Mortgage Renewals
Posted by John Draper | Filed under Credit Wise, Economics 101, Home Buying
With interest rates on the rise, a lot of people are asking me if they should go long, choose a variable rate mortgage or wait out the U.S. presidential election before locking up their mortgage rates.
If you want to know how to make this decision for yourself, you’re going to have to wrap your head around an economic concept called the “yield curve.”
The yield curve is a graphic representation of the interest rates being paid on government bonds of differing maturities. If the one-year bond is at 5%, the two-year at 6%, the three-year at 7%, and so on, you can see that the longer the term, the higher the interest rate. The yield curve is curving upward from left to right. This is referred to as a Normal Yield Curve because this is the way the curve usually looks. A normal yield curve represents investors desire to charge more for the use of their money over the long term because longer term investments are inherently more risky. To encourage investors to plunk down their money for a longer period of time, a higher interest rate is offered as compensation for the extra risk being taken.
Sometimes yield curves are Inverted: the longer term carries a lower interest rate. And sometimes the curve isn’t a curve at all; it’s flat, but it’s still called a Flat Yield Curve. That’s when there is virtually no difference between the interest rates right now and those five years from now.
So what can the yield curve tell you about mortgages? Well, if the curve is normal, then the longer-term rates are predicted to be higher than the shorter-term rates. In other words, right now Them That Knows say that interest rates are going to go up. All you have to do is look at the difference between the one-year and five-year mortgage rates to see where interest rates seem to be going.
If they are, in fact, predicted to go up (I say “predicted” because anything can happen), then the question you have to ask yourself in making the decision of what term to choose is how much the increase in interest rates will affect your ability to make your mortgage payment.
Find a mortgage calculator on the net. Put in the mortgage amount and the new higher rate. If you have 10 years to go on your existing mortgage, put that 10 under the amortization period. (Do not used a longer amortization period because you want to see a lower payment. That’s delusional.) Look at what the monthly payment amount will be.
Let’s take the example of a $350,000 mortgage amortized over 12 years.
At your existing rate of 4%, your monthly mortgage payment would be $3,058. But if the one-year rate has jumped to 6% your monthly payment is $3402, biting another $344 a month from your cash flow. If the five-year rate is 7.5 %, your new monthly mortgage payment will be $3672, a jump of $622 a month.
While my numbers are examples taken from a net calculator and will differ from what you get from your lender, they are enough to paint the picture.
Here’s the tough part. Now you have to decide if you are going to take the “risk” of a one-year renewal where rates are less, but there is no security, so rates may go up even further, in order to keep your increase to only $344 OR are you going to bite the bullet and take the five-year term, coughing up another $622 a month so you know where you stand for the next five years.
I can’t make that decision. If you’re mature enough to have bought a house, you’re mature enough to decide your own term. I will say, however, that there are more than a few people who say if you consistently take a three-year term, you can iron out the bumps a little more easily. And while Adjustable Rate Mortgages (ARMs) have been the hot ticket to lower costs historically, lenders are eliminating the “premium” (the interest rate discount on ARMs) so that right now they are a lot less attractive.
Do the math, take your stress levels into account, and then decide what you’re going to do. Make sure you negotiate hard for the best rate going. Just because the mortgage rate is posted at 7.5% doesn’t mean that’s what YOU have to pay. Lenders routinely discount their posted rate for customers who have shown they are trust-worthy. If you’ve been a good borrower, now’s the time to use it to your advantage.
FYI: The Yield Curve is also said to be able to predict a recession since for the past 50-odd years an inversion in the yield curve has proceeded every recession on record. An inverted yield curve means that Them That Knows think that rates are going to come down from where they are today. Why does that smell like a recession? Usually it’s because Them That Knows believe the central bankers are trying to fight inflation, so they’re tightening up the money supply to discouraging people from borrowing. When the curve inverted in 2007, that might have been The Signal We Ignored that the economy was about to hiccup and then choke.
Bookmark: del.icio.us Digg StumbleUpon
October 2, 2008 at 8:34 am
Thanks for writing this post today Gail! This gives me a much better understanding of what I needed to know. My mortgage comes up for renewal next May, I’ve been debating back and forth between breaking my current mortgage @4.4 % ( $62,900 was my starting point and will have my mortgage down to about 53,000 in May) and refinancing in order to have some work done to my home or waiting and having a reduced debt load next May. To me it makes more sense to take my chances and wait, but I’m looking @ having my mortgage lock in for 15yrs so I don’t have to worry about sky rocketing rates! My biggest debt besides my mortgage is my student loan, which stands @ 10,332.43. I pay 250/biweekly on my SL and can actually see it drop by at least 200 biweekly. Thanks for all your common sense advice.
October 2, 2008 at 12:17 pm
If you are having a tough time trying to pick a term, another option may be “split” your mortgage into to different terms. Some instituions allow you to lock in a portion of your mortgage for 3 years (at the 3 year rate) and another portion for 5 years (at the 5 year rate). There are lots of terms and options available you just have to ask and that way to can have the best of both worlds. Just another feature to keep in mind when renewal time comes around.
October 2, 2008 at 5:21 pm
Well now you come out with this information…I just renewed my mortgage on my house last week and I locked in to a 1 yr mortgage term for 4.65 % which was 1% lower than my last 1 yr mortgage. I was offered 5.25 % for 5 years, but I’m one of those people who is very leery of locking in long term. I have been doing a lot of reading on personal finances lately (been to the library instead of purchasing) and one writer’s comment really struck a chord with me. He said that it’s best to borrow short term and invest long term. He then went on to explain what he meant by that and it really made a lot of sense. I’ve owned three homes in the last 14 years and since my first 5 year mortgage term ended (9.4%) I’ve only ever gone 1 year at a time. I am really nervous about what is happening in the US and what might happen here, but I’m prepared to ride it out for now.
The only bit of information that concerned me was when the mortgage specialist advised me that my biweekly payments weren’t accelerated, I remember specifically asking for that when I purchased the house two years ago and was shocked to learn that I wasn’t doing that. With my new lower rate I end up paying $539 bi-weekly up from $536 from before, but I’m happy in the fact that more will be paid against the principal than before.
October 3, 2008 at 8:14 pm
Gail..I LOVE your blog. I love your show. This was a great post…and I’m a big weinie…I’ve got a 10 year term on my mortgage. BIG fan of financial certainty here…
October 9, 2008 at 9:03 am
Interest rates were just cut…