- The Washington Times - Thursday, May 5, 2005

Q: I have read somewhere that we will soon have an inverted yield curve. Can you

explain that?

A: Interest, by definition, is the cost of renting money.

If I want to borrow some money for only one month, a lender will charge me a certain interest rate — perhaps 4 percent. If I want to borrow money for 30 years, to buy a house for example, the lender will charge me a higher interest rate, maybe 6 percent.

The logic is easy if you put yourself in the lender’s shoes. Lending money over the short term carries less interest-rate risk than lending money over the long term. Interest rates move up and down over time, so a lender who commits his money over the long term to yield a certain rate, such as 6 percent, is taking a risk.

Why? Because if interest rates rise, he loses out on the opportunity of receiving a better return because his money is already out on loan.

If 30-year fixed-rate loans jump to 7 percent in 2006, the lender is effectively losing one percentage point on his return because he already lent out the money at 6 percent.

This is why fixed-rate mortgages carry a higher rate — there’s no risk to the borrower of the rate going up, but there is risk to the lender because he would lose the opportunity of reaping a higher yield.

Short-term loans are those where the rate can adjust with market movements. This is why you see that adjustable-rate mortgages carry a lower initial interest rate than do fixed-rate loans.

Interest-rate risk is placed on the borrower instead of the lender. It makes sense that loans with short-term fixed rates will have lower rates than loans that guarantee a certain rate for 30 years.

Now let’s go to the concept of an inverted yield curve. This means that rates on short-term loans are higher than rates on long-term loans. It doesn’t happen very often, but it’s possible. Here’s why.

Short-term rates, in general, are governed by the Federal Reserve Board. The board can pretty much set short-term rates where it wants. Lately, the Fed and its chairman, Alan Greenspan, have been raising short-term rates.

Long-term rates are market-driven, which means they can blow whichever way the market wind takes them. Lately and unpredictably, long-term rates have remained fairly low.

If short-term rates rise while long-term rates remain the same, eventually short-term rates could overtake long-term rates, and we’d have what’s known as an inverted yield curve.

It certainly hasn’t happened yet, but it’s possible. Mr. Greenspan raises short-term rates to stave off inflation, but if the market sees no inflation on the horizon, it will keep buying long-term investments, which, in turn, will keep long-term interest rates down.

Basically, if the market continues to disagree with the Fed, we will continue to see short-term rates rising and long-term rates remaining stable. From a mortgage standpoint, it means that short-term adjustable-rate mortgages become less attractive and longer-term fixed-rate mortgages become more attractive.

Most economists had predicted that 30-year fixed-rate mortgage rates would be far higher than they are today, and most continue to predict higher rates in the upcoming months.

So far, they’ve been wrong. Yet the Fed keeps nudging up short-term rates.

We don’t have an inverted yield curve, but it is certainly flattening.

The bottom line for mortgage seekers? Maybe take out a five-, seven- or 10-year fixed product. These are the ones that seem the best bargains these days.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (henrysavage@

pmcmortgage.com).

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