I want to follow up on the current trend of rising mortgage rates. Predicting interest rates is difficult and can be dangerous.
Last week, a reader posed the question: Where are interest rates headed?
Well, it’s not a completely unanswerable question. It is probably safe to suggest that short-term rates, such as those tied to home-equity loans, credit cards and adjustable mortgages, will continue to head north.
How am I able to make such a bold prediction? Easy. The Federal Reserve Board and its chairman, Alan Greenspan, have direct control over two key short-term rates: The federal funds rate, which is the rate banks charge each other for short-term loans, and the discount rate, which is the rate the Fed charges when it lends money directly to banks.
When the Fed moves these rates, other short-term rates will follow. And the Fed has made no secret of its intention to continue to raise these rates at a “measured” pace.
So there you have it. Adjustable-rate-mortgage holders, beware: Expect your rate to continue to rise for a while.
Does this mean they should panic? Does this mean folks who decided on the safe road by taking out a fixed-rate mortgage should gloat? Not necessarily.
Let’s look at some data: Fixed-rate mortgages were hovering around 8.50 percent in mid-2000, after Mr. Greenspan’s rate-hike rampage that took the prime rate from 7.75 percent to 9.50 percent in 12 months.
Various adjustable rates weren’t a whole lot lower because the Fed had pushed short-term rates so high.
A year later, Mr. Greenspan realized he may have been a bit overzealous in raising rates. He began to ease credit by lowering the Fed funds and discount rates.
As expected, all other short-term rates followed the path. In 2001, the prime rate dropped from 9.50 percent in January to 5 percent by December. Monthly adjustable mortgages fell to well below 6 percent. Meanwhile, fixed-rate mortgages dropped only to about 7.25 percent.
By the end of 2002, lenders were offering monthly adjustables with rates as low as 3.375 percent and fixed-rates at around 6.25 percent.
Can you see what had happened? Interest rates across the board have dropped since 2000, but short-term rates have dropped more dramatically.
This is what is known as a “steepening of the yield curve,” meaning that the spread between short-term and long-term rates grows wider.
Let’s fast-forward to the present. The Fed has already made several rate increases and is likely to continue to do so. Monthly adjustable-mortgage rates are now hovering at about 4 percent.
A 30-year fixed-rate loan with no points can be found at about 5.75 percent. The yield curve is beginning to flatten out.
The bottom line is that despite the fact that fixed-rate loans recently hit 40-year lows and are only about a percentage point higher today, ARMs have been a good deal for anyone who has chosen to take one.
Choosing the right mortgage always boils down to having a firm understanding of the borrower’s particular situation.
Risk-averse folks who are buying for the long term should, indeed, take out fixed-rate loans. But there are many who plan on selling in far fewer than 30 years.
There are also those who like the financial benefits of a lower-rate ARM. True, the rate on an ARM can increase, perhaps to a level significantly higher than what may have been available as a fixed rate, but until that time comes, ARM holders will be paying a lower interest cost.
For those who hold an adjustable-rate mortgage: You can expect your rate to climb a bit further as long as Mr. Greenspan continues to nudge rates up. Fixed-rate mortgages are more influenced by economic and market forces, making these rates much more difficult to predict.
Here’s my guess: The Fed will bump short-term rates a few more times. After that, there will be a period of stagnation, and then short-term rates will start to fall again.
Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (henrysavage@pmc@mortgage.com).
Sign up for Daily Newsletters
