There are probably half-a-dozen different types of graphs and each has a particular “best use”. One type is the time-series graph. That’s the one that has the horizontal “x” axis along the bottom showing time and the vertical “y” axis up the side showing values. A time-series graph shows changes over time, something a lot of graphs aren’t set up to do. It illustrates the phrase, “Look, Winston, we’re selling more replacement tires than we used to!”
It’s necessary to be a little cautious with graphs because the scale can obscure important points. If Winston glanced at the ten year chart and saw the line leave the right side of the page higher than it came in on the left, he might agree with his partner. Yes, we are indeed selling more.
If the scale were reduced to show tire sales for only the most recent Tuesday, then a comparison with previous Tuesdays might show that sales had declined. “Just look at this, Winston! Sales have collapsed 30%!” even though sales might be up substantially year over year. The conclusion drawn about tires depends a lot on the scale of the data looked at. It’s the same with interest rates.
If we take the short term view on interest rates, we might conclude that rates have made their big move. “Look! Rates have stabilized. They are the same as they were four weeks ago”. The 10 year T-note on the day this is written yields 2.73%. One month ago it was 2.70%. That’s pretty stable and is well within normal market fluctuation. A three basis points (3/100th of 1%) adjustment is a negligible movement. It would change the interest payment on a $1,000,000 loan by less than $25 a month. You would probably not wish to be married to a man totally fixated upon such minutia. You certainly would not give him a chance to be the father of your children.
Oddly, you’d be surprised by the number of people who, against all sense of proportion, are consumed by such incremental changes of no immediate import. But their position is not without merit. Let me defend them by quoting the boiling frog phenomena.
The story is that if you throw a frog into boiling water he’ll jump out. But if you put him into tepid water and turn on a slow heat the frog will remain in the pot until he boils to death. The story is probably apocryphal, but it does illustrate the point. Consistent incremental increases – the slow heat – in interest rates will ultimately injure the folks remaining in the pot. So while someone who gags on a $25 increase on a $1,000,000 mortgage would be miserable to live with (“Why did you buy those shoes from Nordstrom’s? You can buy shoes at the Shoe Attic for less!”), and you may not wish him to be the father of your children, such a man would be exactly right to manage your 401K. We’re all fit for something.
Here’s the issue on small interest rate increases. There is a normal fluctuation in the marketplace. When the “ups” and “downs” offset each other, the market is basically stable. When the “ups” are greater than the “downs”, we’re in an uptrend. A simple way to discern the trend is to look at the 10 year Treasury (http://www.multpl.com/interest-rate/table) for the first trading day of each year. In January, 1982 it was 14.59% and subsequently down-trended until January, 2013 when it was at 1.91%. That’s a compound annual decline of a touch over 6% per year. Then the trend reversed and twelve months later, in January 2014, the 10 year Treasury was at 2.85%. That is a 49% increase in one year: 94 basis points.
We don’t know where rates are going in the future. Conventional wisdom seems to be that as the QE taper continues and the economy improves there will be a greater demand for borrowed money and rates will climb still further.
The best rates were last year. That may have been the bottom, but it’s not possible to refinance at last year’s lows. The train has left the station. If we are indeed in a period of up-trending interest rates as the last 12 months indicate, then a year from now I’ll probably be writing “It’s no longer possible to refinance at low 2014 rates: that train, too, has left the station.”
You would think people would manage their mortgages as closely as they would their 401K’s. After all, interest expense is a huge portion of the total cost of an investment. The principal repayment never gets bigger: if you borrowed $100,000 no matter what your total payments were over the next 30 years only $100,000 would go towards retiring the principal. Everything else would be interest. At a hypothetical 5% interest the monthly payments would be $536.82, a total repayment of $193,355 over thirty years. Subtract the original $100,000 principal borrowed and it’s obvious that the interest portion is pretty much equal to the original amount borrowed. You managed the principal portion by negotiating the best purchase price you can. Now it’s time to manage the interest portion as well.
The principal portion is the result of a one-time negotiation. When agreement is reached, that’s that: there’s no do-over. Interest rates have do-overs, which is great for us. Appropriate refinancing is how we manage our lifetime mortgage expense. But we can’t look behind us and pick a historical rate that’s no longer available. You can’t say “I want that 2013 mortgage indexed at 1.91%”. That’s gone. So to make an informed decision about our options, we have to form an opinion on future rates.
Consider looking at a time-series graph (shows changes over time, remember?) of, say, the 10 year Treasury note. The 10 year note is a common index and usefully reflects the trend in rates, and it’s the trend we’re looking for, not the rate itself. The trend tells us when to act. The graph should be of proper scale, almost certainly greater than one year. A ten-year scale might be even better because it would show the end of the downtrend leading to the 2013 low, the turning point at the bottom, and the beginning of the following uptrend. That sort of historical perspective might be very useful.
With this level of due-diligence, most people would probably conclude that, yes, rates have entered the uptrend portion of the cycle. Our choice now is to decide whether we would be better off refinancing our low rate mortgage immediately (i.e., turning a variable 3.0% mortgage into a 7 year fixed 4.25% mortgage) or not refinancing and watch our variable 3.0% adjust until it shoots past the 4.25% level on its way up to who-knows-where. In a period of climbing rates these refinance decisions should not be postponed. If rates are indeed climbing, the 7 year fixed 4.25% mortgage won’t be available very long.
In a period of rising rates there is much to be said for refinancing every time the present mortgage slips into the adjustable phase. Granted, in a period of rising rates, each refinance would be at a higher rate, but the rate would be “market” at the time. And we’d know in advance what the mortgage payment would be for the next seven years: we could sleep peacefully as market rates climbed.
To repeat: our example mortgage has a 30 year amortization period and the payments on the $100,000 loan at a hypothetical 5% will be $536.82 monthly. That’s about $193,000 (monthly payments times 360 months). Subtract the original $100,000 borrowed and what’s left almost equals the original principal amount. Sums this size are huge reasons for managing the debt payments.
This does not, however, mean that every loan should be refinanced. Unless you were pulling money out to buy another building, you would probably not want to refinance if:
- Rates are trending down,
- There are several years left in your fixed rate period,
- There is an unacceptable pre-pay penalty (i.e., one that cannot be recaptured in a reasonable period),
- Your loan has a low cap on the maximum interest rate that can be charged during the life of the loan, or
- Your loan is close to being paid off.
Other than these few examples, it’s hard to think of a good reason to not manage your interest expense by proactive refinancing.
Takeaways: The default position is to use refinancing to limit your interest expense. Review your loan documents to determine if it’s better for you if you don’t refinance, perhaps due to the reasons above. Refer to an appropriately scaled 10 year time-series graph to (a) get a sense of the direction and degree of change in interest rates, and (b) estimate the benefits to managing your mortgage through strategic refinancing. Finally, ask yourself “if not now, when?”
If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].