Sunday, February 03, 2008

You May Not Want to Wait to Refinance That Mortgage Market Features
02/03/08 - 12:17 PM EST
Terry Savage

With all the headlines about Federal Reserve rate cuts, it's easy to jump to the wrong conclusion: that you can afford to wait to refinance your home. But that's a dangerous position to take. It's one thing to speculate with interest-rate futures.

It's quite another to gamble with the roof over your head.

Last week, mortgage rates ticked slightly higher across the board, from fixed-rate 30-year loans to adjustable-rate mortgages. The bond market, and the mortgage market, may be looking across the temporary decline in rates to the inflation that is likely to follow this current round of Fed easing.

Dangers of Playing the Refi Game

There are two important reasons not to "game" the mortgage rate if you know you need to refinance, or are one of the very few still buying a new home.

First: The Fed does not "control" long term rates! The Fed can pump liquidity into the system, and can set short-term rates. But it can't control the longer-term bond market, where trillions of dollars of debt are freely traded each day. In that bond market, the very sophisticated participants are considering the impact of all that liquidity -- and its potential to create inflation down the road.

Typically, the 30-year fixed-rate mortgage tracks the yield of the 10-year Treasury note (because very few mortgages are actually held for 30 years). It is not the same rate as 10-year treasuries, of course, because individual mortgages have a higher degree of risk -- as we've all seen lately!

Inflation Fears Push Rates Up, Bond Prices Down

If bond buyers are worried about inflation, they're going to demand higher rates to compensate. In reality, if they sniff inflation coming, they start to sell the bonds they own, pushing prices down and yields up.

Remember, in bonds, the yield moves inversely to the price. A bond may have a fixed rate promise to pay off the principal in ten years, and a promise to pay a certain interest rate every year until then. But though the face value of the bond may be $1,000 -- which you'll get back at maturity -- the trading price of the bond may be much lower.

When you purchase a bond at a lower price than face value, your "yield to maturity" is higher than the interest rate on the face of the bond. That's how existing bonds trade to compensate for fears of future inflation. So even "old" 10-year Treasurys may be trading to give a higher yield as sellers push bond prices down.

Here's the simple rule to keep in mind: When interest rates rise, bond prices fall.

That's something beyond the Fed's power to control over the long run. The market is bigger than the Fed when it comes to long-term interest rates.

Which brings us back to your mortgage.

What Could Happen to Mortgage Rates

Mortgage rates might fall a bit farther if there is a deep recession, lowering the business demand for money. Or, there could be an economic recovery because of all this liquidity, with renewed growth causing rates to rise.

But the worst case is that the liquidity the Fed is pushing into the economy now doesn't create growth, but does create fears of future inflation. That creates the possibility of stagflation -- higher rates, but still a slow economy.

That's the first and main reason why you want to refinance as soon as possible into a fixed rate loan. Don't try to beat out the bond traders, because the upside risk on rates definitely exists, and could be devastating if you still have an adjustable-rate mortgage.

The Other Risk: Home Prices Fall Farther

I mentioned that there are two reasons to lock in rates now. The second reason is that if we do have a continued economic slowdown, the appraised value of your home could fall still farther. In fact, if you don't have enough equity in your home, you simply can't refinance -- as millions of homeowners have already learned. They're stuck in adjustable rate loans, worrying about the possibility of higher monthly payments.

Take advantage of this possibly temporary dip in mortgage rates to start the refi process now. And as you start the process, get a written rate guarantee from your lender.

If rates drop again, and your house retains its value, you can always refi another time. But if rates rise, you may not get this chance again. And that's The Savage Truth!

Terry Savage is an expert on personal finance and also appears as a commentator on national television on issues related to investing and the financial markets. Savage's personal finance column in the Chicago Sun-Times is nationally syndicated, and she released her fourth book, The Savage Number: How Much Money Do You Need? in June 2005. Savage was the first woman trader on the Chicago Board Options Exchange and is a registered investment adviser for stocks and futures. A Phi Beta Kappa graduate of the University of Michigan, Savage currently serves as a director of the Chicago Mercantile Exchange Corp. She also has served on the boards of McDonald's and Pennzoil.

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