We knew this was coming, and now it looks imminent. A little while ago, three newspapers, the Wall Street Journal, the New York Times, and the Financial Times each reported that the Federal Reserve agreed amongst themselves to quit buying bonds in October, 2014. Just saying that rates will someday go up is one thing, but a committed target date makes it actionable.
Even after the Fed stops buying bonds few observers expect rates to immediately shoot up. That would suffocate the nascent semi-recovery and the Fed has other tools at hand. Rates have been steady (subject to normal market fluctuation) over the past year, but once the bond buying ceases it’s probably reasonable to expect rates will increase a little faster. While it’s too early to think rash thoughts, it could be time to review the Wayne Gretsky Fundamental Principle of Credit Management: Skate to where the puck will be.
The baseline for most mortgage loans is the ten-year Treasury note. Over the last 15 years (since 2000) its yield on the first market day of the year has varied from 1.91% to 6.66%. On the day this is written the 10 year T-note yield is 2.45% (up 8 basis points). Few people expect yields to fall.
“The moment there is a sniff of economic expansion or a weakness in revenue and receipts of the U.S. government, we will see interest rates rise,” predicts Curt Lyman, managing director of HighTower Advisors in Palm Beach Gardens, Fla. (http://www.bankrate.com/finance/savings/5-savings-strategies-before-rates-rise-1.aspx)
“ Rates continue to hover at historic lows, but it’s only a matter of time before they rise.” (http://www.cnbc.com/id/101589070) .
“Interest rates, which recently hovered at their lowest levels in 40 years, are rising.” (http://www.investinginbonds.com/learnmore.asp?catid=3&id=57) .”
Here, then, is the question. If the consensus among market watchers is that rates will rise after the Fed quits buying bonds, would a person be better off refinancing now or waiting until rates are higher? That’s not a frivolous thought. Under certain conditions it might be very reasonable to wait until rates are further along in their rise.
Refinancing and Pre-Pays
Prepayment penalties impact the multiple benefits of refinancing. There are two kinds of pre-pays: step down and yield maintenance. Step down pre-pays come in different flavors, but generally last as long as the initial fixed rate period. A seven year fixed rate period may carry a seven year prepay (5-5-4-4-3-2-1). A five year fixed rate period might carry a five year prepay 3-2-1-1-1. In this latter example, if you refinance during the first 12 months you have the loan, there’s a penalty equal to 3% of the remaining loan balance. The next year the prepay drops to 2%, then 1% for each of the last three years of the fixed rate period. After the fixed rate period expires, during the adjustable period, there is seldom a penalty if you pay off the (step-down) loan.
It might be that an investor with a step down penalty may be willing to pay 1% or 2% to pay off the existing loan through a refinance. But an existing loan with a high prepay may be unacceptably costly. It may be better to wait until the loan is seasoned a while and the prepay works its way down the ladder before refinancing. This might be true even if the investor expects interest rates to rise between now and then.
The second type of prepayment penalty is yield maintenance, which makes the bank indifferent on whether or not the loan is paid off early. Yield maintenance pre-pay lasts the entire length of loan. That’s because in exchange for a slightly lower interest rate the borrower agrees to compensate the lender for losses sustained as a result of the prepayment. The formula is complex and typically completed by an independent third party. Even so, I’ve seen yield maintenance pre-pays of more than 20% of the loan balance. “Yes, Mr. Borrower, it will be just fine if you refinance and pay us off early. As always, our first concern is your happiness. There will, however, be a token penalty of $346,000. Shall we put that on your Visa?”
This is obviously a good deal for the lender, who will be so eager for you to accept yield maintenance pre-pay that they will often reduce the interest rate by a token 10 to as much as 25 basis points. A basis point is 1/100th of one percent, so 25 basis points is ¼ %. If the going rate is 5% and the borrower accepts yield maintenance pre-pay, his (adjusted) interest rate will likely range between 4.75% and 4.90%.
Is there any time when a yield maintenance prepay might be acceptable? Hypothetically, assume you believed rates were just beginning their cyclical long-term rise when you bought a new (to you) apartment building on a fully amortized 15 year loan (occasionally possible). Your intention was that the building will eventually provide an increasing portion of your retirement income. If you’re as certain as you can be that you’ll never refinance, then a yield maintenance provision might be acceptable?
You’ll find the type of pre-pay you agreed to the Final Commitment Letter (sent just before the lender draws the loan documents) and in the final loan documents. By the time it’s in the signed loan docs, it’s too late.
Refinancing into Rising Rates:
There are at least four major elements here: (a) how close is the current loan to being paid off? (b) is your existing loan in its variable period? (c) what is the interest rate lifetime “cap” on your existing loan? (d) If you refinance, what is the payback period?
Even if the existing loan is nearly paid off a refinance can still make sense if it’s to harvest the necessary down payment to buy another building. When you’re in the period of your life when you’re accreting assets, well, that’s how it’s done: you refinance an existing building to buy the next one.
But except for reinvestment, if you’ve had the existing loan a while it may not make sense to refinance. The general guideline is that during the first half of the loan term most of the monthly payment just goes to pay interest. In the second half of the loan term most of the payment applies to paying off the principal. So if you’ve had a 30 year loan for more than 15 years, you might wish to refinance another one of your buildings and to leave that one alone.
Folks who refinanced recently are probably still in the loan’s contracted fixed rate period, and that means a pre-pay applies. See above. If the fixed rate has expired and the variable rate period begun there are two possibilities: either the loan has an acceptable interest rate cap or it doesn’t.
Some of the apartment loans we provided when rates were really low have lifetime caps of 7%. It’s hard to imagine one of those loans being refinanced. Current lifetime rate caps are hovering around 9.5%. But other apartment loans have much higher lifetime caps – some can be north of 12%.
With the first five to seven years of a loan being its fixed rate period and the remaining 23 to 25 years at a variable rate, here’s one way I like to look at those 12% lifetime caps. Functionally, they have to be considered a fixed rate loan priced at their lifetime cap, with a ramp up (i.e., the fixed rate period) of five or seven years. We don’t know how high rates will eventually get this time around, but in the autumn of 1981 (the last time rates were on a secular upswing) mortgage rates were over 18% . . . and you had to pay two points to get the loan.
When rates are trending lower it’s common to figure a “pay-back” period, which is the length of time required to recover the cost of an investment. For example, if you refinance to a lower rate would save you $1,000 a month and the costs of the refinance were $20,000, then the pay-back period would be less than two years.
Pay-back periods are nonsensical during the “rising” period of the interest rate cycle, because your payments will be higher, not lower. At such times properties are refinanced not to minimize current interest expense, but to reduce future interest costs. We’re skating to where the puck will be.
Right now, as this is written, my office can provide apartment loans at 4.25% to 4.75% (first seven years fixed). If you wanted only five years fixed, the rates are even more favorable. Where within that range your loan will fall is largely determined by the specific property, its location and the loan amount (the higher the loan, the lower the rate). It’s important to know current rates because it gives us a reference point to continue this conversation.
Generally, after the transition to the variable rate period, mortgage documents allow for rates to increase every six months. The maximum increase per adjustment is 1% (2% annually), so it can get to its lifetime cap pretty fast. Often, but not always, current rates reflect what an existing borrower might experience if his current loan transitioned into its variable period today. If you’re paying 4% interest or more during the fixed period, you’ll probably be looking at beginning your variable period at about the same rate you could get “fixed” for seven years on a refi. Given that, it’s unclear to me why somebody would let their loan morph into a variable rate.
A refi that provides seven years of fixed interest rate payments should be enough to get over the hump. Data shows that rates were in the 10% range in early 1979, rose to over 18% (see above), and by Spring, 1986, returned to the 10% range. Seven years was sufficient then; we hope it will be now.
Takeaways:
- If you have yield maintenance pre-pay, this may not apply to you.
- If your lifetime “cap” is low, this may not apply to you.
- If you’re in the second half of the loan’s life, this may not apply to you.
- Rates are projected to go up; we don’t know how much or for how long.
- Prudent credit management requires us to minimize the hurt.
- Refi into a mortgage with an extended fixed rate period.
- Skate to where the puck will be.
Disclaimer: 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].
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