Everybody with a ARM needs to refinance now. The Fed has been raising the Fed Funds rate since end of 2015, and doesn’t plan to stop until the economy shows signs of softening. With US GDP at over 4% in 2H2018, it is an absolute certainty more rate hikes are on the horizon.
Take a look at LendingTree for some of the most competitive mortgage rates online. All you’ve got to do is enter your information and banks will compete for your business until you get the best rate possible.
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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 12-month CD for 2.5% with CIT Bank. 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%.
Now, the best CD rate is by CIT Bank with their 12-month, 2.5% CD. This was unheard just several years ago, when you could only get 0.5%. But due to the Fed raising rates, the short end of the yield curve has really risen. After such a huge rise in the stock market and real estate market since 2010, it’s a GOOD idea to build up a greater cash hoard, especially since rates have risen.
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% 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?
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Shop around for a mortgage: Check the latest mortgage rates online through LendingTree. 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 from them or your existing bank. When banks compete, you win.
Updated for 2019 and beyond.