Mortgage Choices: Mid-2009

As our long-tenured clients know, we have advised for many years that over a full interest rate cycle, we expect they will benefit by avoiding long-term fixed rate mortgage products in favor of short-term fixed or, better still, fully adjustable mortgage products.

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The fundamental premise at work is that lenders charge too great a premium for assuming interest rate risk. With fully adjustable mortgages, the risks are having payments that tend to vary monthly, and are sometimes higher than the fixed rate alternative would have been. With short-term fixed loans, the chief risk is that the fixed rate period may expire during an unfavorable interest rate climate. Those clients who are willing to bear that risk themselves avoid paying that premium. We expect that they will enjoy a positive net present value, given the alternative uses available for their funds.

With short term rates at historic lows, clients with fully adjustable rate mortgages have enjoyed an almost guilty pleasure opening the monthly mortgage bill lately. In a number of instances, we’ve seen the monthly payment due on a $1 million mortgage fall below $1,000 (implying an annualized rate of less than 1.2%)!

However, in the current climate, with talk from some quarters of the potential for higher future inflation, many clients are asking about the wisdom of locking in a fixed rate, now, before rates generally increase. Other clients are in need of new loans for home purchases. This article discusses strategy for selecting a mortgage product in these uncertain times. First we’ll look at refinancing an existing mortgage; then introduce a new tool – interest rate swaps; and then discuss loans for new purchases.

But first a few comments about the mortgage environment.

As a result, for homes financed in the past couple of years, it can be more difficult to qualify for a new loan of the same size as under the old standards. Some lenders have revamped their underwriting criteria to require greater income-to-payment ratios. This can be troublesome for retirees or entrepreneurs whose businesses are struggling in the current recession.

Refinancing An Existing Loan

If you already have an adjustable rate mortgage, or a mortgage with an initial fixed rate period about to expire, causing the rate to begin floating, this is a good time to consider your refinancing alternatives. Although fixed rates are currently low by historical standards, the rate you’d get on new fixed rate loan would very likely be higher than what you’re rolling off of, resulting in an increase in your monthly payments. You might be willing to accept this higher expense if you think interest rates will increase materially in the near future (we don’t) and remain elevated for some time, and if you expect to retain the loan for many years. On the other hand, if you either expect to retire the loan within the next couple of years (before any sustained increase in interest rates), or are confident that rates won’t materially increase over the life of the loan, you should consider an adjustable rate mortgage product...which brings us back to our general recommendation.

Most adjustable rate loan products have interest rate ceilings (some lenders have introduced interest floors, a feature that was not common in the past). We’ve seen these ceilings set at 10-12% on new loans, so they would apply only in the face of drastic interest rate increases.

Interest Rate Swaps. Interest rate swaps are derivative contracts that have been around the financial world for a long time, though not available at a scale useful to residential mortgage holders. Until now!

With a swap, a borrower can, in essence, convert the variable rate on his or her loan to a fixed rate for a set number of years (the underlying variable rate loan remains in place and is unaltered by the swap). For example, a client whose mortgage rate was recently 1.16% (1 month LIBOR plus 0.85%) was offered the choice of fixed rates, using a swap contract, at 3.80% (for 5 years), 4.28% (for 7 years), or 4.64% (for 10 years). Incidentally, a swap can be used with any loan with a variable rate - a mortgage, a home equity loan, business loan, etc.

This client’s loan was made several years ago when banks were offering loans with skinny margins to win business. Those days, of course, have passed, and new loans have much more substantial margins. As a result, the swap rates quoted above were 1.45 - 1.85% lower than those available in a contemporary bank refinancing.

But while this attractively priced variable rate loan can be converted into a relatively attractive fixed rate loan, is the swap attractive in absolute terms? Considering the 5 year swap (fixed rate of 3.80%), unless the client expects the one month LIBOR rate to average more than 2.95% over the next five years (up from 0.31% now), the client would prefer the current variable rate loan over the swap rate. As discussed in the nearby inflation article, we think that very short term rates on low risk credits (inter-bank loans in this case) are not likely to reach those levels.

If you are interested in exploring what swap rate would apply to your adjustable rate loan, contact your client service team. To arrange for you to receive a quote, we’ll need the following information on your current loan:

  • the index

  • the margin (spread above the index)

  • the ceiling and floor levels; and

  • whether it is amortizing or interest-only.

We can request quotes for several contract durations (e.g., 5 years, 10 years). There are some structural and tax complications which we can review with you; but you may still find the opportunity worthwhile relative to a straight-forward refinancing

Loans for New Purchases

From their current low levels, it seems likely that interest rates will increase, somewhat, in the years to come, though it’s extremely difficult to be a great deal more specific as to pacing. With that in mind, though, locking in today’s low rates is likely to be a sound, cautious strategy if the holding period is sufficiently long.

On the other hand, if the likelihood is high that you’ll sell the property or at least retire the note within the next couple of years, the expected net present value advantage of an adjustable rate or a fixed for a term, interest-only loan could be attractive. We believe 30-year jumbo mortgage rates are somewhat higher than they should be due to reduced trading liquidity in the secondary market and the flight to quality that has driven Treasury prices up (and their rates down). As these technical factors resolve, we believe jumbo rates won’t rise as much as interest rates generally, and might even decline>

Your client service team is eager to help you evaluate your refinancing alternatives in the context of your overall financial circumstances. Please contact us if this topic of interest to you.

Mike Fitzhugh

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