Mortgage rates have been declining in concert with falling interest rates on long-term Treasury bonds. The situation in the mortgage market facilitates the plans of home buyers, who can find 30-year fixed rate at 5.08% (as of 12/17/09). However, there is no guarantee that these rates will last. The mortgage market is highly fluctuating and a possible rebound in long-term Treasury yields is likely to cause mortgage rates to increase again.
If you worry about a mortgage rate spike before you can find a new property, there are ways to hedge against this probability provided you realize that if mortgage rates rise considerably, you may end up ‘trapped’ in your property. When mortgage rates are so low, consumers do not sell their properties until their mortgage matures. Although the solutions available may not the simplest, they are worth considering because they can save you from the cost of even a slight rate change, which can be a lot of money on an amount of $ 200,000 mortgage.
In particular:
a) Investing in index funds that track long-term interest rates
There are several exchange-traded funds that track long-term interest rates. One of the most commonly known ETFs and the most successful ones that track long-term interest rates is the ProShares Short 20+ Year Treasury fund (TBF). This ETF calculates daily returns of an index that can be equal to 200%. Due to the compounding of daily returns, your returns over a period of time may differ in amount from the target return. Therefore, you need to monitor your ProShares investments on a daily basis to make sure they are consistent with your investment profile and strategies. ProShares Short 20+ Year Treasury fund (TBF) can be purchased on the stock market like shares.
Another successful ETF is the Rydex Inverse Government Long Bond Strategy mutual fund (RYJUX). This ETF is inversely correlated to the price movements of long-term Treasury bonds and seeks total returns before expenses and costs. Through investment to a significant umber of derivatives including futures, options and interest rate swaps, the Rydex Inverse Government Long Bond Strategy mutual fund focuses on financial instruments that perform opposite to fixed-income securities.
b) Investing in call options of index funds
ProShares Short 20+ Year Treasury fund is highly volatile because it tracks daily moves rather than long-term moves. Its high volatility may double the market up but it may also double the market down. This means that, in case of a mortgage rate spike before you find a new house, you may save money on the mortgage, but will lose money on the ETFs.
A very good alternative is investing in call options of these funds.
By purchasing call options on an ETF, you actually purchase a sort of insurance if mortgage skyrocket out of the blue.
To illustrate better, we assume that today with 30-year Treasury rates a 4.375% (as of 12/19/09), the ProShares Short 20+ Year Treasury fund (TBF) has a net asset value of $ 49.22 per share (as of 12/18/09). However, for $ 1.20 per share you can buy a $ 50 call option on the TBF anytime between December and March that allows you to buy the fund at $ 50 between December and March. This means that, having the right to buy the fund at $ 50 per share, even if mortgage rates rise over the next months, and the TBF increases to $ 60 from $ 49.22 per share, you will have a profit of $ 10.78 per share minus the $ 1.20 that you gave to buy the call option.
As it is impossible to know the correlation between long-term Treasury rate and the price of TBF in the future, buying a call option is a good strategy to trade off the possible losses from tracking daily performance.
c) Understand your budget
To properly evaluate the impact of a mortgage rate spike on your finances, it is extremely important to understand how you are spending your money. Setting up a budget in Excel or using a financial planning software will enable you to list all your expenses and keep track of your finances. In doing so, you will be able to see how an increase in mortgage rates affects each item in your household budget and what changes you need to make to lower your basic costs.
d) Consider debt consolidation
Debt consolidation is another possibility when mortgage rates are on the rise. The aim is to lower the interest expenses by consolidating your debt payments and putting your debt payments and salary payments in sync. For instance, if you’re paid weekly, arrange to have your mortgage paid on a weekly basis so that you reduce your total interest costs and boost your cash power. Besides, you may consider a high-interest savings account rather than a regular bank account to ensure more cash.
Major considerations
Lower mortgage rates actually translate into less of a safety net. Currently, homeowners have less equity in their properties because they are using it to borrow it to take advantage of the lower mortgage rates. However, this is likely to lead in a higher debt than their properties’ real value. Besides, even if their first mortgage is controllable, there is always a risk involved in paying the additional costs of refinancing.
As the integrity of prime mortgages deteriorates, the pool of money where borrowers can draw from becomes smaller, making it harder for consumers to get loans. Therefore, although the mortgage rates are low, the cost of loans is directly proportionate to the increase in defaults, enabling fewer people to refinance their taxing existing mortgages. This situation creates a chain reaction of events including foreclosures, lower property prices, crumbling equity, and a growing number of prime mortgage defaults.
In conclusion, there is no strategy that can offer 100% protection against a mortgage rate spike. However, there are always solutions provided you are prepared and well-informed. Questioning your spending habits is a good start to protect yourself from a cycle of increasing mortgage rates. The more careful your financial planning is today, the better positioned you will be to cope with a future mortgage rate spike as it comes.
Sources:
http://quote.bloomberg.com/markets/rates/keyrates.html
http://quote.bloomberg.com/markets/rates/index.html
http://www.proshares.com/funds/tbf.html