What is the Ratchet Effect?

The Ratchet Effect is one of the few economic theories that has any relation to reality. As President Harry Truman succinctly observed, if you laid every economist end to end, they would point in every direction, and only be able to explain things after they have happened. In essence it holds that some prices move a lot faster in one direction than another. One example is the price for gasoline, another is long term interest rates for mortgages. While money is still at historic lows, we have seen interest rates fluctuate a lot in the last month. Interest rates always rocket up and float down.

Trying to guess the direction of interest rates, particularly short term rates, is impossible. The way to win is simple. Obtain a mortgage with the lowest possible closing costs. If rates go up you have won. If they drop significantly, you refinance and win again. In most circumstances it is a mistake to spend a lot on front end costs. When we look at the recapture costs associated with a low or no cost loan, it usually takes over five years to break even when you compare the upfront costs and divide by the monthly savings. For example, if the closing costs are $3,600 for a $200,000 mortgage at 4%, and zero closing costs for the same mortgage at 4.5%, the difference in the payment is $60 per month. It would therefore take five years to break even before other factors such as the time value of money, tax effect, etc are considered.

As always do the numbers to determine what is best for your unique, individual financial profile.

Chip Allen

Crestline Mortgage Bankers

A Division of Universal Lending Corp                                     

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