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That 3% Mortgage Just Keeps Getting Better

A resident rakes grass clippings after returning to his home, where the only damage occurred to a garage and patio in the backyard, in the Timberlea neighborhood of Fort McMurray, Alberta, Canada, on Wednesday, June 1, 2016. Residents began returning home Wednesday and companies are resuming operations after Alberta wildfires forced the evacuation of more than 80,000 people from Fort McMurray and knocked more than 1 million barrels of production a day offline this month. (Photographer: Bloomberg/Bloomberg)

The economy has been stronger and inflation stickier than markets and forecasters expected at the start of 2023, prompting traders to place bets that the Federal Reserve could ultimately raise rates as high as 6% — a level not seen since 2000. That would have big implications for the housing market and particularly for homeowners who locked in a low mortgage rate early in the pandemic.

We’ve already seen homeowners grow reluctant to sell their houses because it would mean giving up their cheap mortgages. Now ever-escalating short-term interest rates are going to make it possible for them to turn their financial position into the kind of carry trade that would be the envy of a bank or hedge fund.

We’re seeing an extraordinary dynamic right now — millions of homeowners with low mortgage rates, easy access to low-risk, high-yielding investments and low unemployment. Someone in 1980 who had a 9% mortgage while Treasury notes were yielding 12% and inflation was approaching 15% — with the unemployment rate north of 7% — was more likely consumed by the volatility and uncertainty in the economy than thinking about how to buy bonds that yielded more than their mortgage.

Since the early 1980s, we’ve generally been in a falling interest rate environment that led homeowners to refinance at a lower rate, rather than viewing their mortgage as cheap debt that gave them space to finance higher-yielding investments.

That brings us to today, when we have millions of homeowners with mortgages issued during 2020 or 2021 at rates of 3% or even less — $5.5 trillion in mortgages were refinanced during those two years. Meanwhile, Treasury bills maturing in less than a year now yield 5%. And the unemployment rate is at 3.4%, so homeowners are operating in a labor market where there is very little risk of a prolonged stretch of unemployment. In the housing market, stability, as opposed to a crash, is how the year is shaping up.

So how can someone with one of these cheap pandemic mortgages take advantage of their situation? If it was a corporation, issuing debt at a low interest rate before a surge in interest rates would create the opportunity to buy the bonds back at a discount. For instance, Apple issued $1.75 billion of 40-year bonds at 2.55% in 2020 before the existence of Covid-19 vaccines and when it was unclear if the Fed would ever raise interest rates again. Those bonds now trade around 60 cents on the dollar — if it wanted to, Apple could buy those bonds back in the public markets, earning a nice profit for its fortuitous timing.

But homeowners can’t do that. If you’re a homeowner with a 3% mortgage you obtained when you bought or refinanced your home in 2021, that mortgage bond is currently worth about 85 cents on the dollar. If you have a $300,000 mortgage, you have an intangible asset worth around $45,000, but you can’t go back to your lender and ask for a check. What you can do is treat it as cheap credit that can finance higher-yielding investments.

There was an aphorism in the mid-20th century known as the 3-6-3 rule that described the sleepy regulated banking world of that era. It referred to bankers who collected funds by paying 3% interest to depositors, lent out that money at 6%, earned the spread between the two rates and made it to the golf course for a 3pm tee time.

And while that may have been more fiction than fact, it’s the kind of situation many homeowners could find themselves in this year. Their low mortgage rates mean they’re borrowing at 3%. Nearly risk-free investments like Treasuries now yield as much as 5%, and that rate seems likely to increase over the next several months as the Fed continues to raise interest rates.

In a case where someone has a $300,000, 30-year mortgage with a rate below 3% while also having $300,000 available in cash, interest rates on low-risk short-term investments are getting high enough to generate income that can cover principal, interest, taxes and insurance on a mortgage. That would essentially allow them to live in their house for free before maintenance costs.

This is an illustration of the dynamic that’s going to keep a lid on the inventory of homes for sale until interest rates start falling again. It’s not only that homeowners don’t want to swap out of a low mortgage rate for a higher one on a new property. Why would anyone want to pay off a $300,000 loan at 3% when they can invest essentially risk-free at 5% or more? It’s a way they can make high interest rates work to their advantage.

While anyone can earn that same income off Treasuries, it’s a peculiarity of our times that for some fortunate homeowners with the cash to invest, there is an easy way for investment earnings to actually cover the cost of their mortgage — at least as long as interest rates remain high.

More From Other Writers at Bloomberg Opinion:

• Gaming Mortgage Rate Locks Will Only Cost You: Alexis Leondis

• Safe as Houses Again, or the Next Big Crisis?: John Authers

• Save for a Home or Retirement? Choose the Latter: Erin Lowry

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Conor Sen is a Bloomberg Opinion columnist. He is founder of Peachtree Creek Investments.

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