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What Do Rising Rates Mean?

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Posted On: 12/23/2015

QUESTION:

What will happen with mortgage rates now that the Federal Reserve has raised interest rates for banks?

ANSWER:

It’s surely not much of a raise, just 0.25 percent, but it’s important for mortgage borrowers.

To understand why let’s look at what the Fed actually did. It raised an interest rate – the Federal Funds Rate – which is important to banks and credit unions that borrow money overnight – and as a result it is possible that mortgage rates also may go up.

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But maybe not. The reason that we may not see much of a mortgage-rate increase, or maybe no increase once the markets calm down, is that the Fed’s action was not a secret. Lenders have thought for months that the Fed would act, and the result is that they built the risk of an increase into the rates they have been charging.

To lenders a mortgage is an asset to be sold in the secondary market or held in portfolio. With fixed-rate loans a rate hike is a problem because it reduces the potential sale value of the mortgage. For instance, let’s imagine that an investor will pay $1,000 for a $1,000 loan with a 4-percent interest rate. Let’s say interest rates go up and investors can now get 4.25 percent for their $1,000. They will not buy the 4 percent loan for $1,000; instead they will pay something less, a discounted value. The sale value of that 4 percent fixed-rate loan will fall, and that new and current value can impact lenders’ books.

It is the fear of rising rates that causes lenders to offer adjustable-rate mortgages with attractive terms, maybe an enticing lower interest rate or easier qualifying standards than a borrower can find with fixed-rate financing. If a lender owns an ARM and rates rise, that’s fine because the borrower’s interest is not set for 30 years; it can increase with the market once the start rate ends.

As this is written, in mid-December, the Mortgage Bankers Association says that fixed-rate conforming mortgages – loans that can be sold to Fannie Mae and Freddie Mac – are priced at 4.14 percent, while 5/1 ARMs have a 3.25 percent start rate, a rate good for five years.

If you borrow $150,000 at 4.14 percent the monthly fixed-rate payment will be $728.28 for principal and interest over 30 years. A 5/1 ARM at 3.25 percent has an initial $652.81 monthly cost for principal and interest. The ARM start rate lasts five years, so a borrower will save $75.47 per month, $905.64 a year, and $4,528 over five years. What happens after five years is unknown; the ARM rate can rise or fall.

Is it worth $4,500 to face the risk of higher rates in five years? Choosing between fixed-rate and adjustable financing is a decision only borrowers can make.

The last time the Federal Funds Rate changed was December 2008. The mortgage market we have had since then now is changing. One result is that we are likely to see lenders with real differences between them as they respond to rate changes. For this reason it’s important to shop for rates because even a small savings – say a quarter of a percent – can make a big difference in terms of your ability to borrow, in addition to your monthly expenses.

Peter G. Miller is the author of The Common-Sense Mortgage and a veteran real estate columnist. Have a question? Please write to peter@ctwfeatures.com.

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