Long Term Mortgage Rates Dip Below Short Term Rates

Freddie Mac’s chief economist just announced that “Interest rates for one-year ARMs exceeded those for 30-year fixed-rate mortgages over the last two weeks; this is the first time this has happened since Freddie Mac began collecting data for ARMs in January 1984.”  This is a pretty monumental occurrence, but it seems to have been received with surprisingly little fanfare.

One would naturally expect long-term rates to be higher than short-term rates, since the inherent uncertainty of the future must be priced into loans. As a result, there is a trade-off between duration and the rate of interest that a borrower must come to terms with when taking out a mortgage. If you want a long-term mortgage, you should pay a higher rate of interest in order to compensate the lender for future uncertainty surrounding your personal financial situation as well as the macroeconomic situation. In other words, the lender (bank) will charge you a higher premium because it doesn’t know where interest rates will be 15 years from now and also doesn’t know whether your ability to make payments on your mortgage will change over time. The disappearance of this trade-off means that borrowers can effectively borrow for a relatively longer period of time without paying the associated higher rate of interest.

It’s not clear exactly what’s responsible for this development. The benchmark 15-year fixed mortgage rate has gradually declined since the inception of the credit crisis; at 4.48%, it is currently hovering around an all-time low. This is also surprising, given that one would have expected the jump in risk aversion to be accompanied by a surge in mortgage rates. After all, it was excessively low mortgage rates which caused the crisis. The credit for keeping rates low probably belongs to the Federal Reserve Bank, whose “current policy during the financial crisis is to keep mortgage rates low….The effort seems to be working. Bankrate’s benchmark 30-year, fixed rate has been under 5.5 percent since the beginning of February.”

As for short-term rates, they are also falling, just at a proportionately slower pace than long-term rates.

Since this is the first time that the mortgage yield curve has (partially) inverted, it’s not clear what the implications are. An inversion of the Treasury yield curve is often seen as a harbinger for economic recession. In this case, however, recession has already descended upon the economy. Maybe it means that the recession will continue to worsen. Maybe reflects the possibility of deflation. Or maybe it is simply a reflection of supply and demand for mortgages.

Regardless of what it means, it is certainly a welcome development for home-buyers.