Why You Must Get Out of Your Adjustable Mortgage Today

I don’t have a crystal ball but I follow the fundamentals and the market is screaming to get out of your adjustable mortgage if you have one as soon as possible. Here is why.

The federal funds rate is the interest rate at which banks lend their excess reserves to other banks which don’t meet the minimum reserve requirement established by the Fed.  Currently the banks park their excess reserves with the Fed for which they are paid 25 basis points.  Even though it’s known that the Fed controls this rate (by selling and buying securities to banks via the Open Market Operations) today we’re living in a climate of banks controlling such rate.  Their excess reserves which exceed $1.6 Trillion create a liquidity trap that keeps rates below what the market would otherwise dictate.  Take a look at the St. Louis Fed chart and ask yourself how much higher can these excess reserves go.

From 2009 until now the banks’ excess reserves grew exponentially. Such event occurred because the banks were selling securities (in many cases the toxic assets of the foreclosed real estate they held) to the Fed in exchange for dollars. In addition, they get paid a .25% to keep their reserves at the Fed.  This is the reason for which you see on this chart why their excess reserves spiked in a little more than two years.

For the federal funds rate to go up one of at least two events must happen.  The Fed sells securities back to banks thus reducing the banks’ excess reserves and contracting the money supply.  This scenario is not much likely to happen because Mr. Bernanke is a deflationist and he fears deflation.  Politically speaking he couldn’t do that even if he wanted to.  Why?  Because money deflation leads to Wall Street deflation and the artificially inflated stock market bubble would burst.  Such event cannot happen especially during an election year.

The next and a more plausible event to occur would be when banks will start lending again.  Banks are in the business of lending money therefore the question is how long will it be until banks start lending again?  Obviously it can’t go on indefinitely.

Of course, other events could happen which could trigger the rise in the rate. The collapse of the dollar, China decoupling its economy from ours, the dollar’s status of the world reserve currency replaced with another stronger currency, or a devastating inflation.

Without confusing the matter too much, when the federal funds rate is low generally your adjustable mortgage will be low.  When that goes up you can most certainly expect your ARM to go up, as well.  And it really doesn’t matter much to which index your mortgage is tide to.

I’ve been told over and over by hesitant property owners that if the rates go up they’ll sell the property.  If they can’t sell they will refinance.  Here is the problem.  For the past four years the real estate activity was sustained by sales of – what many would call – below market value properties.  Of course, that’s debatable because the real value is based on what the market dictates (based on supply and demand) and not on what the current owner thinks his property value is nor on what the outstanding balance on the underlying mortgage is.

For he who believes he can sell his property when rates go up I wonder what makes him think that in a higher rate environment his property would sell for the price he’d want to sell it for?  If his property doesn’t sell today when rates are low why would it sell later when rates go up?

The second option is to refinance when rates go up.  If you study the chart above you’ll notice that during the late 1970s the rate went up abruptly.  It wasn’t a slow and gradual increase, it was fast and furious. That increase was the result of the Fed’s contraction of money supply.

When today’s refinance loans take a minimum of two to three months, if not longer, it’ll take even longer time to close on a loan when rates start spiking.  Why?  Because everyone else who’s in that position will be standing in line to refinance (before the rate goes higher).  Not to forget that tomorrow’s fixed rates will be way higher than today’s.  And folks, you must understand that the rates cannot go any lower.  The chart above says it all.  The federal funds rate is close to zero now.

Getting a low fixed rate for as long of a term as possible is the solution to a not so distant problem.  It applies not only to those who have ARMs but also to those who have loans due to mature in the next few years.  If your loan has a prepayment penalty it should not deter you from being proactive.  The cost of waiting could be steep.  In the long run saving today by avoiding the penalty may end up costing way more in form of a high interest rate on your mortgage.