Interest expense is falling for those who refinance their mortgages.
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Mortgage interest rates are falling, but they’ll drop even more in the coming weeks, giving some 18 million homeowners an opportunity to save money by refinancing.
Key interest rates dropped sharply in the early days of the pandemic, but mortgages rates did not follow in pace. The spread between 30-year fixed-rate mortgages and the yield on 10-year treasury bonds usually runs between 1.5 and 2.0 percentage points. That spread rose, though, hitting a peak of 2.71 percentage points in April. Since then, mortgage rates have come down well below three percent (as of August 6, 2020), bringing the spread down to 2.33 percentage points. That’s good news for today’s borrowers, even though the spread remains above long-term norms.
To see how much further mortgage rates will drop, we need to understand why the spread rose so high. This is the crucial question, because the 10-year treasury yield is very likely to remain low in the near future. As of this writing it is just 0.55%.
Most mortgages except jumbos are originated by a bank or mortgage company, then sold to a federal agency, usually Fannie Mae or Freddie Mac. The agency guarantees repayment of the loans and budnles them into securities sold to institutional investors. In recent years the Federal Reserve has been buying many of these mortgage-backed securities.
The huge volume of refinances—up 84% from a year ago, according to a Mortgage Bankers Association report—was a bit much for the market to digest. Investors hesitated to buy all of the supply, causing interest rates on wholesale mortgages to rise.
Compounding this was a rise in retail spreads. The local bank or mortgage company that makes the loan will resell that loan to an agency, pocketing a spread. This is just like your neighborhood grocery store buying bread wholesale and selling at retail prices to consumers. When mortgages rates dropped, millions of savvy homeowners tried to refinance—all at once. The mortgage originators had trouble scaling up. Some were hesitant to hire new employees, and even those who hired had to train the new workers during the Covid-19 pandemic.
Mortgage originators take some risk. Although they will sell the mortgages, so a default down the road isn’t a big problem, there’s always a chance that something goes wrong between making the loan and reselling it. Originators may also find that mortgage rates have changed from when they made their commitment to the borrower. And the longer the mortgage process takes, the greater the risk. With huge increases in volume, processing times were sure to lengthen. Mortgage originators pushed up their spreads both to compensate for their higher risk and because they couldn’t handle all the volume coming at them.
Spreads have fallen in recent weeks, helping homebuyers as well as refinancing homeowners. Banks and mortgage companies have succeeded in gearing up their operations for higher volumes and are now willing to accept lower profit margins to fill their pipelines. They should be able to work through the backlog of would-be customers. But remember that as they bring mortgage rates down, more people will step up to refi. Black Knight recently reported, “As of July 23, with the 30-year rate at 3.01%, there were still 15.6M refinance candidates that met broad-based underwriting criteria, which included being current on their mortgage, having a credit score of 720 or higher, and having at least 20% equity in their homes. These refinance candidates could also reduce their 30-year interest rate by at least 0.75% through a refinance, with an average savings of $289 per month and an aggregate savings of more than $4.5B per month if each of those homeowners were to refinance their mortgage.”
They had estimated 18 million refi candidates earlier when mortgage rates were lower, so potential demand is very sensitive to interest rates. That means the decline in mortgage rates will be gradual.
How far will they drop? The spread between 30-year fixed rate mortgages and 10-year treasuries is now 2.33, and it should come down to at least 2.00. However, treasury rates are pretty low and could easily rise again by 5 or 10 hundredths of a percent. The latest mortgage rate reported by Freddie Mac as of this writing is 2.88%. That could easily drop to 2.65%. A more significant drop is possible. The spread is often as low as 1.5 percentage points, which could pull the mortgage rate down close to 2.0%.
Someone is sure to ask just exactly when to refinance, or at what rate to pull the trigger. Wait for 2.65% or hold out for 2.05? There’s no sure answer. A good strategy is to get in the ballpark, do the deal, and not regret having missed the very best possible rate.
Jumbo mortgage rates have dropped a lot in the last month, probably thanks to better economic news. Most jumbos are held by banks because they are not guaranteed by Fannie Mae or Freddie Mac. The lender worries about credit risk: will the recession prevent the borrower from being able to make payments. Conventional mortgages are risk-free so long as they conform to agency guidelines, but that’s not the case for Jumbos. Look for jumbo rates to decline gradually as the economic outlook improves.
