- The Washington Times - Thursday, December 9, 2004

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).

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