The Fed cutting the overnight by a quarter point does entice people to do more mortgage financing. This does stimulate the economy somewhat, but also stabilizes it.
A lot of people have a mortgage but don’t really realize what shapes mortgage rates. This is good to know if you are wanting to buy or refinance a home and are looking for some guidance on how mortgage rates may be trending.
Mortgage rates are now the lowest that we’ve seen since 2016, but 2016 was a time where the overnight rate that the Fed charges were on the way up. They raised the rates by a quarter point in both 2015 and 2016 so the overnight rate going down certainly didn’t cause these low mortgage rates, because the opposite was going on then.
The real reason why mortgage rates were so low back then was actually because bond yields were so low, and this is the reason why they are so low these days, as bond yields have plummeted to right around where they were three years ago. 2016 set some records for low yields in fact and we came very close to breaking them this month.
The overnight rate and mortgage rates are actually on opposite ends of the lending spectrum, with one rate only applying to overnight borrowing and the other for up to 30 years. Short term rates fluctuate quite a bit, and when a lender is looking to lend you money for 30 years, the overnight rate in August of 2019 isn’t going to have a meaningful impact on the life of a loan that long out.
Bond rates do matter though, and treasuries run as long as mortgages do, 30 years in fact. It’s the 30-year treasury bond that we want to be paying attention to here, and the reason is that this is the risk-free opportunity cost of a bank lending you money over this period of time.
Banks do buy bonds as well as lend out money, and even though mortgages are secured by home ownership, there is always risk involved. The risk of the U.S. government defaulting on its treasury notes is as low of a risk as there is, less than you not paying back your mortgage, less than your bank going under and you losing your deposits, less than any other investment out there.
We then use the 30-year treasury to establish a benchmark for mortgage rates, and if they were at the same rate, banks would certainly prefer treasuries over mortgages. It’s not that treasuries don’t have any risk, as a civilization ending event such as a meteor hitting earth or all-out nuclear war might cause the U.S. government to collapse, but these risks are remote enough to just disregard, or at least be rendered meaningless because whether or not we collect our interest payments on our treasuries won’t matter if money doesn’t spend anymore or we’re all dead.
Banks therefore need to add a premium to these treasury rates to make extending mortgages worth their while, and as these bond rates move, so do mortgage rates. If we’re looking to predict mortgage rate trends, we can just look at bond yield trends and not only have this a good guess but get real insight into where we are going.
This is Indeed a Good Time to Consider Refinancing Your Mortgage
If, for instance, we started the year looking to refinance our house and wondered whether it would be better to wait and see if bond yields would keep dropping, that would have been a good idea rate wise anyway, even though delaying paying off high interest debt can save a lot of money and we therefore need to take these things into account as well.
Those not so much in the know may write things like the Fed cut rates and mortgage rates are declining in lock step, and we did have the two move together this month, but only because this rate cut produced a corresponding drop in bond yields.
Over the last week, bond yields have stabilized, so this would seem to be a very good time to refinance your mortgage, although once again there are other considerations to account for. These other considerations always involve borrowing at a lower rate regardless, so they may add the need for haste to the decision but they never really give us a reason to delay, so when rates are low and you can benefit from a refinance, the time is certainly now.
While bankers understand the benefits of refinancing mortgages pretty well, since it is their business to, a lot of people outside the business really don’t, including a lot of people who comment on these things in the media and analysts or others in positions to advise. We see a lot of negative views about refinancing but for the most part refinancing mortgages is a move that benefits borrowers greatly.
There are indeed cases where we may think that the ability to refinance may have people overextending themselves, but as long as there are risk controls in place, limitations of capacity in other words, this will be kept under control. In most cases, people use this tool to either borrow at a lower rate or get a better rate on debt that they already have, which are both sensible and desirable.
Just because the Fed puts the overnight rate down by a quarter of a point doesn’t mean that mortgage rates will decline by that much, and this month so far, they have only declined 0.15%. Once again though, this rate cut only matters to the extent that it has brought bond yields down so this isn’t even a sensible comparison.
If we have a housing bubble that is about to explode though, then too much refinancing can indeed be dangerous. Although refinancing has picked up lately, its levels are nothing like they were in 2007, when we refinanced mortgages at a rate of 5 times what we are doing now, but that was overdoing it under the circumstances at least.
The reason why this was excessive wasn’t because we borrowed so much, something that in itself is actually healthy provided it doesn’t accelerate economic growth too much and be too inflationary, it was because of the trillions of dollars of bad mortgages that we had at the time, accidents just waiting to happen and waiting to topple over the economy.
Refinancing Both Expands the Economy and Stabilizes It
Some may think that this boost in refinancing will have a big effect upon the economy, and might be a little disappointed to see this not materialize as much as they thought, but quarter point cuts don’t have that much of an effect upon growth overall and mortgage refinancing is only a portion of the growth that these cuts stimulate.
Wolfe Research’s Chris Senyek has pointed out that, over the last year, mortgage refinances have increased by $75 billion, and that is not a lot of money in the grand scheme of things. He also points out that 54% of the equity borrowed goes to paying bills or is saved, which he feels doesn’t have much of an impact upon the economy at all.
This remark is interesting though, because while paying off bills or putting money in the bank does not have any direct effects upon the economy, they sure have indirect effects, especially paying the bills.
Paying off debt or increasing savings both contract the economy. Paying off debt reduces the money supply, and increasing savings reduces spending. However, in this case, people aren’t actually paying off debt with these refinances, they are just refinancing it and still owe the money, just to someone else.
We do pay back less at lower rates but this also frees up the money that we save so we can spend it on something else. People also generally do not refinance their mortgages just to put the money in a deposit account, and the intention instead is to spend it later, usually within a year.
In both these cases we end up with more spending, and this is how this does expand the economy. All additional borrowing accomplishes this in fact, and when rates go down, people borrow more, aggregate demand goes up, the money supply expands, and this is also inflationary to some degree. If the goal is to expand the economy and even to bring up inflation rates, this is a good way to do it and the Fed does know what it is doing here, regardless of what impact mortgage refinancing may contribute.
The main way that mortgage refinancing helps the economy isn’t even by expanding it, it is by lowering default risk. By lowering the amount that people need to pay to service their debts, this reduces the risk of their not being able to pay the money back, in other words default.
Refinancing accomplishes this objective two ways, by lowering the rate of interest paid and also by extending the amount of time we have to pay back the loan. Many borrowers have been saved from financial ruin by restructuring their debts by way of a refinance, where they go from not being able to keep up to being able to do so fairly comfortably.
Loan defaults, not slower growth, is the real beast out there, and when we have a lot of defaults this will slow growth like nothing else, as we saw in 2008-09. The economy was growing rather nicely at that point until our money supply got crushed by this massive default level, and it took all the King’s horses and men and a fair bit of time to bring us back from this.
We might think that we should just be looking at overall debt levels, but it’s actually the payments that are important, because it is the payments not being made that cause defaults. We can actually borrow more and have our payments lowered overall and lower our overall risk, which is what mortgage refinances are famous for.
This is the real reason why mortgage refinancing is such a key element in our economy, although few understand the dynamics of all this to fully appreciate this or even come close. Lower interest rates also accomplish this, and this is also why rising interest rates are so dangerous, not just because it causes people to pay more interest but mostly because it causes more defaults.
We therefore can be pretty happy at the fact that refinances have gone up notably this month, but it’s not so much because it has made a big impact on stimulating the economy. This sort of thing does stimulate it but it also protects it, which ends up being a nice deal all around.