What Are Interest Rates Going to Do?

Image of Magic 8-BallShake, shake, shake.  "Reply hazy, ask again," it says.  

For people looking to buy a home in Silicon Valley, it's the age-old question: "What are interest rates going to do?"  Especially since the difference between 6% and 6.25% on an $800,000 mortgage (30-year principal and interest) adds up to $129.34 per month.  I'd rather see that money go towards things that make you happy than on some lender's bottom line.

Data compiled since April 1971 shows that interest rates are historically low right now.  You don't need to take my word for that --- the Federal Reserve does their own surveys.

The challenge is that predicting interest rates is something no one can do accurately.  Global events such as the oil embargo in the 70s or 9/11 in 2001, which have a major impact on interest rates, can't be predicted with any certainty.  That's why mortgage lenders treat money like the commodity it is: in essence, they price their products based on how expensive the money is for the period when they need to use it.

While there is no crystal ball for determining what rates are going to do today, tomorrow, next month or next year, I'll present some "back-of-the-envelope" ways to tell which way the wind is blowing when it comes time for you to buy a house in Silicon Valley.

Be forewarned, this article is a lot more esoteric than usual and given the unpredictable nature of interest rates, needs to be disclaimed more than usual too!

Parsing the Enigma of the Federal Reserve

Predicting where mortgage rates are going to be, even in a year or two, is a very inexact science.  Folks make assumptions about Federal Reserve biases towards interest rates and listen intently to the news for those keywords from analysts: neutral, tightening, relaxed.  But those biases can shift.

And, you've probably heard the saying, "Do what I say, not what I do."  In keeping with that cliche, words coming out of the Federal Reserve ---- starting with Alan Greenspan's tenure and extending somewhat into current Fed chair Fred Bernanke's term --- are parsed and re-parsed for signals and nuances.

But when it comes to the Fed, the saying should be, "Believe what I do, not what I say" because the federal bank's real power comes from surprising the market.  (Readers who are also into the stock market know this through, sometimes harsh, experience!) 

In other words, they don't always signal their intent or the magnitude of their actions accurately, and they do this on purpose.  That said, a good start is looking at what the Fed says --- about what they say they're going to do. 

The Fed usually moves deliberately so people with a long-term view for purchasing real estate in Silicon Valley can use this as a relatively easy-to-track indicator.

Surveying the Mortgage Brokers

For those with a 30- to 90-day focus, one way to find out what interest rates are going to do is to ask a sample set of mortgage lenders.  Mortgage-X.com runs a mortgage rate trend survey of "more than 250 experts" each week to gauge what brokers think interest rates are going to do.  

Not all agree, of course.  In the April 9, 2007 edition, one broker said rates will increase over the next quarter because, "Bonds have broken their trading range now and look to rise slightly in the near future" and another said rates will decrease during the same time because, "Money has recently flowed from bonds to stocks, thus reducing bond prices and increasing yields."

But given the large sample set, they do generate an interesting bell curve that leans towards which way the crowd believes the wind is blowing. 

Looking at Short-Term Indicators

Mortgage brokers, lenders and economists will argue correctly that what I'm about to present to you is an oversimplification.  But the goal here isn't a Masters in Economics. 

By giving you a sense of what's going on inside the black box of interest rate voodoo, my hope is that you feel more at ease with a decision-making process which (I know from experience) can be life-changing.

The numbers I believe give you the best bang-for-the-time-constrained-buck, when evaluating interest rates when buying Silicon Valley real estate in the near-term, are the prime rate and the 1-year constant maturity treasury (CMT) rate.  

1/  Prime RateThe prime rate used to be the rate a bank would charge to its most reliable customers --- you'll see that definition all over the Internet --- it has evolved into an index that banks use to determine what your interest rate is going to be on a loan.  They do this by adding or subtracting percentage points (or fractions) from the prime rate based on the type of loan and the credit-worthiness of the customer, among other factors.

In general, the Wall Street Journal's published prime rate is "the" prime rate.  (They survey 30 institutions; 23 need to change their rate before the WSJ changes its published number.) 

This number usually changes, at most, once per month, if at all.  Its consistency and relatively low volatility make it a useful benchmark that's easy to track. Plus, changes in the prime rate reflect the Fed's major announcement decisions (i.e. changes in the Federal Reserve Funds rate.  But the prime rate, more focused on the short-term, doesn't have anything to do with mortgage rates, does it?

2/  1-Year CMT Rate.  The prime rate follows the 1-year CMT rate very closely.  This 1-year CMT rate is an index that represents the interest you would receive if you invested in a set of U.S. Treasury securities (like bonds, notes, bills, etc.) for one year.  This index is updated frequently, often weekly.  Many adjustable rate mortgages are directly based on CMT rates.  

How Home Equity and Piggy-Back Loan Rates Are Affected 

The prime rate directly affects most home equity lines-of-credit (HELOCs).  If you are planning on buying a house with less than 20% down, one of your options will be to get a "piggy-back" loan that usually comes in the form of a HELOC.

People with good to exceptional credit can get HELOCs for below the prime rate, prime minus some number or fraction of points.  In almost all cases, the interest rate on the HELOC will be more expensive than the base mortgage.  Since the piggy-back loan is smaller, getting a good rate on the HELOC is not as important as getting a good rate on the mortgage --- which is usually 8x larger (with that much more to pay interest on).

Changes in the prime rate directly affect the HELOC rates you can get and most will adjust based on the prime rate during the course of the loan.

Making Fast, Educated Guesses on Mortgage Interest Rates

The chart linked below shows mortgage interest rates since January 1992.  (This direct link to Mortgage-X.com is required for permission to republish it on my site.  We're not affiliated in any way.)  It includes data for mortgages (30-year fixed, 15-year fixed, and 1-year ARM) as well as the prime rate and 1-year CMT.

Image of Historical Mortgage Rates

People Gravitate Towards the Cheapest Money

If you had a choice --- let's assume they're both just as easy to get and equally beneficial for you --- between getting a car loan of $20,000 at 8.5% interest or buying a car and using $20,000 from another loan at 6%, which would you choose?   Clearly you'd choose the less expensive option.

Getting a mortgage is harder, for example, than getting a prime-plus rate car loan.  But since they're substitutes, the two rates would rather approach each other than diverge from each other.  Because the two are related, it's possible to make educated guesses about one using the other.

The white line on the graph (the one with the stair step pattern) represents the prime rate.  The red line represents the 30-year fixed interest mortgage rate.  As you can see, over the past 15 years, the two have tangled together, and the prime rate has higher peaks and valleys because of it's shorter-term focus.

Gauging the Wind Behind the Prime Rate 

Nothing is certain in the land of interest rates, just like it is in the stock market, but take a look at the green line.  This is the 1-year CMT rate plus a margin.  For our purposes, this margin helps compare the 1-year CMT to the prime rate.

As you can see, changes in the 1-year CMT rate happen rapidly.  And, since January 1992, you can see from the chart that the 1-year CMT rate usually leads the prime rate by about one to four months.  In other words, you can usually see changes to the prime rate coming 4 to 16 weeks beforehand by looking at the 1-year CMT plus 2.75% margin interest rate.

Since this isn't an economics thesis, I haven't run a statistical analysis to prove that, so proof by inspection (eyeballing) will have to do.  Except for a big peak in the 1-year ARM during January 1995 and a disproportional dip in September late 1998, you can see the 1-year CMT leading the prime rate pretty consistently.

One Opinion on Mortgage Rates

Personally, I look to see whether the 1-year CMT plus 2.75% margin is less than the prime rate for a period of about three to six months.  (I prefer to think about it as when the green line is below the white one.) 

In general, I would track rates as stable or decreasing during those periods.  The chain of reasoning is that the less the government pays on their securities, the less banks pay people to deposit money with them, the more incentive people have to spend their cash rather than borrow money from banks, the more incentive banks have to lower their loan interest rates in the near-term, barring daily fluctuations.  A larger difference between the 1-year CMT and the prime rate usually means a change is afoot --- indicated through their actions, not words.

But then again, there could be another Katrina, more captured U.K. soldiers in Iran, or inordinately cold weather driving up heating costs that month. 

I believe the best advice for people looking to buy a home in Silicon Valley is to budget for varying interest rates, establish a timeline for purchasing, investigate properties in your price range, lock-in a rate you're comfortable with using a vendor you trust --- and don't look back because no one has a perfect Magic 8-Ball.

(c) Steve Leung for the Silicon Valley Real Estate Blog at 1SiliconValley.com

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