Break-Even Calculations

 


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This difference indicates the breakeven inflation rate, the level of inflation at which investments in both kinds of securities would be equally profitable for a given maturity. Breakeven inflation rates provide particularly useful measures of inflation expectations because they are available at a high frequency for a wide range of time horizons.

However, using breakeven inflation rates as measures of inflation expectations can be problematic. In addition to the expected inflation component, breakeven inflation is governed by two unobservable factors: The inflation risk factor pulls the observed TIPS yields down relative to nominal bonds, causing breakeven inflation to be correspondingly high.

The liquidity factor pushes observed TIPS yields up, bringing breakeven inflation down. The yield premiums associated with both factors vary over time and often in offsetting ways, making it difficult to capture the residual expectations component of the breakeven inflation rate.

In this respect the usefulness of breakeven inflation for assessing inflation expectations depends on the relative importance of the inflation overshoot and liquidity risk factors, and the modeling techniques used to separate out these risk factors from the expectation component.

Currently, the extent to which the liquidity differential between nominal and real Treasury bonds affects pricing remains a point of contention, causing some to question the reliability of the models used to extract inflation expectations from Treasury yields. Thus, determining the liquidity premium in TIPS pricing is an important step in improving such models and achieving more accurate measures of inflation expectations. In this Economic Letter , we utilize the maximum range for the TIPS liquidity premium described in Christensen and Gillan to adjust observed real yields for potential liquidity effects.

We demonstrate how this bound converts into a maximum range for the estimated inflation expectations using a model of nominal and real Treasury yields. To get a handle on the potential magnitude of the liquidity effects in observed TIPS yields, we use the model-independent maximum range for the TIPS liquidity premium Christensen and Gillan This range is constructed by subtracting breakeven inflation from the inflation swap rate for the comparable maturity.

The difference between breakeven inflation and the comparable swap rate then represents the sum of trading frictions in both the inflation swap and TIPS markets. Identifying where the premium falls within the range is difficult. But, by considering the two extremes of the range, we can account for all possible variation in the TIPS liquidity premium. The lower bound of the range is zero because we assume TIPS to be less liquid than nominal Treasuries.

This lower extreme represents the case where the liquidity of nominal Treasuries and TIPS are the same. If the TIPS liquidity premium is at the upper bound, then the opposite is the case and inflation swaps are unaffected by liquidity factors. Figure 1 TIPS liquidity premium: Figure 1 shows the maximum TIPS liquidity premium at the year maturity in blue, with the admissible range shaded in gray underneath. The range grew substantially during the crisis, indicating the level of the TIPS liquidity premium was potentially substantial at the time, while the upper bound was considerably lower during the rest of the period.

A few researchers have tried to estimate the TIPS liquidity premium directly and use these results to adjust estimates of inflation expectations. In other words, we perform two model estimations. The first uses real yields as observed, implying there is no liquidity premium in TIPS. The second uses liquidity-corrected yields produced by deducting the upper bound of the admissible range from observed TIPS yields.

See the model of nominal and real yields developed in Christensen, Lopez, and Rudebusch and Christensen Figure 2 shows year inflation expectations for the two scenarios using the Christensen et al. The dark blue line represents the expected inflation that results from correcting real yields with the maximum admissible liquidity premium. The light blue line corresponds to no liquidity correction.

This means that frictionless TIPS yields that are not biased by liquidity factors would be correspondingly low. As a result, liquidity-adjusted breakeven inflation would be higher than the observed rate, implying higher estimates for expected inflation.

Conversely, a liquidity premium near the zero lower bound of the range results in lower estimates for inflation expectations. Are you eligible to refinance? What will refinancing cost? What is "no-cost" refinancing? How do you calculate the break-even period? Refinancing calculators How can you shop for your new loan?

The interest rate on your mortgage is tied directly to how much you pay on your mortgage each month--lower rates usually mean lower payments. You may be able to get a lower rate because of changes in the market conditions or because your credit score has improved.

A lower interest rate also may allow you to build equity in your home more quickly. Increase the term of your mortgage: You may want a mortgage with a longer term to reduce the amount that you pay each month. However, this will also increase the length of time you will make mortgage payments and the total amount that you end up paying toward interest. Decrease the term of your mortgage: Shorter-term mortgages--for example, a year mortgage instead of a year mortgage--generally have lower interest rates.

Plus, you pay off your loan sooner, further reducing your total interest costs. The trade-off is that your monthly payments usually are higher because you are paying more of the principal each month.

Refinancing is not the only way to decrease the term of your mortgage. By paying a little extra on principal each month, you will pay off the loan sooner and reduce the term of your loan. If you have an adjustable-rate mortgage, or ARM, your monthly payments will change as the interest rate changes. With this kind of mortgage, your payments could increase or decrease.

You may find yourself uncomfortable with the prospect that your mortgage payments could go up. In this case, you may want to consider switching to a fixed-rate mortgage to give yourself some peace of mind by having a steady interest rate and monthly payment. You also might prefer a fixed-rate mortgage if you think interest rates will be increasing in the future. If your monthly payment on a fixed-rate loan includes escrow amounts for taxes and insurance, your payment each month could change over time due to changes in property taxes, insurance, or community association fees.

If you currently have an ARM, will the next interest rate adjustment increase your monthly payments substantially? You may choose to refinance to get another ARM with better terms. For example, the new loan may start out at a lower interest rate. Or the new loan may offer smaller interest rate adjustments or lower payment caps, which means that the interest rate cannot exceed a certain amount.

If you are refinancing from one ARM to another, check the initial rate and the fully-indexed rate. Also ask about the rate adjustments you might face over the term of the loan. Home equity is the dollar-value difference between the balance you owe on your mortgage and the value of your property.

When you refinance for an amount greater than what you owe on your home, you can receive the difference in a cash payment this is called a cash-out refinancing. Remember, though, that when you take out equity, you own less of your home. It will take time to build your equity back up. This means that if you need to sell your home, you will not put as much money in your pocket after the sale. If you are considering a cash-out refinancing, think about other alternatives as well.

You could shop for a home equity loan or home equity line of credit instead. Compare a home equity loan with a cash-out refinancing to see which is a better deal for you. Many financial advisers caution against cash-out refinancing to pay down unsecured debt such as credit cards or short-term secured debt such as car loans. You may want to talk with a trusted financial adviser before you choose cash-out refinancing as a debt-consolidation plan.

The amortization chart shows that the proportion of your payment that is credited to the principal of your loan increases each year, while the proportion credited to the interest decreases each year. In the later years of your mortgage, more of your payment applies to principal and helps build equity.

By refinancing late in your mortgage, you will restart the amortization process, and most of your monthly payment will be credited to paying interest again and not to building equity. A prepayment penalty is a fee that lenders might charge if you pay off your mortgage loan early, including for refinancing.

If you are refinancing with the same lender, ask whether the prepayment penalty can be waived. You should carefully consider the costs of any prepayment penalty against the savings you expect to gain from refinancing. Paying a prepayment penalty will increase the time it will take to break even, when you account for the costs of the refinance and the monthly savings you expect to gain. The monthly savings gained from lower monthly payments may not exceed the costs of refinancing--a break-even calculation will help you determine whether it is worthwhile to refinance, if you are planning to move in the near future.

Determining your eligibility for refinancing is similar to the approval process that you went through with your first mortgage. Your lender will consider your income and assets, credit score, other debts, the current value of the property, and the amount you want to borrow.

If your credit score has improved, you may be able to get a loan at a lower rate. On the other hand, if your credit score is lower now than when you got your current mortgage, you may have to pay a higher interest rate on a new loan.

Lenders will look at the amount of the loan you request and the value of your home, determined from an appraisal. If the loan-to-value LTV ratio does not fall within their lending guidelines, they may not be willing to make a loan, or may offer you a loan with less-favorable terms than you already have.

If housing prices fall, your home may not be worth as much as you owe on the mortgage. Even if home prices stay the same, if you have a loan that includes negative amortization when your monthly payment is less than the interest you owe, the unpaid interest is added to the amount you owe , you may owe more on your mortgage than you originally borrowed.

If this is the case, it could be difficult for you to refinance. It is not unusual to pay 3 percent to 6 percent of your outstanding principal in refinancing fees. These expenses are in addition to any prepayment penalties or other costs for paying off any mortgages you might have. Refinancing fees vary from state to state and lender to lender.

Here are some typical fees and average cost ranges you are most likely to pay when refinancing. For more information on settlement or closing costs, see the Consumer's Guide to Settlement Costs. You can ask for a copy of your settlement cost papers the HUD-1 form one day in advance of your loan closing.

This will give you a chance to review the documents and verify the terms. This charge covers the initial costs of processing your loan request and checking your credit report. If your loan is denied, you still may have to pay this fee. The fee charged by the lender or broker to evaluate and prepare your mortgage loan.

A point is equal to 1 percent of the amount of your mortgage loan. There are two kinds of points you might pay. The first is loan-discount points, a one-time charge paid to reduce the interest rate of your loan. Second, some lenders and brokers also charge points to earn money on the loan. The number of points you are charged can be negotiated with the lender.

The length of time that you expect to keep the mortgage helps you determine whether it is worthwhile to pay points up front to reduce your interest rate. Unlike points paid on your original mortgage, points paid to refinance may not be fully deductible on your income taxes in the year they are paid. Check with the Internal Revenue Service to find the current rules for deducting points.

Ask the company carrying your current title insurance policy what it would cost to reissue the policy for a new loan. This may reduce your cost. Lenders require a survey, to confirm the location of buildings and improvements on the land.

Some lenders require a complete and more costly survey to ensure that the house and other structures are legally where you say they are. You may not have to pay this fee if a survey has recently been conducted for your property. Some lenders charge a fee if you pay off your existing mortgage early. Loans insured or guaranteed by the federal government generally cannot include a prepayment penalty, and some lenders, such as federal credit unions, cannot include prepayment penalties.