How Good Are Current Mortgage Rates?

Mortgage rates are at record lows. And with the economy in a deep recession, they might stay there for the next few years. The economy will recover eventually, however, and at that point, rates are bound to increase. By how much? Take a look at the chart, below, which shows the recent history of 30-year mortgage rates.

Over the last twenty years, the average rate on 30-year mortgages has been about 7.5%. You could start by assuming that the future will look like the past, and that the average mortgage rate going forward will be 7.5%. The problem with that approach is that much of the historical variation in mortgage rates was driven by inflation, which arguably will be lower in the future. I've included a measure of inflation on the same chart. Although the correlation is far from perfect, it seems clear that mortgage rates have trended lower in response to lower inflation. That suggests that we should focus on the difference between mortgage rates and inflation, i.e., the so-called real mortgage rate.

Take a look at the chart, below, which shows the recent history of real mortgage rates. (It’s important to note that the real mortgage rate is an implied rate, which isn’t stated anywhere. I calculated it by subtracting the trailing one-year rate of inflation from the stated nominal mortgage rate.)

Unlike the stated nominal mortgage rate, the implied real rate has been fairly stable over time. (For most of the last twenty years, it remained in a band between 4% and 6%.) That's to be expected. Since it erodes the value of lenders’ capital, inflation should be regarded as a cost of doing business. Lenders will therefore subtract the inflation rate from the nominal interest rate in order to calculate the true return from lending money. In other words, lenders ultimately care more about real interest rates than nominal interest rates. Assuming that lenders' return expectations are stable over time, we'd therefore expect real mortgage rates to be stable as well, even when inflation fluctuates.

The average real mortgage rate over the last twenty years has been about 4.75%. Assuming that lender expectations are similar going forward, you can get a rough idea of where mortgage rates will be by adding an estimate for the expected inflation rate. Until recently at least, the Federal Reserve seems to have been comfortable with an inflation rate somewhere between 2% and 3%. If you split the difference and assume that inflation will run at 2.5%, that suggests a mortgage rate of around 7.25%. By way of comparison, mortgage rates are currently running at around 5.25%.

As I mentioned in an earlier blog entry, mortgage rates are likely to fall even further in the near term. In the long term, however, rates will probably go the other way. In fact, considering the massive amount of monetary and fiscal stimulus that is currently being provided, inflation and real interest rates are both likely to be higher than we've experienced in the last twenty years. But even if we're lucky enough to repeat the past, we're still in for a substantial increase in mortgage rates over the next five to ten years.

Borrowers with Adjustable-Rate Loans Have Some Breathing Room

A friend of mine told me today that she has a home equity loan, and said nervously that she hoped rates would remain low. I told her that she would probably be safe for awhile. But for how long? As luck would have it, Paul Krugman addressed this issue in his blog today, so he made my job easy. Take a look at the chart, below, which shows the history of the Fed Funds rate over the last twenty years.

The shaded regions indicate recessions, as defined by the National Bureau of Economic Research (the commonly accepted arbiter of recessions in the United States). According to the NBER, the 1990-91 recession began in July, 1990, and ended in March, 1991. The Fed didn't start raising short term interest rates until February, 1994, almost three years later. The 2001 recession began in March, 2001, and ended in November of the same year. The Fed didn't start raising rates until June, 2004, over two and a half years later.

Why did the Fed wait so long after the recessions had ended to start raising rates? The short answer is that while the economy had stopped deteriorating by the time the recessions ended, it was operating well below its potential. In other words, there was enough slack (read that, unemployment) in the economy that the Fed could continue providing monetary stimulus without fear of igniting inflation.

It seems reasonable to assume that the same thing will happen this time. In other words, the Fed Funds rate is likely to remain close to zero for at least two and a half years after the recession ends. When will that be? The consensus seems to be that the recession has at least another six months to run. Assuming that that's right, the Fed Funds rate will probably remain near zero through the end of 2011.

Most home equity loans are tied to LIBOR or the prime rate, which are in turn either directly tied to Fed Funds, or else are closely linked to it. If you have a home equity loan, my guess is that you'll be safe for at least another three years.