3% for a 5/1 ARM with the 10-year yield at 2.15%. In the next year the 10-year yield does indeed move up to 3.2% making 5/1 ARMs now 4%. You essentially sold short $100,000 worth of bonds at 3% and made $25,000. How so? To get to a 4% interest, your original $3,000 annual interest cost must now be divided by $75,000 in principal (3,000/75,000 = 4%). Read this paragraph carefully again as I know the inverse relationship between interest rates and principal can get confusing.
Look at the above situation from the banks point of view. They hate receiving only 3% a year when they can now receive 4% a year. Good thing they’ve matched assets and liabilities. Banks hope you either prepay your mortgage, refinance to a higher rate, or sell your property so somebody else can get a new higher rate mortgage. As a mortgage holder in an increasing rate environment, you want to hold on until the very end and never prepay!
Based on a two year chart interest rates still look low if you are kicking yourself for not being proactive enough to at least get a no obligation quote online.
INTEREST RATES OVER A 10 YEAR TIME FRAME
Even if the 10-year yield ramps to a two year high of 3.2%, that’s still quite low compared to a 10-year high of around 5%. I don’t think we’ll be getting anywhere close to 5% over the next 10 years, but we shall see. What’s most interesting in this chart is how the 10-year yield only got to a low of 2.2% during the DEPTHS of the financial crisis. Four years have passed and the economy is much stronger yet the 10-year yield is still only at 2.15%. Got to love central bank intervention!
Bonds have been in a 30 year bull market and I’ve been going along for the ride for the past 10+ years as a homeowner. Not only have rents increased but so have property prices despite the correction. Meanwhile, the value of homeowner’s mortgages have also increased as I’ve explained above. Locking in a 30-year fixed mortgage rate for the past two decades has been a suboptimal proposition due to the decline in rates. Please read Adjustable Rate Mortgage Or 30-Year Fixed where I argue why locking in long term wastes you money. The best mortgage option would have been based on a 1-month LIBOR rate. The question is what now?
Even with the recent rise in interest rates, if you can find a new mortgage rate 50 bps lower than your current mortgage rate, with a duration that matches your risk tolerance, then I would still refinance. Over a 2-30 year period, mortgage rates are still dirt cheap. The big fear in the bond market is that the Fed stops feeding us their juice. They’ve got to slowly ease off their monetary stimulus probably over a course of five years if they don’t want to hammer stock market addicts.
WHAT I’M DOING TO POTENTIALLY MAKE MONEY
My primary mortgage was refinanced a year ago before I left my job thank goodness. Otherwise, I would never have been able to refinance due to a lack of W2 income. Refinance before quitting please! My vacation property received an out of the blue loan modification earlier this year so that’s set. The only thing I’m left with is my primary rental property which has an interest rate of 3.35% with four years left on a 5/1 ARM. I would ideally like to refinance this ARM to another ARM at closer to 2.75%, however, the mortgage amount is small and I plan to either sell the property within five years or just let it float after the lock is over. In four years, the principal will be reduced by another 13% or so if I add no extra payments, giving me some buffer in case rates rise.
The investor in me does not believe the Fed will allow the 10-year yield to continue ramping so soon. As a result, I am going LONG the 10-year bond (believe yields will fall from 2.15%) by buying the ETF, IEF (see chart). I don’t plan to make or lose more than 3% on IEF, as a result I’ve dumped a chunky 35% of my IRA into the name. IEF is my hedge against a collapse in equities and a place to park my cash which earns nothing. My year-end target for the 10-year yield is 2% or lower.
The irony is that the higher the 10-year yield goes, the more susceptible equities are to a pullback because bonds become more attractive relative to equities. The bullish way to look at a rise in interest rates is a rise in monetary demand due to an improving economy. Finally, for those interested in buying property, maybe, just maybe a rise in rates will slow down the torrid rise in property values (March prices were up 10% YoY). Then again, the herd is probably thinking “buy now or be priced out forever” again.
RECOMMENDATIONS TO BUILD WEALTH
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Updated for 2016 and beyond.