Especially good to keep in mind for borrowers who are trying to negotiate payoff amounts for fixed term loans. A 5% interest rate increase means you can potentially negotiate a loan payoff for significantly less than you owe for loans that have multiple years remaining. Has anyone been successful at this for consumer loans recently?
The rate for fixed rate mortgages is now around 4-5% p.a. If you had taken out a 30-year fixed rate mortgage for $100k when rates were around 1%, you can now prepay it for just $70k, i.e., at around a 30% discount.
Another interesting feature is that the mortgage can stay with the property when it is sold (subject to the lender approving the new owner). This means that the current economic value of the mortgage can be factored into the purchase price.
> If you had taken out a 30-year fixed rate mortgage for $100k when rates were around 1%, you can now prepay it for just $70k, i.e., at around a 30% discount.
Maybe this is a dumb question, but could you finance the prepayment with a new mortgage?
This isn't optimal money management. If you have a loan at below market rates, pay it off as slow as possible. Instead of using $70k to pay it off, invest the $70k in something that pays more than the 1%. You'll monetarily be much better off.
In other words, borrow money at a lower interest rate, and invest it at a higher interest rate. You make money on the difference.
A friend of mine who I helped coach through financing his car, did just that. The interest rate at the time was the market rate, and I advised him to accelerate his car payments. But interest rates have risen so much, I advised him to switch to making minimum payments. He caught on quick :-)
It is fixed exactly until my loan is due.
Then there is a slight chance that you can convince the bank to give you a bonus for refinancing with them.
Edit: Although if the bank was mismanaged into a bad liquidity situation, they might want to offer an even better price than the difference between treasuries would provide as incentive.
edit to add:
Also, in the context of loans/notes/bonds, duration refers to sensitivity of the price of the instrument to a small change in interest rates.
Knowing the duration of the instrument is all you need, it is very odd to say 'by approximately 1% per year of duration' If the duration is 4 yrs, a 100bp increase in rates will result in a 4% decline in the price of the bond.
The problem is that the bank is carrying the loan on its books and pretending it has full value. Negotiating that improves their actual financial position, but requires recognizing the loss that they are trying to ignore. If the stop ignoring it then they are possibly going to fail.
That is why the banking sector badly needs such a giant bailout right now.
The main problem is if they switch any loan from "to maturity" to "to market", every loan has to switch or none.
If you want to estimate current dollars, and forecast dollars at the end of the month, quarter, year, etc; that's fine too, and would probably give a better picture of the books than wrong math where current and future dollars are compared directly as if they were the same.
Mortgage banks drove the UK bankrupt cap in hand to the IMF in 73 with far far less of a rates delta than is happening now.
Edit : there was a similar breakdown of society as is happening already today almost everywhere , back in 73 in the UK. The main difference is that the banks managed to put much more of the pain onto the common man since then.
But even if that happens, the delta between book value and market value for the banks is mostly covered by shareholder equity, so banks may fail but the system should be fine.
Do you mean that you could refinance it to defeat the rule of thumb?
Suppose then prevailing rates go up to 10%. Now you have incentive to take less than a million dollars if I pay it off now. You could take the million bucks and lend it back out at 10% now, but you're stuck with 5% with me.
The question is "how much incentive/how much less would you rationally take?"
Do they?
https://www.federalreserve.gov/monetarypolicy/reservereq.htm
> meaning the total money they can lend out isn't infinite and therefore the money they lent to me they might wish to have back and lend it out to someone else at the higher rate.
That's assuming they have someone else to lend it out to who is not only equally creditworthy, but equally creditworthy at the higher interest rate and therefore payment amount.