The foundation for our next financial crisis is being laid right now. The question isn’t whether we will have another, but when. The biggest clue can be found on websites where you can search for mortgages to purchase or refinance a house. On my last visit to bankrate.com, for instance, a person with good credit (score of 740 or higher) and a 20 percent down payment could expect to pay about 3.5 percent for a 30-year fixed rate mortgage or as little as 3.0 percent for a 15-year fixed rate mortgage.
This is very cheap money. So cheap it expands the pool of potential homebuyers. It allows homebuyers to buy larger homes. It allows home refinancers to reduce their monthly payment burden. It makes debt the new thrift, and refinancing as good as saving. Low interest rates aren’t all bad.
Skeptics should consider this quick exercise. If you have a $200,000 mortgage at 5 percent interest, refinancing it down to 3.5 percent will reduce the monthly payment from $1,074 to $898, a saving of $176 a month or nearly $2,112 a year. (Yes, this is less than the nearly $3,000 of interest saved in the first year, but let’s be conservative.)
To earn $2,112 a year in interest on the highest yield one-year bank CD quoted on the bankrate.com website, a yield of 1.1 percent, you would need to deposit $192,000. To earn that $2,112 a year in what bankrate.com quotes as the national average yield of 0.32 percent you would need to deposit a whopping $660,000. This means careful refinancings— including automobiles— are producing better “yields” than we can get on money saved. Debt really is The New Thrift. (Of course there is a bit of apple and orange in this because we’re moving from 30 year borrowing to 1 year CDs, but the reality is that most of us don’t want to put money away for 30 years.)
This is all good news, at least for borrowers. For savers, not so much.
But you knew that.
What’s worrisome here is what’s going to happen to the market value of all these mortgages when, and if, interest rates return to more normal levels. When that happens, the institution holding the mortgage will be holding a loan whose market value is far lower than it’s face value. Suppose, for instance, mortgage rates rise to 5 percent over the next 5 years. At that point a 3.5 percent 30-year mortgage that is new today will have a term of 25 years and an outstanding balance of $179,768 but its market value will be $153,627.
That’s a loss of 14.5 percent, a loss that would wipe out the equity of most lenders. If mortgage rates rise to 6 percent over the next 5 years, the market value of the mortgage will be $139,390. That would be a loss in market value of 22.5 percent.
The same holds true for shorter-term loans such as the 1.99 percent auto loans that are becoming common . Were interest rates to rise quickly to 5 percent, every $1,000 of new 1.99 percent five-year car loan would sink in market value to $928. That’s a loss in market value of about 7 percent, enough to threaten the solvency of the lender.
Note that we’re not talking financial Armageddon and runaway inflation here. We’re just talking about a return to interest rates that are on the low side of what we’ve seen over the last 50 or 60 years. Indeed, for some readers this will be a case of “deja vu all over again”— rising mortgage rates would be a replay of what was experienced in the 1970s, an event that culminated in the thrift crisis, destroyed the thrift industry and produced a financial crisis that paralyzed the real estate industry for years.
Can we find a silver lining somewhere in this dark cloud? You bet. First, let’s not fret about our financial institutions; they already own Congress and can take care of themselves. The silver lining is for younger families: higher future interest rates amount to a major wealth transfer. Lenders will lose, borrowers will gain. Younger households may be able to recoup some of their losses from the last decade as home prices rise and the true value of mortgages declines.
Scott Burns is the retired Chief Investment Officer of AssetBuilder, the creator of Couch Potato investing, and a personal finance columnist with decades of experience.