|
April 23, 2001, Revised
September 13, 2005
Should
Borrowers Forecast Interest Rates?
"I have been pre-approved for
a loan on my new home but have yet to lock in the interest rate. When
would be a good time to lock, and what indicators should I be looking
at?"
"They say that interest rates
will be reduced at the next meeting of the Federal Reserve Board, so I
intend to wait until after the meeting to lock."
These letters assume that it is
possible for mortgage borrowers (or their advisors) to forecast the
direction of interest rates with a better than 50-50 chance of being
right. In my view, that is wrong.
There are a lot of professionals
out there who spend their entire working time analyzing the market, and
who have a lot of money riding on the accuracy of their interest rate
forecasts. Over time, virtually all approach 50% accuracy. Even if there
are a few who do better than that consistently -- and I don�t know who
they are -- a non-professional doesn�t have a chance.
Prior to the meeting of the
Federal Reserve Open Market Committee on March 20, 2001 it was reported widely
in the news media that interest rates would be reduced, the only question
being by how much. This expectation was confirmed when it was announced
after the meeting that rates were being cut by � percent. But whatever
impact this widely anticipated event had on mortgage rates had already
occurred well before the meeting.
The Federal Reserve targets two
interest rates. One is the discount rate, which is the rate banks pay the
Federal Reserve when they borrow. This rate is administered by the Fed and
is wholly under its control. The second is the Federal Funds rate, which
is the rate that banks charge each other on overnight loans. While the Fed
does not administer this rate, it can control it by buying and selling
securities, termed "open market operations". The Fed dropped
both rates by � percent at the March 20 meeting.
But these rates are only loosely
related to rates on bonds and mortgages. This is evident from what
happened to the Treasury 10-year bond rate during the week that straddled
the March 20 meeting, as illustrated below. The rate hardly moved at all
during this period.
|
Date in
2001
|
10-Year
Treasury Yield
|
|
Friday,
March 16
|
4.78%
|
|
Monday,
March 19
|
4.82
|
|
Tuesday,
March 20 � Meeting Date
|
4.78
|
|
Wednesday,
March 21
|
4.77
|
|
Thursday,
March 22
|
4.73
|
|
Friday,
March 23
|
4.80
|
Can You
Stand the Risk of Higher Interest Rates?
In developing your lock strategy,
forget about trying to guess the direction of interest rates. The first
thing to consider is your capacity to take the risk of a rise in market
rates. If you barely qualify at today�s rates and an increase would
knock you out of the market, or force you to accept other unfavorable
terms, you should lock immediately.
Pros and
Cons of Delaying a Lock
If you can withstand a rise in
rates, there is a benefit in delaying the lock. If market interest rates
don�t change, the lock price falls as the lock period shortens. For
example, a lender may quote a price of 7% plus 1.5 points on a 60-day lock
and 7% plus 1.25
points on a 30-day lock. (One point is 1% of the loan amount). The reason
is that the lender takes less risk with a shorter lock.
Working in the other direction,
however, is that you lose the ability to walk away from your loan
provider as the closing date approaches. This would not be a problem if
the loan provider spelled out in advance exactly how the market price is
determined on the day you lock. For most loan
providers, however, the market price on the day you lock is what they say it is.
If you don't have the time to make a switch, you are at their mercy.
You are safe in delaying a lock if
you are dealing with an internet lender who posts your price on the internet
every day. You are also safe if you are dealing with an Upfront Mortgage
Broker (UMBs) because she will give you the best wholesale price on the lock
day and show you the price sheets.
On a purchase transaction,
therefore, with the exceptions noted in the preceding paragraph, I
would lock while there was still time to change loan providers. On a
refinance, you can always change loan providers, so it�s safer to delay
the lock until shortly before closing. The loan provider, however, should
be made to understand that you understand how the game is played.
Copyright Jack Guttentag
2005
|
