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Since 2009, interest rates on adjustable-rate mortgages have dropped faster than for the benchmark product's fixed-rate counterpart. Going forward, that trend should reverse.
The Federal Reserve has set the 5-year ARM and the 30-year fixed on a near-term collision course.
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Traditionally, mortgage rates for an ARM product -- conventional, jumbo, FHA or otherwise -- are lower than the mortgage rates for a comparable fixed-rate mortgage. There's a good reason for this. It's because of how mortgage rates are made and how mortgage markets work.
Mortgage rates aren't "made from thin air". They don't come from the bank. They don't come from the Federal Reserve. Rather, mortgage rates are based on the price of mortgage-backed bonds, securities bought and sold on Wall Street.
Mortgage bonds are like any other bond -- they have some up-front cost; they make regular, periodic payments to investors over some numbers of years; then, upon maturation, they make a lump-sum payment back to the investor.
Mortgage bonds (and mortgage bond repayments) are denominated in U.S. dollars.
Because mortgage bonds are denominated in U.S. dollars, the long-term value of owning mortgage bonds can be closely tied to the long-term value of the dollar itself. If the U.S. dollar gains value over time relative to other currencies, the relative value of owning mortgage bonds increases. This is because mortgage bond repayments are, literally, worth more than originally projected at the time of purchase.
Conversely, if the dollar loses value, mortgage bonds lose value, too -- repayments are smaller than projected.
This is why inflation matters so much to mortgage rates.
Inflation is the devaluation of the U.S. dollar so when inflation is present in the economy, mortgage rates have reason to rise. When inflation is present in the economy, those bond repayments have less value over time and bond investors know it. They demand higher long-term returns because of inflation which, to homeowners from Huntington Beach, California all the way to Loudoun County, Virginia translates into higher mortgage rates.
This is one reason why 5-year ARMs and 30-year fixed rate mortgages don't rise and fall at the same speed. There is less inflation risk over a 5-year period than there is over 30 years. Investors can predict and plan for the next 5 years with more certainty than for the next 3 decades.
In late-January, the Federal Reserve issued an economic forecast for the next few quarters. In it, the Fed said that dual mandate of supporting price stability and maximum employment is best supported by an inflation rate of 2 percent.
This is the first time in the Federal Reserve's 99 years that the group set an explicit target for inflation.
Until now, the Fed had monitored all parts of the economy, allowing inflation to run high as needed, and low when needed. Tons of data backed them up, but Fed members managed U.S. inflation on "gut".
That's no longer the case. Beginning immediately, the Federal Reserve will implement new economic policy as needed, with the stated goal of keeping inflation at or near 2 percent.
For mortgage bond investors, this provides a tremendous amount of certainty. With the Federal Reserve steering inflation to a particular rate and keeping it there, the long-term inflationary risk of owning a bond is reduced to nearly nothing.
Inflation targeting reduces the risk factors that make 5-year ARMs so much cheaper than 30-year fixed rate mortgages. Going forward, we should expect the mortgage rate spread between the two products to narrow. The benefits of choosing a 5-year ARM over a 30-year fixed should lessen.
With the Fed's inflation target set to 2 percent, adjustable-rate mortgages are likely to rise in the coming weeks; current mortgage rates reflect inflation rates below the Fed's target. Even fixed rate loans may rise.
Mortgage rates remain ultra-low and home affordability is high. Stop waiting for rates to fall. They already have.
Dan Green (NMLS #227607) is an active loan officer with Waterstone Mortgage. Email Dan ator click to get a free, no-obligation rate quote.
You can also find Dan on Twitter and Google+.
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