What is a yield curve & how does it relate to mortgages?

If you were fortunate enough (or unfortunate, as the case may be!) to have taken an Economics course in school, you probably recall hearing something about a yield curve. Never ever believing that it could someday be useful, you probably put it to rest somewhere in the gray matter of your brain. Well time to wake up and utilize it to help you make a wise mortgage decision.

Alan Greenspan might define a yield curve as “a graphic depiction of the relationship of a group of interest rate sensitive securities sharing to a great extent a series of quite common characteristics but varying greatly with respect to ultimate and precise maturity”. We define it as the relationship between interest rates and term of loan.
While there are many shapes to yield curves, the three most common shapes in our world are: “flat”, “normal” and “steep”.

To illustrate each of these, we will use, three, five, seven and ten year Intermediate Adjustable Rate Mortgages (learn more about these by going to Loan Programs and then Intermediate Adjustable Rate Mortgages on this web site) along with fifteen and thirty year fixed rate mortgages.

A perfectively flat yield curve finds rates for 3, 5, 7, 10, 15 & 30 year mortgages all equal to let’s say 5.500%. It would look like the illustration below:

While this would be quite unusual, if a borrower had to make a choice in this type of interest rate environment, the obvious selection would be a 30 year mortgage because it would have the exact same rate as a 3 year mortgage, that being 5.500%.

Next let’s look at what might be considered a normal yield curve. A normal yield curve would exist in an interest rate climate where the FED has neither an interest rate tightening or easing bias. (Learn more about the FED by going to What is the FED’s Role in this section of our web site). In other words, the FED would be neutral and the yield curve would have a gentle, ascending slope as reflected below.

"Normal Yield Curve"
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In this type of interest rate environment, a borrower could expect a reasonable increase in interest rate as the loan term was extended. In other words, a borrower mortgage decision should not be significantly influenced by the shape of a normal yield curve.

Now let’s look at what might be considered a steep or steepening yield curve. A steep yield curve would exist in an interest rate climate where the FED was acting in a manner to stimulate the economy. That is the FED’s credit policy would have an easing bias putting pressure on short term interest rates to decline.

"Steep Yield Curve"
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In this type of interest rate environment, a borrower could expect to pay a substantial premium for extending the term on their mortgage. What would a borrower gain from paying a premium for a longer term mortgage? Probably not much. This is due in part to the economic theory that supports the premise that as the FED begins to lower short term interest rates to stimulate the economy, long term rates will eventually begin to decline, thereby providing an opportunity for the borrower to go long term at a lower interest rate.

This is a very interesting environment for us and as such we tend to have a bit of fun with it. Take, for example, a borrower who is debating between a 7 year rate of 5.00% and a 30 year rate of 7.50%. Let’s further assume that the borrower is seeking a $300,000 mortgage. Given the substantial cost for extending the loan term from 7 years to 30 years, we might suggest that a borrower select the 7 year term (5.00%) but actually make a payment as though the 30 year term (7.50%) was selected.

$300,000 @ 7.50% generates a monthly payment of $2,097.64
$300,000 @ 5.00% generates a monthly payment of $1,610.47

So the question is whether to select the 7 year rate or 30 year rate committing in either case to a monthly payment of $2,097.64. The remaining balances after the 84 month term for both options are amazingly different.

After 84 pmts. of $2,097.64 @ 7.50% the balance would be $275,502.06
After 84 pmts. of $2,097.64 @ 5.00% the balance would be $214,957.48

Told you we could have fun with this!

Finally, let’s look at what might be considered a flat or flattening yield curve. As you will see, it is not “perfectly flat” as illustrated earlier. But rather, it has a much more moderate slope compared to either the normal or steep curve. A flat yield curve would exist in an interest rate climate where the FED was acting in a manner to slowdown the economy. That is, the FED’s credit policy would have a tightening bias, putting pressure on short term interest rates to increase.

"Flat Yield Curve"
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In this type of interest rate environment, a borrower could expect to pay only a slight premium for extending the term of their mortgage. This environment is particularly interesting for a borrower who is “reasonably certain” that they will not be residing in a property for more than 7 years. “Reasonably certain” can mean different things to different borrowers. Take, for example, a family with three children, ages 12, 14 & 16, living in a 5000 square foot home, a family that is reasonably certain that they will be selling their home once their youngest has completed high school. In this example, it seems fairly certain that this family would downsize their living arrangement and, as such, we would not advise them to seek a longer term mortgage, regardless of the slight premium.

On the other hand, take a family with two small children and one on the way, living in a comparable 5000 square foot home, claiming they are “reasonably certain” they will not be in this home in seven years……..because, “we have never lived in a home over 5 years”. In this example, we might tend to encourage the borrower to consider the longer term mortgage with only a slight interest rate premium.

Even though in the long run it is all economic gobbledygook, we have a very good understanding of the concept and, as such, can provide you with some interesting perspectives and options before making a mortgage decision.

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