Rate Reduction: Time to Refinance Your Mortgage?

March 21, 2001 -- Now that the Federal Reserve has cut interest rates once again, is it time for you to refinance your mortgage?

While history indicates that it may be, there are a few potential variables — from mortgage-backed securities to the Nasdaq Composite — to keep an eye on.

Though the Fed's stance on interest rates can signal a longer-term trend for the direction of mortgage rates, it's not inevitably the case. Investors who are trying to time the market might be disappointed with the results.

First of all, mortgage rates often move ahead of what the Fed does, say economists, making timing mortgage rate moves a tricky endeavor.

In 2000, for example, the Fed raised its key interest rates in February, March and May. Predictably, the rate on the 30-year fixed-rate mortgage rose steadily during the same time period, reaching a peak of 8.64 percent the week ended May 19, according to Freddie Mac. But after that, rates on the 30-year fixed-rate mortgage declined until the end of the year, when the rate hit 7.13 percent on Dec. 29, just a few days before the Fed lowered rates on Jan. 3, 2001.

"The market anticipated what the Fed was going to do," says Freddie Mac chief economist Robert Van Order. "In some sense, effects sort of precede their causes."

The Homeowners' Game Plan

If this is the case, what's a homeowner to do? At a rate of 6.97 percent for a 30-year fixed-rate mortgage for the week ended March 9, mortgages are hovering around their 30-year lows. At that rate, it probably makes more sense to go ahead and refinance.

"It's hard to believe that rates are going to get a lot lower," says Van Order. "It's not going to get a whole lot better than this. If you've got a good deal and you want to refinance, deferring it isn't going to make that much sense."

Plus, if you have a mortgage that has no points and no closing costs, if rates do go down dramatically, you can always refinance again, says David Beadle, president of BestRates Inc., which publishes an online mortgage site that provides mortgage rate information and analysis.

"The goal is to do a no-point, no-closing cost loan, then your timing doesn't have to be perfect — it just has to be decent," says Beadle.

The Nasdaq Variable

"Most people seem to feel that if the Fed cuts rates on the 20th, I should wait (to refinance)," agrees Barry Habib, managing director at New York residential broker Manhattan Mortgage. "That couldn't be further from the truth."

Habib offers a slightly different twist on why consumers should not wait for the Fed to move to refinance. His theory is that it's how the Nasdaq Composite reacts to a rate cut that is important for the direction of mortgage rates.

He says over the past few years, the yields on mortgage-backed securities, which are bonds backed by payments on mortgage loans, have tended to track the performance of the Nasdaq. Because the performance of these bonds determines the direction of mortgage rates, it is important to watch their performance, says Habib.

This relationship comes about because as the Fed lowers rates, investor confidence in the economy is boosted, sending them headfirst into the stock market. When that happens, bonds prices, including the prices of mortgage-backed securities, suffer as investors sell off their bonds to buy stocks. That activity drives down bond prices and increases their yields, sending mortgage rates up with them.

Perils of Prepayment

Another feature of mortgage-backed securities is that they have prepayment risk, which means that homeowners can opt to prepay some or all the principal amount of their mortgage at any time. So when interest rates fall, naturally, investors start jumping on the refinancing bandwagon.

Prepayments are bad for mortgage-backed investors because they then have to reinvest in bonds that offer lower interest rates. This puts even more selling pressure on mortgage-backed securities as these investors might opt for more attractive alternatives such as Treasurys. In short, all of this selling of mortgage-backed securities adds up to higher rates.

"If you want to find out what mortgage rates are doing, get a quote on mortgage bonds," says Habib. "If the Fed cuts rates [Tuesday] and the Nasdaq yawns at it, then we will see mortgage rates continue to improve."