Mortgages

Most people will need a mortgage to buy. Even if you can pay cash, you might want to borrow. Here’s the ins and outs.

Fixed Mortgage vs. ARM (Adjustable Rate Mortgage)

The “default” option is to get a 30-year Fixed Mortgage. The mortgage payments never change over the whole 30 years, and that appeals to a lot of people. But I think it’s overkill. Many people would be better off with a 5-Year or 7-Year ARM. And here’s why:

  1. It’s still Fixed for some time. - A 7-Year ARM still has a fixed rate for the first 7 years. The average loan lifetime is actually exactly 7 years before many people refinance or move. Ask yourself how long you actually plan on staying in this home. The Fixed mortgage’s benefit doesn’t even begin until Year 8.

  2. It’s a lot cheaper. - It costs more to lock in a rate for a longer term. ARMs put the risk of rising rates on the borrower, so ARMs have lower starting rates. It can be a lot lower, depending on the yield curve.

    Consider how much ahead you would be if you took the saved-interest over the first 7 years and put it into your mortgage principal. Rates would have to rise a lot for you to come out behind.

  3. ARMs only hurt if rates rise - ARMs only hurt borrowers in the floating period if rates rise. Rates have been in a steady decline for the last 30 years. Moreover, given point #2, rates have to rise quite a bit for you to come out behind with an ARM.

  4. The maximum rate is capped. - After the fixed period, your rate can only rise to a maximum cap. It’s not a completely floating mortgage. That means your downside is capped. You will get a loan estimate. Look at the maximum payment carefully.

  5. You can refinance or sell. - If after the fixed period, your rate is going up a lot, you can refinance into a 15 year fixed, or sell. If rates are very high, this generally means the economy is roaring or inflation is high. Either way, the value of your home will be higher in this case.

  6. Bear risks you can bear. - Lenders love to prey on the fears of borrowers. Paying an extra 0.5% or 1% for a Fixed rate is very expensive insurance for rates rising.

    Smart people bear risks they can tolerate, and only insure risks they can’t. If you can afford it, rising rates should be a remote and managable risk. Buy a safer car, buy umbrella insurance, or invest in your marriage quality instead.

Long term mortgage rates

There are two major caveats to all the above I’ve mentioned:

  1. Don’t use ARM to buy more house - In other words, don’t go to an ARM because you can’t afford the payments on a Fixed. Use the Fixed payment to guide how much house to buy. Rates can rise.

  2. Make sure you can afford the maximum payment - As I mentioned earlier, rates can rise, but there’s a maximum payment listed in the loan estimate. Make sure you can afford it in the worst case.

More Fixed vs. ARM

So what term Mortgage should I get exactly?

Match the term of your ARM with the expected duration of your stay. If you expect to stay 7 years, got a 7-Year ARM.

If you truly expect to stay 30 years, maybe consider a 30 year fixed, but I probably still wouldn’t, as I prefer to bear the risks I can bear.

Points and Lender Credit

You will have the option of paying “points” to lower the interest rate on your mortgage. I don’t think it’s worth it.

Usually, you will “come out ahead” in 5-6 years. But if you move or refinance, you will never come out ahead. Most people move or refinance in that time. Do your own calculation though.

Additionally, points are generally speaking not tax deductible, but an increased interest rate is. This is only important if you itemize your deductions for your taxes, but it can be a significant difference.

Finally, you can even get “negative points”. That’s when the lender will contribute “lender credit” towards your closing costs in exchange for you agreeing to a higher interest rate. I think this is generally worth it. You will come out ahead if you refinance or move within roughly speaking 5-6 years. But again, do your own calculation.

Ask your lender for a “menu” of possibilities. Your lender should be able to give you a menu like this:

  1. 2.75% - $0 credit
  2. 2.875% - $1,875 credit
  3. 3% - $3,750 credit
  4. 3.125% - $5,625 credit
  5. 3.25% - $7,500 credit

The above menu is for a 2.75% APR ARM where each 3/8ths of a point buys up or down 0.125% of interest rate.

Since refinancing is something entirely in your control, negative points a.k.a. lender credit is a good deal. Just make sure to ask for a schedule of possible points and lender credits, and do your own homework.

One more important point. On ARMs, the point buyup or buydown only applies during the fixed introductory portion of the mortgage. That makes buying points on ARMs doubly bad, and buying negative points (getting lender credit) doubly good.

Before Investing Pay off the Mortgage First

Assuming you have an emergency fund for an unexpected job loss, you should put the extra money towards the mortgage, not invest it in the market. And the rest of the article is to convince you why.

But Mr. Pleb, I can get a higher return in the Stock Market

Yes, if you’re optimistic, you can get a 5+% return in the Stock Market, but not a higher risk-adjusted return. Your mortgage is essentially a risk-free return, and almost certainly higher than any other risk-free return you can get.

By carrying the mortgage debt to invest in the Stock Market, you are taking on equity risk without getting the full equity risk premium. Let me explain that point a bit more, as I think it’s the most important point.

Stocks have to return more than the risk-free rate (what you can get from savings or treasury bills) because stocks are riskier. That extra return is the risk premium for stocks - it’s the market consensus for how extra return is necessary to take on the risk of a stock market crash.

Your mortgage rate is almost certainly higher than the risk free rate. If you’re carrying a larger balance than necessary to invest in stocks, you’re taking all of the risk of stocks without receiving the risk premium you’re supposed to get.

In concrete terms, here are some sample numbers.

Risk-free rate: 2.5% (Interest rate of treasury bills as of time of writing) Reasonable equity return: 6% (Jack Bogle’s reasonable expectations for 10 year stock returns.) Equity Risk-premium: 3.5%

Mortgage rate: 4% The risk premium you would receive if you carried a higher mortgage balance to invest in the market: 2%

But Mr. Pleb, 6% is still bigger than 4%

That’s true. You might still choose to take the riskier bet. In that case though, you clearly believe you’re “smarter” than the market and that the market is overestimating the equity risk premium. That’s your choice to make, but I’ll say that every time I’ve tried to outsmart the market, the market has won.

But Mr. Pleb, I have FOMO. My buddy invested in TSLA at 20.

That’s a difficult psychological thing to overcome, but it’s best to try. There will always be people luckier than you. Your buddy also probably didn’t mention the times when he lost money.

As a general point though, people experience loss more powerfully than they experience gain. At the end of the the next 10 years, if the stock market goes way up, you’ll feel moderately stupid that you missed out on those gains, but your debt will still be greatly reduced. If the stock market has a lost decade, or a crash, think about your reaction in that case.

Black Swans, Rare Events

I have one more point to bring up: The stock market, your home’s value, and job security are highly correlated, and that’s not necessarily a good thing.

Consider four possible scenarios:

  • A1: Economy great, pay off debt: You missed out on stock market gains, but your income is probably good. No one will be hungry in your household regardless.
  • A2: Enonomy great, leverage and invest: The best possible scenario, you are rolling in it, but the only difference between A1 and A2 might be a luxury car and some exotic vacations.
  • B1: Economy bad, pay off debt: You’re going to be extremely relieved you didn’t lose all that money in the stock market crash. If you lost your job, you’re going to still have less debt and more resilience than if you invested. You will probably survive.
  • B2: Economy bad, leverage and invest: Your home declined in value, you may have lost your job, and your investments crashed all at the same time. All of them are correlated and this could be a life-changingly bad outcome.

A1, A2, and B1 are all okay. Don’t be in B2.