The “Yield Curve”; What It Is, and Why It Matters

After the 2008 meltdown, almost all of our borrowers insisted on only 30 year fixed rate mortgages b/c so many had heard horror stories about adjustable rate mortgages, or ARMs.

The ARMs that earned the bad rap, however, were primarily sub prime adjustable rate loans with short 2 year fixed periods and very steep adjustments.

The A Paper ARMs, such as the “5/1” and “7/1,” were and remain competitive and safe. But we still only encourage buyers to take ARMs if their time horizons are short (they know they will sell in five years).

The reason for this is that the Yield Curve has been relatively flat.

In other words, the rates for ARMs were only slightly lower than the rates for 30 year fixed rate mortgages, so there was no reason to take an ARM. Why not get the extra security of a 30 year fixed rate mortgage if the interest rate is almost the same as the ARM rate?

The term yield curve refers to the relationship of interest rates to the length of debt or loan maturities. Usually, the longer the maturity, the higher the rate. This is b/c there is more risk associated with a longer maturity, so investors demand higher rates of return (the higher the risk, the higher the return – Finance 101).

In other words, a loan with a 30 year maturity should have a higher rate than a loan with a 5 year maturity. If it does, it means there is a normal or positive yield curve.

If a 5 year ARM has the same rate as a 30 year fixed rate loan, the yield curve would be considered flat.

If a 5 year ARM has a higher rate than the 30 year loan, the yield curve would be inverted, meaning rates are higher for short term debts than they are for long term debts.

A sharply positive yield curve (when long term debt has much higher rates) indicates investors expect inflation. An inverted yield curve often means investors expect a recession (investors are willing to lock in lower returns in the long run b/c they expect things to only get worse).

We are seeing more competitive ARMs surface and if the Yield Curve gets steeper, we will start to encourage more buyers to take A paper ARMs that are fixed for 5 or 7 years.

Jay Voorhees at (925) 855-4491
Real Estate Broker, CA Bureau of Real Estate, BRE# 01524255, NMLS# 335646