Homeowners have enjoyed rock-bottom mortgage rates for years now. But with the recent spike up in bond yields, mortgage rates have followed suit, climbing a full percentage point to about 4.5% for 30-year mortgages in just the past two months. Given the speed of the rate increase, concerned would-be homebuyers are wondering just how far mortgage rates could climb.
A recent column from financial analyst Richard Barrington asked how quickly rising mortgage rates could come, and he argues that 6% rates could be just a year away without anything more extraordinary than a return to more normal conditions in the credit markets. Let's take a closer look at the arguments for and against continued rises in mortgage rates and the impact they could have on your finances.
Focusing on margins
One way to look at mortgage rates is from the perspective of the lenders that make mortgage loans. As Barrington notes, lenders have to pay special attention to the potential for future inflation because the long-term nature of mortgage loans can potentially leave them exposed to interest-rate risk for decades. Historically, when you look at the spreads that lenders have demanded over expected inflation rates over the past 40 years, you find mortgage rates that were typically almost 4.5 percentage points above the rate of inflation. Therefore, when you look at past inflation since 2008 that has averaged about 1.5%, you get a "standard" mortgage rate of 6% once those spreads get back to normal.
Interestingly, though, this analysis doesn't mention an important factor: Increasingly over the past decade, major mortgage lenders haven't held onto their loans but rather have sold them on to government-sponsored enterprises Fannie Mae (OTC:FNMA) and Freddie Mac (OTC:FMCC). During the housing boom, mortgage lenders Bank of America (NYSE:BAC) and Citigroup (NYSE:C) didn't perform as well as they did because they were securing particularly high margins on their mortgage loans. Rather, they collected transaction-based income by immediately reselling conforming loans to Fannie and Freddie, often retaining streams of income from risk-free mortgage-servicing rights without keeping any liability for potential loan default. Even now, Wells Fargo (NYSE:WFC) relies on strength in mortgage-related income, and decreases in refinancing activity pose a threat to income growth in future quarters -- although unlike many of its peers, Wells has actually retained a good portion of its loans on its own books.
Will the government allow mortgage rates to rise further?
The recent hit to the bond market has led many to question just how much influence the Fed can exercise over long-term rates in the long run. Even the possibility of cutbacks on its bond-buying program was enough to send rates soaring, prompting several Fed officials to take issue publicly with what they saw as an overreaction in the bond market to the message that policymakers were trying to send. With the Fed continuing to buy bonds with particular attention to the mortgage-backed bonds that help keep mortgage rates low, it would take a complete loss of control from the Fed to allow mortgage rates to hit 6% in anything approaching the 2014 timeframe that a reversion to normal interest spreads would imply.
Still, given the government's interest in keeping the economy growing, allowing a quick rise in mortgage rates to 6% would probably cause substantial collateral damage. Home prices that have risen by double-digit percentages over the past year would suddenly be in jeopardy of dropping, as monthly payments on a $250,000 mortgage would rose from around $1,125 at 3.5% to almost $1,500 at 6%, making homes much less affordable for many prospective borrowers. Homebuilders that have seen big recoveries in buying demand would suddenly see buying interest dry up, and the employment prospects for workers in the industry as well as those helping to provide related services would decline as well. That's a downward spiral that the Fed can't afford to allow to happen.
Be ready, but be patient
Eventually, a return of mortgage rates to more normal levels in the 6% range seems likely. But it will only happen once the economy shows signs of being able to withstand the pressures on economic growth that would come with such an increase. That doesn't seem likely by next year, but it could come sooner than you think -- and so being prepared and taking advantage of still-low rates while they last makes long-term financial sense.