Understanding the Impact of an Inverted Yield Curve
An inverted yield curve occurs when short-term interest rates exceed long-term rates (think Fed Funds Rate), a once rare phenomenon that often signals economic uncertainty or an impending recession. This inversion significantly impacts financial markets, including mortgage rates, altering the traditional relationship between Adjustable-Rate Mortgages (ARMs) and Fixed-Rate Mortgages (FRMs). In this blog, we will explore how this inversion influences mortgage rates.
What is an Inverted Yield Curve?
An inverted yield curve, sometimes called negative yield curve - which makes it easier to understand in my opinion - happens when short-term interest rates surpass long-term interest rates. Typically, investors expect higher returns for lending their money over longer periods, so long-term rates are higher than short-term rates. However, during an inversion, short-term yields rise above long-term yields. What does that mean to mortgage rates? ARMs may be the same, or higher, than FRMs!
Narrowing Rate Advantage for ARMs
Under normal economic conditions, ARMs are appealing due to their lower initial interest rates compared to Fixed Rate loans. The lower rates are primarily because the fixed-rate period in ARMs is typically shorter (for example 5, 7, or 10 years), thus presenting less risk to lenders. However, in an environment where the yield curve has inverted, this advantage begins to shrink or even reverse.
Our first mortgage was an ARM. I remember being very nervous about what would happen after the five years elapsed. Ultimately we refinanced before the adjustment occurred.
ARMs can be a great loan option for folks who:
A. Are risk averse
B. Expect to sell (or refinance) prior to rate adjustment
Several years ago we saw investors like Fannie Mae and Freddie Mac significantly reduce their ARM offerings, especially to low down payment borrowers. Limited ARM products has been an ongoing challenge in this lending environment.
Why not take an ARM, and then just refinance, you ask? I wish I had that crystal ball. The downfall to this, aside from the context of this blog where ARM rates aren't compelling, are the facts that refinancing costs money and we have no way to predict what mortgage rates will be doing in the future.
Reduced Borrower Appeal
As you can imagine, with ARMs offering less of an initial rate advantage (if any!) and carrying the reality of future rate adjustments in a rising mortgage rate environment, they are not as appealing. This uncertainty makes borrowers more reluctant to commit to ARMs during these times, favoring the predictability and security, of a Fixed Rate repayment.
Nicole's Expertise
Although ARMs are limited, we do work with Investors who have an appetite, and thus some decent options. I read an article from The Journal of Consumer Affairs written in Spring 2024 that said the average U.S. homeowner stays in their home for 11.9 years. That doesn't mean they stay in the same loan. If they secured an ARM there was necessity to change if rates were rising.
We used to say that the average time in a home, or loan, was 5 to 7 years. Times change! And more importantly, each individual's plan varies. Think about your future. Is this home your starter home? Your forever home?
There is a gentleman I know who got stuck in the wrong mortgage TWICE! He had a fixed rate when rates were down, and due to stricter lending requirements after the 2008 Financial Crisis, he was stuck. Then he refinanced to an ARM, and got stuck again in a rising rate environment.
Overall he still made the right financial decision keeping his property. It is a multi-family that has gained significant equity over the years, with steady income from tenants, and he finally has a great mortgage. Moral of the story is that any mortgage, even one that is higher than current market rates, can be a super investment in yourself and your financial future.
Nicole's Conclusion
While the inverted yield curve is presenting challenges for those considering an ARM, it also offers opportunities for borrowers to capitalize on lower long-term interest rates. Ultimately, the choice between an ARM and an FRM hinges on individual financial circumstances and the broader economic outlook. By staying educated and working closely with your mortgage professional, you can make the most informed and advantageous decisions regarding your home financing.
It is always our pleasure to help game plan your mortgage and ensure it's the best choice. Seeing it on paper helps! I always say, the answer usually jumps right off the page at you.
