Election Results Influences Rates
Long-term U.S. mortgage rates continued to surge in the aftermath of the election of Donald Trump. Since the election, the value of mortgage bonds has dropped significantly, causing mortgage rates to climb roughly half a percentage point to a 16-month high.
The turnaround, that was in part driven by post-election market expectations that a President Trump would lift corporate profits, cut taxes and spend money on infrastructure and roads, caught most experts by surprise.
However, there are other factors that have impacted mortgage rates. Before we dive into them, let’s first take a look at how mortgage bonds work…
How Do Mortgage Bonds Work?
Understanding how mortgage bonds work and why rates move higher and lower is best explained by an example. Let’s take a $100,000 loan that seems like a “perfect mortgage.” It has a 10% LTV (loan-to-value) with no second mortgages allowed, an 800 FICO (credit score), and a 5% back ratio. For this example we’ll say this loan has a 4% rate, which at simple interest nets a yield of $4,000 per year.*
It looks like a really safe loan. This is where misconceptions about how mortgage bonds work comes into play. Most folks (even those in the mortgage industry) would say this is a great loan..that it’s risk free. In actuality the risk isn’t in repayment, the risk is in the market.
To illustrate this point, say you wrote this loan with your own money. What would happen if a year from now if rates went to 8%? Is this asset still worth $100,000?
The answer? NO.
If this $100,000 were in cash, you’d be free to be able to do whatever you like with it. However, it’s not in cash – it’s tied up for 30 years – tethered to a return that’s fixed at 4%. So if the open market rates rose to 8%, your rate at 4% would be far less.
If rates change, how then do you determine your investments value? You compare it – asking the question “How much would need to be invested in an 8% market to yield the same $4,000 a year return that you’re getting in the initial 4% year example?” The answer is $50,000 (column 2). An 8% rate at simple interest on $50,000 equals the same $4,000 per year yield. While this example isn’t exact numbers, the key point is as interest rates rise, the value of a loan decreases.
Let’s take this example in the opposite direction. What would happen in that same scenario if interest rates went to 2% (column 3)? This signifies a climbing market. In this example, the asset appreciates. We determine the level of appreciation by asking the same question…how much needs to be invested at 2% to yield the same $4,000 per year return? The answer? $200,000.
Return To Zero From Negative Interest Rates
“Zero” use to be as low as we thought interest rates would go, because who in their right mind would give money and then pay people for taking it? However, according to the central bankers in Europe and Asia, about $11 trillion dollars worth of their loans have negative interest rates.
Why buy a loan with a negative yield? It’s not because of the yield, but because of the potential capital appreciation. In our initial example when the 4% rates drop to 2%, you can make a lot of money. So, lets say you invested when rates were at -1%, even though you’re paying 1% per year for that investment, if rates went to -2% or -3% you could make a tremendous amount of money seeing rates drop lower into the negative. Once the floor of zero was broken, people thought the bond market was infinite and they continued to buy at a negative rate.
Recently however, the central banks of Europe and Japan realized it was not generating the economic activity they thought it would. It was hurting their banking system by crushing margins and hurting the stock market so they brought it back to a common sense floor of zero. With this change, investors are not buying as much in mortgage bonds as we had seen, and this has caused rates to rise.
Rising Global Yields
Another reason we’ve seen interest rates go up is the global rise in yields. Thanks to Brexit, the pound in the UK has dropped in value, equating to cheaper exports and more costly imports. When the currency drops, it’s good for your exports because they appear cheaper to someone, but your imports get more expensive. If you import a lot like Great Britain does, then these more expensive imports bring in inflation.
What does Great Britain’s inflation have to do with the US? When the UK experiences inflation, their bond yields have to rise. And as their bond yields, they rise in Europe, they rise in Japan and they’ve been rising here in the US.
Inflation’s Effect on Mortgage Bonds
Inflation causes the yield from mortgage bonds to rise because it erodes the buying power of that bonds fixed payment over time.
For example, in the US a $100,000 investment at 4% is $4,000 a year in simple interest or $333 per month. Let’s say you spend that $333 on a basket of goods and services every month, like your cell phone bill, household items, some recreational stuff, some medical costs. Overtime, because of inflation, you can’t buy as much stuff – it starts to erode your buying power. How much? Let’s take a look.
With just 2% inflation (first column in the chart below), which is the Federal Reserves annual target, in 1 year that $333 still feels like $333 a month. However 5 years later, it would only buy you what $301 would buy you today. 10 years later, it would buy you what $272 would buy you today and 20 years later that $333 a month will feel like $222.
Even a light inflation of 2% creates significant erosion of value. What if instead of 2%, it was 4% inflation (2nd column)? In this instance you can see the erosion happening more dramatically. So as inflation rises, the erosion happens more rapidly.
When we have inflation – or even if it’s just perceived to be coming – interest rates rise. This is because interest rates are compensating for this erosion. In other words, even if you can’t do anything about inflation, the next time you lend money, if inflation is higher, you’ll want to make sure you preserve some of that buying power.
So how do you do it? You start off at a higher rate (Column 3 show a rate of 4.92% with expected 4% inflation) that returns a bigger yield so over time it will average to about the same number. In year 1 that rate yields $410 a month, and in year 11 will yield $273 providing the same buying power it did with only 2% inflation (highlighted area). This is why when inflation moves higher, interstate rates move higher.
The Impact on Home Purchases
While rates appear to be headed modestly higher in 2017 because of some of these global factors and inflation, they shouldn’t adversely affect the strong real estate market that we currently have. However, this should create a sense of urgency and opportunity folks to make purchases before yields rise further.
Why? Because just a 1/2% increase in rate to a $350,000 loan will add over $100 to the monthly mortgage payment.