Updated in January 2019
Always pay attention to the US government long bond yield e.g. the 10-year US Treasury yield. Rates reached a low of around 1.37% in 2016 and will likely stay low for the rest of the decade due to so much international turmoil and demand for US-denominated assets like bonds, real estate, and stocks.
That said, the Federal Reserve has finally begun to raise the Fed Funds rate, which in turn has led to the 10-year bond yield to finally move up in 2018. But after the stock market turmoil in 4Q2018, mortgage rates moved back down as investors found safety in treasury bonds.
As you can see from the chart below, rates have been coming down for years. Although we breached 3% on the 10-year bond yield briefly, the long term trend is down due to better coordinated economic policy, a better understanding of economic cycles, and productivity gains that keep inflation muted.
From this simple chart, you will understand:
* The risk free rate of return
* Expectations on interest rates
* Expectations on inflation
* Borrowing/credit costs
* Risk aversion, or lack thereof
* The health of the world
That’s right. By understanding what the latest 10-year treasury means, you will be able to save a lot of money, make a lot of money, and stop being an bozo who just follows the heard and listens to whatever people tell you to do. Think for yourself!
I’m dismayed how people are paying more in mortgage interest than they have to. A large part of it is because the media and mortgage officers continue to push people to get as long a fixed rate mortgage as possible. In America, the longest conforming standard is 30 years.
Borrowing on the long end is a suboptimal use of funds. The people who are pushing you into 30-year fixed loans: 1) Are not economics majors or bond traders, but journalists, and/or 2) Have a vested interest in you borrowing as long as possible so they can make as much money off you as possible. The higher the rate, the easier it is for them to earn a wider spread.
Why A 30-Year Fixed Mortgage Is A Waste
* Upward sloping yield curve. It’s important to understand that due to the time value of money and inflation, the longer you borrow the higher your interest rate. If you borrow money from me today to pay me back tomorrow, I won’t charge you interest. But, if you want to borrow money from me today, to pay back over the next 30 years, you better hell believe I’m going to charge you an interest rate above inflation to counteract inflation, make some money, and bake in some risk of default. In other words, if you borrow at a 30-year fixed rate, you are borrowing at the most expensive part of the yield curve.
* Average length of stay. First of all, the average duration one lives in and owns a home is about 8.7 years. If that’s the case, what on earth are you doing borrowing a 30-year fixed rate mortgage for? A 23 year + overestimation of ownership is a serious miscalculation based on the statistics at hand. With a 5/1 ARM, your underestimation is only 3 years, but you already have baked that in.
* Match fixed rate with length of stay. If you plan to live in your house for 10 years, take out a 10 year fixed rate (amortizing over 30 years) as the most conservative loan duration. A 10 year fixed rate is cheaper than a 20 year or 30 year fixed rate. It is only logical that you match your mortgage fixed rate with your expected duration of stay. Sure, you might stay longer, but you might also stay shorter as well. If you know you plan to stay in your house forever, it’s more justifiable to take out a 30-year fixed, but I still wouldn’t because 1) You will likely pay down your loan faster than 30 years, and 2) The spreads are unjustly high in this environment.
* Adjustable rate loans have an interest rate cap. People think, thanks to fear mongering by the media and mortgage officers, that once the adjustable rate loan period is over, your mortgage rate will skyrocket and make things super unaffordable. This is not the case because everything is relative and rates are capped. I got a 5/1 ARM in 2014, and in 2019, the maximum it can reset to is 4.5%. Whoopdee doo! After 5 years, if I don’t pay any extra principal, my principal mortgage amount is about 10% less. A 4.5% mortgage rate on a 10% lower principal amount is very digestible.
* If rates rocket higher, you will be celebrating. Things don’t happen in a vacuum. The 10-year yield is a reflection of inflation expectations. If the 10-year yield, and therefore mortgage rates are skyrocketing, that means inflation expectations are at the very least skyrocketing. However, you don’t have inflation expectations going higher unless demand for real goods and services going higher. Higher demand is a reflection of a stronger economy, and your real assets (property), by very definition or inflating! So what if inflation rises from 2% to 5%, causing your mortgage to reset to 7% due to the 2% spread? If your home is now inflating by 5%, and you have a 80% loan-to-value ratio, your cash on cash return is going up by 25%!
* 35+ years in a row of deflation. Look at the historical 10-year treasury yield. Rates have gone down for 35 years in a row. That’s right folks. Are you telling me there’s no trend here? Are you saying that we are going to see massive inflation spikes on the way (which are fine as I just wrote) all of a sudden? In these 30 years, we’ve become a much more efficient society who enacts monetary and fiscal policy in anticipation or with shorter lead times. Yes, there will be occasional upward blips in pricing, but I highly doubt there will be a 5-10 year continuous ramp in inflation, which means your 5-10 year ARM is just fine.
What Is Your Peace Of Mind Worth?
Insurance salesmen and mortgage officers are very skilled at evoking fear. They will paint worst case scenarios of super inflation and crushing payments so you can pay more money now than you should. Have a 30-year fixed provides a great peace of mind that your payments will never go up. In fact, your real payments will actually go down over time given you will be paying back a fixed loan with ever depreciating dollars thanks to deflation. The question is, at what price is this worth?
Given you know the yield curve is upward sloping, you must study the spreads between each borrowing point. Let’s say a 30-year fixed loan is currently around 4% vs. 2.625% for a 5/1 arm. Let’s say you borrow $1 million, the ideal mortgage amount. $1 million X 1.375% = $13,750 more in interest expense you will have to pay every year for the length of ownership.
If you own the home for 7 years, that’s $96,250 more in interest expense you would have paid if you borrowed at 30 years. If interest rates stayed the same (not down as it has for the past 30 years), then you would have paid over $420,000 more in interest during the lifetime of the 30 year fixed loan! That is just ridiculous. However, if your peace of mind is worth $96,250 or $420,000, and you can’t handle the reality of economics, don’t know your options, and don’t believe in yourself, then why not.
The next time someone is hawking you a 30-year fixed ask them: 1) What their major was in college or grad school, 2) How many times have they refinanced before, 3) Quiz them on what the current 10-year treasury yield is, 4) Where was the 10-year treasury yield 10, 20, and 30 years ago, 5) If they are a homeowner, 6) How much more are they going to make off you.
Addendum: Please not there is a BIG difference between a negative amortization loan and a adjustable rate mortgage like the ones I’m referring to here. A Neg Am loan causes your principal to grow larger every month because it is by definition, negatively amortizing. The Neg Am loan generally is only fixed for one year and a teaser low rate. Hence, you have a lower than market rate + a payment that’s based on a lower amount that gets added to the principal. This is where people get in trouble. People who have normal ARMs have not been getting in trouble because when their ARM floats, their rates are LOWER than when they first locked! Please understand this point.
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Shop around for a mortgage: LendingTree allows you to compare offers from multiple banks from their huge network of lenders to find the best offer for you. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible. This is exactly what I did to lock in a 2.5% 5/1 ARM for my latest refinance. For those looking to purchase property, the same thing is in order. If you’ve found a good deal, can afford the payments, and plan to own the property for 10+ years, I’d get neutral inflation and take advantage of the low rates.
Updated for 2019 and beyond.