Is now a good time to refinance your mortgage or buy a new house?

We will not tell you (because we don’t know) where real-estate prices are going, but we can give you a framework to think about mortgage rates and the likelihood of rates moving higher or lower.  Mortgage rates seem really low.  However, mortgage seemed low two years ago and then went even lower.

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Can mortgage rates continue to go lower?

Before we answer this question, we should first highlight its importance. With a typical 30 year mortgage, over 2/3rds of the money which you pay will go towards interest. By lowering your interest rate by just 1% you are likely to save hundreds of dollars per month.

You can think about mortgage rate being composed of two components:

1. A base interest rate (how much does it cost to borrow money in general, if there is no risk of default)
2. How much extra it costs to borrow money to buy a house.

To measure how much it costs to borrow money, we will use the interest rate on the 10 year US government bond. To measure how much extra it costs to borrow money to buy a house, we will use the difference between the 10 year government bond rate and the 30 year mortgage rate.

30 Year Mortgage Rates Track the 10 Year Treasury

The traditional 30 year mortgage rate has a 98% correlation with the yield on the 10 year US government bond. This means that both mortgage rates and 10 year government bond rates move together most of the time.

For the math geeks out there, the reason why is because a mortgage is an amortizing security, meaning that you pay both interest and principal back at the same time, reducing the amount of debt owed over time. This is in contrast to a bond where you only receive interest payments and then all the principal is paid back at maturity. A more complicated way of saying it is that the duration of a 30 year mortgage is around the same as the 10 year government bond.

You can see this relationship in the below chart.

The Spread over the 10 year treasury

While mortgage rates and 10 year government bond rates generally move in the same direction, they do not always move by the same amount.  We can see this by looking at the spread between the two rates, which is calculated by subtracting the 10 year treasury yield from the 30 year mortgage rate.  (for more on credit spreads go here)

During times of economic uncertainty and/or market fear, often times that spread will widen out. Investors favor safe investments, like Treasuries, and drive interest rates down for the safest investments. On the other hand,  banks become more skittish about lending and therefore charge a higher rate than they otherwise would.  You can see this clearly on the below chart.  During the 2008 financial crisis spreads widened out dramatically.

10 Year Treasury/30 Year Mortgage Spread

The Bottom Line

Currently the 10 year treasury rate is near all time lows. Looking back just five years, the ten year treasury rate was around 5%. If you go back another 5 years, the rate was even higher. The all-time low for the 10 year treasury was 1.39% so it is unlikely to fall much further than that.  In terms of the treasury rate component of mortgage rates, the is a reasonable chance that the 10 year could fall by 0.50% or rise by 3.00% over the next few years.  In other words, by waiting for a more favorable interest rate, your risk is six times greater than your potential reward in terms of overall interest rates.

The spread between treasury and mortgages is a bit high by historical standards and could drop by another 0.25% based on historical averages.  However, this is a relatively small amount and does not change the overall risk / reward balance

We think now is a great time to refinance or get a mortgage.

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