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I currently own a house with an ARM loan (with ~5 years left before it starts floating). I expect to move out in five years and would want to purchase another house and thus would be getting another mortgage (meanwhile prepaying the entire mortgage that I currently have). Chances are that the rates would be substantially higher by then. Is there anyway to lock in the historically low mortgage rate now and continue to finance the future property purchase?

Location: US

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    Pay off your home, and when you move use the 100% down plan. This way your interest rate will be locked at 0%. – Pete B. Mar 20 '17 at 13:26
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    @PeteB. Appreciate your comment, though it seems irrelevant to the question, which is about financing. BTW the "0%" comes with opportunity cost, but that's a different issue I suppose. – xiaomy Mar 20 '17 at 14:33
  • I would disagree about the relevancy. While quoting opportunity cost, do you also put a price on risk? Many in the mid-2000's failed to do so, and as such I thought ARMs were dead. Do you think interest only loans will be in vogue again soon too? – Pete B. Mar 20 '17 at 14:48
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    @PeteB. There is surely a price on risk, however in this particular scenario it seems to me that the risk is pretty limited / out of scope - I am not making any assumption about underlying property price, nor am I concerned about the expiry of the teaser period. If your argument is "do not purchase a property until you have accumulated enough wealth to buy it with cash", well, that's simply a matter of risk appetite and is rather subjective. – xiaomy Mar 20 '17 at 21:31
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First consider the basic case of what you are asking: you expect to have a future obligation to pay interest, and you are concerned that the rate when you pay it, will be higher than the rate today. In the simplest case, you could theoretically hedge that risk by buying an asset which pays the market interest rate. As the interest rate rises, increasing your costs, your return on this asset would also increase. This would minimize your exposure to interest rate fluctuations.

There are of course two problems with this simplified solution:

(1) The reason you expect to pay interest, is because you need/want to take on debt to purchase your house. To fully offset this risk by putting all your money in an asset which bears the market interest rate, would effectively be the same as just buying your house in cash.

(2) The timing of the future outflow is a bit unique: you will be locking in a rate, in 5 years, which will determine the payments for the 5 years after that. So unless you own this interest-paying asset for that whole future duration, you won't immediately benefit. You also won't need / want to buy that asset today, because the rates from today to 2022 are largely irrelevant to you - you want something that directly goes against the prevailing mortgage interest rate in 2022 precisely.

So in your specific case, you could in theory consider the following solution: You could short a coupon bond, likely one with a 10 year maturity date from today. As interest rates rise, the value of the coupon bond [for it's remaining life of 5 years], which has an implied interest rate set today, will drop. Because you will have shorted an asset dropping in value, you will have a gain. You could then close your short position when you buy your house in 5 years. In theory, your gain at that moment in time, would equal the present value of the rate differential between today's low mortgage rates and tomorrow's high interest rates.

There are different ways mechanically to achieve what I mention above (such as buying forward derivative contracts based on interest rates, etc.), but all methods will have a few important caveats:

(1) These will not be perfect hedges against your mortgage rates, unless the product directly relates to mortgage rates. General interest rates will only be a proxy for mortgage rates.

(2) There is additional risk in taking this type of position. Taking a short position / trading on a margin requires you to make ongoing payments to the broker in the event that your position loses money. Theoretically those losses would be offset by inherent gains in the future, if mortgage rates stay low / go lower, but that offset isn't in your plan for 5 years.

(3) 5 years may be too long of a timeline for you to accurately time the maturity of your 'hedge' position. If you end up moving in 7 years, then changes in rates between 2022-2024 might mean you lose on both your 'hedge' position and your mortgage rates.

(4) Taking on a position like this will tie up your capital - either because you are directly buying an asset you believe will offset growing interest rates, or because you are taking on a margin account for a short position (preventing you from using a margin account for other investments, to the extent you 'max out' your margin limit).

I doubt any of these solutions will be desirable to an individual looking to mitigate interest rate risk, because of the additional risks it creates, but it may help you see this idea in another light.

  • This is an interesting perspective. If I have unrestricted access to various financial instruments and markets, I suppose being a payer in a vanilla interest rate swap would satisfy my hedging needs. With the various constraints on capital and access to market, perhaps another way is to build option positions with a net positive rho to benefit from the likely rate hikes, which ties up less capital. – xiaomy Mar 22 '17 at 18:10
  • @max8126 Yes, there are various ways that you could generally hedge yourself against interest rate risk (in either direction), but the caveats I note above will typically apply to all of them. What may be hardest would be finding a product that you invest in today, with a time window that allows you, in five years, to sell that product, which at that point contains a value based on the interest rate from the following 5 years. To do all this would be quite a commitment to one specific type of financial risk (compared with all other financial risks we all face). – Grade 'Eh' Bacon Mar 22 '17 at 18:26
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You can't transfer mortgages when you purchase a new property. You can purchase a new property now, or you can refinance your current property now and leverage yourself as far as possible while rates are low.

The higher rates you are worried about may not be as bad as you think. With higher interest rates, that may put downward pressure on housing prices, or when rates do rise, it may simply move from historic lows to relative lows. I had a mortgage at 4.25% that I never bothered refinancing even though rates went much lower because the savings in interest paid (minus my tax deduction for mortgage interest) didn't amount to more than the cost of refinancing. If rates go back up to 5%, that will still be very affordable.

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    How does downward pressure on housing prices help you if you're both buying and selling? – R.. Mar 20 '17 at 3:01
  • As your own answer states, no one said anything about buying and selling at the same time. However the 5 year ARM certainly suggests a different mortgage would be ideal if he doesn't sell right away. – NL - Apologize to Monica Mar 20 '17 at 3:13
  • @NathanL Thanks for the answer. I agree that mortgage will probably still be relatively cheap for quite a while. However given the increasing certainty of multiple rate hikes and the general trend, I'd sure love to capitalize it if there is a way. Although it looks like in this context options are rather limited. – xiaomy Mar 20 '17 at 14:38
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If interest rates have gone up, don't sell when you move. Refinance to lock in a low rate and rent out your current house when you move. Let the rent pay your new mortgage.

  • Would the rent cover the new house with a mortgage at a higher rate? That doesn't have to be the case. Rental rates are dependent on a lot of local factors. Interest rates are only a small part of the rental picture. – NL - Apologize to Monica Mar 20 '17 at 3:14
  • Thanks for the answer. I have actually thought about this. It's doable but certainly more risky, since there are more moving parts as @NathanL has mentioned. Nevertheless it's an option worth looking into. – xiaomy Mar 20 '17 at 14:45
  • Assuming you're moving from/to places with comparable cost of living and with reasonable rental demand, it should. The good reasons against renting vs selling are usually matters of how it might cut into your time/attention you could spend doing more profitable or enjoyable things, not whether or not it's profitable. – R.. Mar 20 '17 at 17:06
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Outside of broadly hedging interest rate risk as I mentioned in my other answer, there may be a way that you could do what you are asking more directly:

You may be able to commit to purchasing a house/condo in a pre-construction phase, where your bank may be willing to lock in a mortgage for you at today's rates. The mortgage wouldn't actually be required until you take ownership from the builder, but the rates would be set in advance.

Some caveats for this approach:

(1) You would need to know the house/condo you want to move into in advance, and you would be committing to that move today.

(2) The bank may not be willing to commit to rates that far in advance.

(3) Construction would likely take far less than 5 years, unless you are buying a condo (which is the reason I mention condos specifically).

(4) You are also committing to the price you are paying for your property. This hedges you somewhat against price fluctuation in your future area, but because you currently own property, you are already somewhat hedged against property price fluctuation, meaning this is taking on additional risk.

The 'savings' associated with this plan as they relate to your original question (which are really just hedging against interest rate fluctuations) are far outweighed by the external pros and cons associated with buying property in advance like this. By that I mean - if it was something else you were already considering, this might be a (small) tick in the "Pro" column, but otherwise is far too committal / complex to be considered for interest rate hedging on its own.

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You could consider turning your current place into a Rental Property.

This is more easily done with a fixed rate loan, and you said you have an ARM.

The way it would work:

  • Refinance to a current fixed-rate loan (around 4.3%)
  • When you move in 5 years, convert your property to a rental property
  • Set the rent to cover your current mortgage payment plus the difference in interest rates
  • Use the rental income to pay off the extra cost of your new, more expensive mortgage.

If you can charge enough rent to cover your current mortgage plus the interest-difference on your new mortgage, then the income from your rental property can effectively lower the interest rate on your new home.

By keeping your current low rate, month-after-month, you'll pay the market rate on your new home, but you'll also receive rental income from your previous home to offset the increased cost.

Granted, a lot of your value will be locked up in equity in your former home, and not be easily accessible (except through a HELOC or similar), but if you can afford it, it is a good possibility.

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