By Michael McKeown, CFA, CPA - Chief Investment Officer
Interest rates are nearing the lowest level in three years. While we discussed what this means for future returns on the asset side of the balance sheet, it is an advantage on the debt side.
In many ways, mortgages are the tail that wags the interest rate dog. If interest rates rise too fast, it can hurt the housing market, which the Fed certainly does not want to see. When interest rates fall though, it allows homeowners to refinance mortgages to lower interest rates, assuming enough home equity is there. It also creates a hedging vortex for real-money mortgaged-backed security investors, which can plunge rates even lower.
The trend in mortgage rates over the last 15 years was down, though not without many zigs and zags. Today, rates are at the lowest point since early 2013.
15-year term mortgages always offer lower interest rates than a longer 30-year mortgage. 15 years ago, this difference was relatively small; only about 0.4%. For the debtor, this was a fairly nominal difference. Today, the difference is approximately 0.75%, which is also a low spread. But when rates go from 3% to 4%, instead of from 7% to 7.5%, it is important to not only look at not the raw numbers, but also the ratio between 15 and 30-year mortgage rates. Doing so, one can see a high percentage increase in interest expense. In addition, we can look at that previous ratio with respect to the 10-year treasury. As seen below, today’s 30-year mortgage rate is about 23% higher than the 15-year.
Refinancing after interest rates fall gives homeowners the chance to pay down mortgages faster, lower interest rates, and lock in a great return on investment (when considering the extra payment as the ‘investment’ and the reduction of interest the ‘return’).
Let’s look at an example of a $250,000 mortgage in year one of the term. Comparing mortgage rates in 2001 to 2016 lets us see how much more valuable a refinancing can be when interest rates are low.
The annual payments increases by $6,153 but the interest paid drops by $1,233, which goes towards principal. This results in a 20% return on investment (ROI), which was four times the risk-free rate of return for the 10-year Treasury.
Let’s look at an example using the average conventional mortgage rates today.
With the 30-year at 3.93%, it makes sense to move to a 15-year at 3.20%, though the tradeoff being that the payment goes up nearly 50%. Still, the interest saved of $1,937 results in a 28% ROI. Since the 10-year Treasury risk free rate is so low today compared to that ROI, it is that much more valuable to refinance. One can make 17 times the risk free rate in the above scenario in the first year. This only increases in subsequent years as the mortgage principal declines at a quicker pace.
The average rate for all outstanding mortgages today in the United States is 4%. In a hypothetical scenario where 15-year mortgage rates fall to 2.5%, the mortgagee could refinance from the original 30-year term to 15-years. That is, if the mortgagee is willing to pay a 34% higher mortgage payment per month. This may sound like a lot, but it is almost matched dollar for dollar by greater principal pay down. The return on this investment is a whopping 80% per year over the first five years! Moreover, assuming the payments are always made, it is a guaranteed return – well worth it in any interest rate environment.
In light of the negative interest rates from Japan to Europe hitting record lows, we will be watching in the months ahead to see if the downtrend in U.S. interest rates continues to create another wave of refinancing activity. Mortgagees should be ready to pounce (and go through the painful refinancing process of pulling documents), but just think about that return on investment and it is well worth it.
This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.