May 17, 2018

 Why Have Mortgage Interest Rates Been Creeping Up Over the Last Few Months?

Recent declines in unemployment to rock bottom levels and the accompanying increase in the inflation rate have induced the Federal Reserve to tighten credit in order to dampen further price increases. The process will continue until the emergence of the next recession, which is overdue.

What Interest Rates Predict the Direction Future Mortgage Interest Rates Will Take?

Before the development of secondary mortgage markets, there was an answer to this question. Changes in mortgage rates lagged changes in corporate bond yields by anywhere from 2 to 8 months.

Today, however, the mortgage market is so thoroughly integrated into the broader capital market that there are no leading indicators of mortgage rates. Mortgage rates and bond yields change together. 

A large proportion of all mortgages are placed in pools against which mortgage-backed securities (MBSs) are issued. MBSs trade actively in the market and are considered close substitutes for bonds. Any change in bond yields, therefore, is transmitted instantly to the MBS market. 

Mortgage loan originators, in turn, base their rates primarily on yields in the MBS market. Originators usually post their rates at about 11am EST, after they see the opening yields on MBSs that morning.

What Are the Legitimate and Illegitimate Reasons Why Jones Gets a Lower Mortgage Rate Than Smith?

The legitimate reasons are embedded in the rate sheets lenders produce daily for their loan officers. Assuming Jones and Smith deal with the same lender, these reasons include the following:

• Jones paid points – an upfront charge -- to reduce his rate where Smith did not.

• Jones had a significantly higher credit score.

• Jones’ loan is secured by his primary residence whereas Smith is borrowing to finance an investment property.

• Jones’ property is a single-family unit whereas Smith’s is a duplex.

• Smith is taking “cash-out” of a refinance, whereas Jones isn’t.

• Jones is willing to set up an escrow account with which the  lender will pay taxes and insurance whereas Smith is not.

• The rate on Jones’ loan was set on Monday whereas Smith didn’t lock his rate until Tuesday after market rates had risen.

• Smith needs a 60-day rate lock whereas Jones needs only 30 days.

If Jones and Smith deal with different lenders, they may be quoted different rates on the same deal just because one of the lenders is pricing more aggressively that day. I would not call that rate difference “illegitimate”, it is the way the system works. In today’s market, those rate differences are small.

Prior to the financial crisis, illegitimate rate differences arose out of the efforts of some loan officers to induce vulnerable  borrowers to pay a rate above the rate set by the lender in its price sheet. Revisions to Truth in Lending have since eliminated that practice. 

Since My Mortgage Interest Charges Are More Than Covered by the Return on My Common Stock, Is There a Good Reason For Me Sell the Stock to Pay Off the Mortgage?

Over long periods, you will probably earn considerably more on a diversified portfolio of common stock than you will pay on a mortgage, which is the argument for retaining your stocks. There is a risk, however, that you could earn less.

To add some precision to this generalization, I recently used the Ibbotson data base of stock returns published by Morningstar to calculate rates of return over every 10, 15, 20 and 25-year period during the 87 years ending in 2012. The average return during the 924 10-year periods was 10.52%, with a high of 21.43% and a low of minus 4.95%. The rate of return was negative during 52 of the 10-year periods.

In contrast, over the 744 25-year periods, the average return was 11.34%, with a high of 17.26% and a low of 5.62%. The return was positive in every single 25-year period.