Long-Term Bond Yields Drop Below 7% : A Win-Win Situation for Those Who Know How to Position Savings, Debt

Borrowers should benefit from the recent sharp drop in long-term interest rates to below 7%. And people with money in short-term savings accounts may not suffer much, if at all, because short-term yields in general haven’t fallen as much as long rates. That’s a remarkable win-win situation for those who know how to position their savings and debts.

Here are some answers to questions about capitalizing on lower long-term rates:

Q. What’s happened to interest rates?

A. Long-term rates, as measured by the benchmark 30-year Treasury bond, have plunged by roughly one percentage point since the beginning of the year--reversing their sharp rises of 1994. The moves have been particularly powerful in the past few weeks. In just one month, for example, the yield on 30-year Treasuries has dropped by about half a percentage point, falling to 6.94% on Tuesday from 7.43% at the beginning of April.

Short-term Treasury security rates have also eased, but not as much as long-term yields.

Q. How does that affect mortgage rates?

A. The effect on mortgage rates is disparate because adjustable-rate mortgages are linked to short-term rates, while fixed-rate mortgages are affected by long-term rates.

Fixed-rate mortgage prices have plunged, while adjustable rates are only slightly lower than they were in January, says Paul Havemann, a spokesman for HSH Associates, a Butler, N.J., rate-tracking firm. Because of the way adjustable rates are calculated, the impact of the recent declines in short-term rates have taken longer to affect ARMs.

For example, Countrywide Mortgage is currently quoting 7.75% for a 30-year, fixed-rate mortgage for borrowers who agree to pay 1.5 points--a fee based on a percentage of the loan amount--upfront. A year ago, the comparable loan was at 8.75%, says Rick Cossano, a Countrywide executive vice president.

On the other hand, Countrywide’s adjustable rates have risen from about 5.5% a year ago to about 6.25% today, he says.

Q. Does that mean it’s time to refinance into a fixed-rate mortgage?

A. Maybe. If you have an adjustable-rate mortgage--or a higher-rate fixed mortgage--it may be time to think about refinancing, says David Lereah, chief economist at the Mortgage Bankers Assn. in Washington. Lereah estimates that about 5 million homeowners will be hit with steep rate hikes on their ARMs this year. Many of them could save money by locking in a fixed mortgage at today’s rates, he says.

However, most lenders charge refinancing fees. Before refinancing, you should make sure the monthly savings you’d get would more than pay for the refinancing costs in the time you plan to stay in the home.

Q. How much would I save on my monthly payments if I did refinance?

A. Obviously, the answer depends on the mortgage amount and interest rate. However, if you shaved one percentage point off a 9%, $100,000, 30-year loan, you’d save about $70 a month, or $840 a year.

Q. Is the payment on my adjustable loan likely to drop when it’s recalculated next?

A. Probably not. Adjustable loan indexes, such as the one-year Treasury bill index and the 11th District cost of funds index, have fallen relatively little so far.

Moreover, many ARM borrowers are playing catch-up and will find themselves paying more because interest rates rose so sharply in 1994.

Q. Why would I still be paying for a 1994 interest rate change?

A. Many ARMs have annual interest adjustment caps. These keep the loan cost from rising too sharply when rates are climbing. However, they also cause you to play catch-up in years following sharp rate hikes because your “fully phased-in” rate may have been higher than last year’s rate cap would allow.

For instance, consider John Q. Adjustable, who has a loan that adjusts just once a year and has a fairly standard two-percentage-point rate cap. He pays a rate that’s three percentage points above an index that was at 3% in 1993. Consequently, his 1993 rate was 6%.

In 1994, his index shot up to 6%, which should have sent his loan rate soaring to 9%. However, the interest rate cap kicked in, keeping his 1994 rate locked at a maximum of 8%. However, he gets hit with the other one-percentage-point hike in 1995, assuming the index stays flat.

Q. What’s happening with auto, home equity and credit card loan rates?

A. Very little. Generally, interest charges on auto, home equity and credit card loans are more closely linked to changes in the prime rate. And the prime rate, which is currently 9%, hasn’t changed since the beginning of February.

Q. What makes the prime rate move?

A. Banks tend to change the prime when the Federal Reserve Board officially raises or lowers its own short-term lending rate to banks. Even though the market has pushed longer-term yields down as the economy has slowed, it’s not clear that the Fed will definitely cut short-term rates any time soon. The Fed may wait for much more evidence that the economy has cooled off.

Q. What about the interest I earn on my savings? Is that dropping too?

A. The good news is that short-term savings rates--particularly on money market mutual funds and on short-term CDs--have actually risen a bit this year, says Martin Bradshaw, publisher of RateGram in Issaquah, Wash. The top-yielding money market mutual funds are now paying 6.21%, compared to about 6% in January.

However, rates on longer-term savings vehicles--such as five-year certificates of deposit--have fallen almost as sharply as mortgage rates. There’s currently very little advantage to putting your money in longer-term accounts, Bradshaw says.

Q. What about other savings vehicles, such as U.S. Savings Bonds?

A. Savings Bond rates are incredibly complicated because they can be calculated in a variety of ways, depending on when you bought the bond and how long you own it. New bonds yield a variable rate that’s equivalent to 85% of rates on one- or five-year Treasury securities. (If you hold the bond longer than five years, your rate is linked to five-year Treasury notes; if you own it less time, your rate is linked to one-year Treasury bills.)

However, many people who bought the bonds in the past have interest rate floors of 4%, 6% or 7.5%, depending on when they bought the bond.

Those who are unsure about how much their Savings Bonds are yielding in today’s environment can call the banks or brokers from which they bought the bonds.