How the market is mispricing mortgage rates

House and coins on scales

In previous posts we have shown you how to save tens of thousands in mortgage interest by leveraging short-term rates and repaying your mortgage faster. In this post we show you that long-term rates are overpriced, and that whilst mortgage rates will increase, it won't be nearly as fast as the media banter would suggest.

Summary

  1. Mortgage rates will increase, but to a lesser extent than wholesale rates.
  2. Long-term mortgage rates are 1.00% higher than they should be and are not good value.
  3. Short-term fixed rates offer the best value for money.

Interest rates will increase

I am in no doubt that we will see mortgage rates increase. I simply think the market has overcooked how quickly, and by how much, mortgage rates will rise. The main issue is that when commentators talk of large rate increases they are often talking about wholesale interest rates and the Reserve Bank's official cash rate (OCR). The mistake that is easy to make is to draw a parallel between wholesale rates and mortgage rates. Mortgage rates did not drop as far as wholesale rates. So when short-term rates do start to increase the opposite is also true: mortgage rates will not increase as fast as wholesale rates. (I have attempted to show this is a diagram later in the post.)

Bank funding costs

Before we dive further into this post I need to explain some terminology upfront. Wholesale interest rates reflect the price that banks are prepared to swap the interest received on mortgages and paid on deposits. The margin (gross profit) on a mortgage is the difference between the mortgage rate and the wholesale rate. Mortgage margins have increased by almost 300% between 2007 and 2009 from 0.80% to 2.30%. Given the massive increase in margins, the natural conclusion is that banks are creaming it. Not true. At the same time mortgage margins have increased, deposit margins have gone from being positive to negative. Banks are having to write deposits at a significant loss to help fund their mortgage books. You can get a six-month term deposit paying 5%. This is 1.50% above the wholesale rate so banks are writing these term deposits at a loss of 1.50%. What you can see is that although the OCR is 2.50%, banks have to pay much higher rates than this to retain deposits. In other words banks actual funding costs are much higher than wholesale rates (and especially the OCR.) This is why some commentators have said the Reserve Bank became ineffective towards the end of its rate cuts and why banks were seemingly slow to pass the benefit on.

Higher interest rates will lower mortgage funding costs

That almost sounds counter-intuitive. When interest rates eventually increase, deposit rates will not need to increase as quickly. In fact, I suspect headline deposit rates won’t change much at all. And as deposit margins improve, this will allow mortgage margins to drop from around 2.25% today to around 1.50%. Bear in mind that 1.50% is still a very high margin from a historic perspective.

Mortgage and deposit margins change through an interest rate cycle. When rates fall, wholesale rates fall further than mortgage rates or deposit rates, causing mortgage margins to expand and deposit margins to contract. The opposite happens when rates rise.

Implied rates

In this next piece of analysis I compare the implied forward curve (market-based forecast) for both wholesale rates and mortgages. What you can see is that it implies increasing margins.

As we have explained, mortgage margins will contract, not increase. As such long-term mortgage rates are clearly overpriced.

Based on where wholesale rates are today, the fair value for the five-year fixed rate is about 7.50%. Even at this price, I think the market is overly optimistic on our economic recovery. I still prefer shorter-term rates.