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Bernanke Gets Mortgage Refinance – Signs of Inflation?

Written By:
December 21, 2011 at 3:37 AM

Recently, Federal Reserve Board Chairman Ben Bernanke mortgage refinanced his 2,100 –square foot townhouse, purchased in 2004 for $839,000. According to public records, Bernanke owes $672,000 for the property, which appraises for $850,000. He has refinanced his home twice -– the later part of 2009, and in September 2011. The second mortgage refinance came after the Feds announced Operation Twist, a monetary policy designed to keep long-term interest rates in check.

Traditionally, financial wisdom advises homeowners to payoff their mortgage by the time they approach retirement age. In a contrarian move, Bernanke, who is 58, decided to buck conventional thinking, as he signed on to pay a mortgage well pass his retirement years. Choosing to employ this strategy so close to retirement, comes down to a personal choice. It depends on an individual’s financial circumstances and must take into consideration any associated risks.

The chairman’s decision to refinance his existing mortgage not only takes advantage of historic low interest rates, but it also places him in a favorable position to benefit from appreciation because of inflation.

Inflation and Mortgage Rates

Mortgage interest rates depend on mortgage bond prices. The dollar loses value during times of rising inflation. When the dollar loses value, as compared to other currencies, investments linked to the dollar such as mortgage bonds also decline in value. As a result, investors sell bonds, causing prices to drop even further.

To stimulate demand and make mortgage bonds more attractive to investors, the owner of the bonds (Uncle Sam) hikes the bond yields. The yields consist of the interest rate paid to investors. When bond yields increase, mortgage interest rates start moving up.

Bernanke may have “inside knowledge” that interest rates will start on an upward trajectory.

Therefore, homeowners who elect to wait, rather than make a home purchase now, may risk paying a higher interest rate on their mortgage.

Homeowners who follow Bernanke’s lead, and lock in a low interest fixed-rate mortgage, gain in two ways.

First, most people purchase their home using “leverage,” in the form of a 10, 20 percent or more for their down payments. They can realize a significant ROI on the down payment because appreciation occurs on the total value of the home.

Second, inflation works to the advantage of borrowers because they make their monthly mortgage payments in inflation-adjusted dollars. The loan costs less (inflation-adjusted dollars) than when the lender originally approved the mortgage.

On the other hand, renters would pay higher, inflation-adjusted prices for rental units.

Appreciation and Home Value

There is a direct relationship between inflation and appreciation of home values. When calculating the cost of a mortgage, borrowers must take into account the inflation-adjusted price of the mortgage, and the appreciation rate of the home or the “real mortgage rate.”

To get a better understanding of the real mortgage rate concept, think back several years to the real estate bubble, at its peak in 2006; home prices appreciated about 17 percent a year. A buyer could purchase a home with a 30-year fixed-rate mortgage, at a six percent rate and realize a -11 real mortgage rate—the equivalent of an 11 percent return.

The formula is simple: Mortgage rate (M) minus Appreciation (A) equals Real Mortgage Rate or M - A = RMR. For example, a four percent appreciation with a four percent mortgage equals a real mortgage rate of zero.

Conclusion

Bernanke’s decision to refinance his mortgage may signal his belief that inflation is in the immediate future. It makes sense. After all, banks have trillions of dollars to loan for mortgages, automobiles, and businesses. If Bernanke is wrong, and inflation does not return, deflation becomes the primary concern.

Stock market analyst Robert Pretcher sums up the effects of deflation in the following statement: “As creditors become more conservative, they slow their lending. As consumers become more conservative, they borrow less or not at all. As producers become more conservative, they reduce expansion plans.”

Other factors will also have a bearing on the future, including employment and worldwide financial issues.

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