Buying a home can be complicated. So can understanding what makes up the components of a mortgage, even one as seemingly basic as a conventional, fixed 30-year mortgage. Balancing years of honed research skills and an understanding of interest rates, with the nuances of lending tactics, and natural behavioral biases further complicate the issue. Of course, being analytically inclined, I had five lenders prepare estimates for me based on nine desired scenarios. I wanted to see estimates for 10%, 15%, and 20% down, on 4.125%, 4.25%, and 4.375% interest rate options. For most, 45 estimates would lead to paralysis through analysis, but when looking for good bond options, there are often times several hundred offerings that need to be analyzed, first relative to each other and then fundamentally on an absolute basis. Nonetheless, if you think you had a tough time choosing a lender and deciding when to lock in a rate, be thankful you haven’t had the following conversation in your head:
“Well, two days ago (June 30th) the 10-year U.S. Treasury rate was 2.53%. Today, after the ADP employment report showed a larger than expected increase in private job creation (281K jobs versus expectations of 200K), the 10-year is up to 2.61%. Because of this rate increase the lender credit, or discount points, worth about $2,000 off closing costs for the 4.25% and 4.375% rate option has vanished. Sure that $2,000 is basically amortized over 30 years (comforting), but it’s also $2,000 gone based on one day’s stalled decision making (less comforting). Now, if I wait one more day until Thursday for the nonfarm payroll employment numbers (projected to be 215K) and the numbers disappoint relative to projections (say 175K new jobs), rates should fall back into the 2.50% range, and my lender credit might magically reappear, woohoo! However, the market seems to be pricing in the good news already with today’s higher yield. Therefore it stands to reason that rates stand to go down more with a negative employment surprise than they stand to increase with continued good news, since at least some of that good news is already factored into today’s rate. That leads me to believe I should wait a day to lock in the rate, since the magnitude of a rate decrease would outweigh a rate increase. To get one level deeper, the 281K in job growth was such a surprise, that the market may have thought it was too good to be true, so that today’s rate of 2.61%, while higher, is still skeptical. In that case, a reaffirmation of job growth with Thursday’s nonfarm payroll report equaling projections would cause a further rate increase (say 2.7%), contradicting my earlier theory.”
This is not made up. It’s how the analytical mind sometimes wanders in well thought out, but ultimately confusing directions. After an internal monologue like that it is necessary to snap out of it. More often than not, whether buying a home or a bond, trying to base your purchase decision on relatively small rate movements will cause you more headache than it’s worth. In this case, any mortgage whose rate has a “4” as the first number is a very good rate on a historical basis. Similarly, we may buy a bond with a 2.5% yield to maturity because it is a good rate that day relative to comparable bonds and the underlying credit is sound fundamentally. If tomorrow’s yield is 2.7% because interest rates moved, yes, the bond will decline in value slightly in the short-term (remember if you hold to maturity the bond repays you par value). However, interest rates can move down as easily as they can move up from day to day. If you like the rate or yield to maturity on that day and you have done your comparative homework, it is a sound purchase. We hope you enjoyed the comprehensive first person perspective on analyzing different types of fixed income investments.