If you are not the lucky few who have locked in a 30 year mortgage at a fixed rate of around 1%, then read on. In this article I talk about the high mortgage interest rates in the USA and Canada and strategies that can help improve your financial health by lowering your Interest Expense.
Rates are High
The above picture is a graph of the US Federal Reserve Federal Funds Rate. The x-axis is the time period ranging from 1997 to present.
The y-axis is the interest rate. As you can see, interest rates have been low over the last fifteen years. The last time rates were this high was just before the great financial crisis.
Why should you care about the US Federal Funds Rate?
The Federal Funds Rate is not the rate that Banks charge for Mortgages. But, it is the rate that is used by Banks to calculate the Mortgage Rate for you. The calculation depends on the Federal Rate (which can be thought of as the minimum rate) and your credit score among other things.
So, if the Federal Funds Rate goes up, the Mortgage rate offered by the Banks will certainly go up. The opposite is usually true as well. Bank of Canada is an independent institution but its actions are highly correlated to the actions taken by the US Federal Reserve.
Why should you lower your Interest Expense?
Interest Expense is the interest you pay on the mortgage amount that you borrow from the Bank. It is a cost. Think of it as a type of rent. A rent for the amount borrowed. You would want to lower the total interest paid to the Bank so that:
- You can keep more of your money and grow your investments to achieve FIRE sooner
- You can pay off your mortgage sooner and accelerate the equity in your house which can be of use in several ways like a rental property or selling to realize price appreciation etc.
Will rates go up further?
This is not knowable for certain. But, based on the Yield curves for 2-year, 5-year and 10-year treasuries the rates are ‘Expected’ to start to come down starting late this year (2023). The keyword here is ‘Expected’. The Fed is fairly independent and can make decisions quickly similar to how they drastically cut rates during Covid.
rates are ‘Expected’ to start to come down starting late this year (2023)
Now that we have some background on interest rates and expectations around rates for the future, let’s look at strategies to lower your interest expense.
Strategy for making payments on your mortgage
The Strategy depends on a key assumption.
You believe that rates are going to go down in the future i.e. 1 -2 years.
Given this assumption, here is how the strategy works. I explain it using a couple of examples.
Example 1
Let’s say your current mortgage rate is 5% and a savings account yields 4.5% interest on deposits.
Then, you are better off aggressively paying your mortgage. This could mean moving some of your funds in savings accounts to paying your mortgage. I would recommend not touching funds in your emergency savings accounts.
The reason here is that your mortgage rate is higher than a savings deposit rate. If you choose to keep your money in a savings account you would gain only 4.5% but you are paying or to be more accurate , you are accumulating interest payable on your outstanding mortgage at a higher rate, i.e. 5% in this example.
Example 2
Let’s say your current mortgage rate is 4% and a savings account yields 4.5% interest on deposits.
Then, you should pay the minimum mortgage payments that will not result in any penalties and keep the rest of your money in the savings account.
The reasoning is similar to the previous example. In this scenario you are accumulating interest at the rate of 4% on your mortgage but you are able to earn 4.5% on funds that are in your savings accounts.
Strategy to Renew/Refinance
If variable now then renew to be on variable.
If you have a variable rate mortgage. i.e. changes immediately when the benchmark rates change. (These types of mortgages are mostly prevalent in Canada and in the US a slightly different flavor exists as ARMs-Adjustable Rate Mortgage. )
And you have to make a decision/make a choice within the next few months between a variable or a fixed rate mortgage.
Then, I would recommend renewing your mortgage to a variable rate.
If fixed now then Renew to variable
If you are on a fixed rate and the rate is higher than any available Savings Deposit or Fixed Income securities yield rates then I would recommend looking for opportunities to renew it to a variable rate mortgage/ARM in the US .
New mortgage – Choose Variable
Go for variable or ARM – Adjustable Rate Mortgage. To reiterate, this is based on the assumption that the interest rates are expected to come down over the next year or two.
Execution and Monitoring
The strategies described above are broad. When it comes to executing them, you will have to take into account your own personal finance situation – Things like your level of emergency funds, expected future expenses, job stability, bank fees and penalties when it comes to renewing/refinancing and so on.
The current economic situation is quite volatile. The pace at which the US fed reserve has increased rates is one of the fastest in history. So, I highly recommend you to keep a tab on the rates and the direction in which the rates are moving.
In any case, never stop shopping for better rates – both on your mortgage and on your Savings.