When is it a good idea to lock into mortgage rates?
Let’s first look at some underlying dynamics of mortgage term selection. Previous market analysis shows how, in an ideal world, mortgage borrowers can optimize their mortgage term selection. A study of alternative mortgage strategy selection over the last 20 years indicates that in theory, mortgage borrowers are better off when they lock into longer- term mortgages at the trough of the interest rate cycle and stay short as interest rates approach the peak of the cycle.
In practice, the opposite tends to happen. If you locked into a five-year term mortgage in the early 1990s, you were not alone – there were many thousands like you. What tends to happen is that mortgage borrowers go long as rates are rising. The major motivator is the fear that mortgage rates will continue to rise. Conversely, they tend to go short as rates fall, hoping to lock into a long-term rate when rates are at their lowest.
Let’s consider your options if you are one of the many mortgage borrowers selecting a mortgage term today.
First, let’s look at where mortgage rates are – most lenders now offer a one year-mortgage term at 6.50% and a five year mortgage term at 8.50%. These are their “posted” rates. There is, however, a big difference between the “posted rate” – the rate that you see on display and the “effective” rate – the rate that you will actually be charged. Depending on the strength of your relationship with your current lender, you can expect to be offered a discounted of between 25 to – 75 basis points off the posted rate when you renew. The size of the discount can depend upon the size of your combined accounts with your lender.
Relative to the five-year mortgage rate, the one-year rate looks attractive – particularly when the discount is included in the equation. Bi-weekly mortgage payments on a $100,000 mortgage at a discounted rate of 6.00% on a one-year term would be $319.51. In comparison, bi-weekly payments at a five-year term of 8.00% (assuming a 1/2 basis point discount) would be $380.98. The difference between the two options is $61.47 every two weeks.
Based on strict comparison of the size of the bi-weekly payment, the one-year term appears desirable. However, right now the theory would be suggesting that borrowers consider locking onto longer terms – a three, five, or even seven- year term mortgage. Why is this? Well, the mortgage yield curve, the absolute difference between short- and long-term mortgages, is large right now. The gap of 200 basis points is high by recent standards. The large gap is telling us something about financial markets: rather than continuing to fall, interest rates could be pushed higher, particularly at the long end.
Borrowers who continue to go short, waiting for the right opportunity to lock-into a longer mortgage rate could be in for some disappointment.