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Insights From Mortgage Math

Photo: Kostiantyn Li | Unsplash

In the last few years, mortgage rates have touched lows we’ve never seen in our lifetimes, and recently have risen to levels not seen in over a decade. In the initial stages of mortgages, the interest calculated is based on the mortgage rate applied to a vastly huge mortgage balance. You might be surprised to learn that even relatively small changes in mortgage rates can have massive impact on the percentage of payments that go toward principal, on the advantage of making early prepayments on the mortgage, and on the value that can be financed in a loan.

By the end of the loan, almost 100 percent of every payment goes to principal, but early on the amount varies widely. For example, for a 2 percent mortgage, 55 cents of every dollar in the first payment goes toward paying off principal. For a 6 percent mortgage, only 16.6 percent of that first payment goes toward principal. This means the lower the mortgage rate you lock in, the quicker you can build equity.

For a 30-year fixed mortgage at the beginning of the loan, how much time does it knock off to prepay one month’s payment? Again, the answer varies widely depending on your mortgage rate. At the extreme of a zero percent mortgage, a month’s prepayment will reduce the term of your loan by exactly one month. At a 2 percent mortgage, it will knock almost two months off, while at 6 percent it will reduce the term by almost six months. As mortgage rates get higher, the numbers get more extreme — at an 11 percent mortgage, a single month’s prepayment early on will reduce the term by over two years! This is interesting, but not very practical. If you have resources to make very large prepayments early in a mortgage, you probably could have just made a larger down payment to begin with and locked in a much lower monthly payment. Nevertheless, it does show that as mortgage rates rise, prepayments become much more beneficial.

Probably the most interesting variable about mortgage rates is the potential impact they could have on house prices. Imagine a 30-year fixed mortgage with a $1,500 monthly principal and interest payment and zero down payment. How much house will that buy? At today’s 5 percent mortgage rate, that payment would finance a $279,000 loan. At 2.75 percent, a rate we were seeing just a few months ago, that payment would buy a $367,000 house. If rates jumped to 10 percent, a rate most of us have seen in our lifetimes, that same $1,500 a month could only buy a $170,000 house.

When mortgages are discussed, the question of paying them off early always comes up. When we run the numbers historically, the answer is that you should not prepay a mortgage at all if you can help it, at least at these rates. It’s difficult to find a 30-year period where the return of a reasonable investment allocation would not meaningfully exceed 5 percent. Ultimately owning a house is far more an emotional decision than a financial one, so making choices in your mortgage for peace of mind, rather than dollars and cents, can make sense — many of our clients pay off their mortgage even knowing it’s not likely to be an optimal financial decision.

There is always uncertainty in real estate, and it feels like these times are more uncertain than usual. Hopefully these facts can help you think through your real estate decisions as mortgage rates rise and more inventory comes on the market.

Gene Gard is Chief Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions. Ask him your questions or schedule an objective, no-pressure portfolio review at letstalk@telarrayadvisors.com. Sign up for the next free online seminar on the Events tab at telarrayadvisors.com.

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Paying Off Debt: When Should I Pay What?

Towfiqu Barbhuiya | Unsplash

Q: I have debt I want to pay off, but I also want to start investing to enjoy the value of compounding. How should I think about household debt?

A: It’s probably never truly wrong to pay it off, but sometimes a little debt might not be a bad idea.

Let’s start with the easy part. Some types of debt should be attacked mercilessly with singular focus and attention until it’s gone. This would include any kind of payday loan, credit card debt, predatory car loans, or anything with a high interest rate. To me, a high interest rate is anything above what a reasonable investment portfolio could hope to produce on average in the future. Over the last 20 years, U.S. stock market returns have annualized about 10 percent a year and are unlikely to exceed that going forward, so any 10%+ interest rate should certainly be considered high these days and attacked with all available resources.

What about loans with lower interest rates? There’s still a good case to be made for paying them off as soon as possible. Even 0 percent interest sounds like a great deal, but it’s still money spent that you didn’t have at the time, and those payments impact your future financial security and flexibility until they’re gone.

There’s a lot of debate about what defines good debt. The most common example is a mortgage, as it represents a hybrid of paying for shelter and investment in the future. Real estate has made many people wealthy over the years, but not without risk. It’s hard to make big returns in real estate without borrowing, which works great most of the time, but can also go wrong, as we saw leading up to 2008. I believe in buying a house because you need a place to live, not as a speculative investment. Enjoy any appreciation, but don’t expect it and certainly don’t rely on it. A mortgage is usually the lowest-priority debt to pay off in a given household.

A case can be made against almost all other kinds of household debt. The problem is that virtually all household borrowing is financing consumption of things that are currently unaffordable. Some things might be necessary, like a reliable car, but a lot of unnecessary money is spent and justified in the name of reliable transportation. Generally, consumer loans like these should be minimized and paid off as soon as possible.

Student loans are a tricky subject, because right now, many people are expecting eventual forgiveness from the government. Forgiveness might come, or might not. Regardless of your expectations, it’s probably wise to avoid taking advantage of any kind of deferment where payments stop but interest continues to accrue.If possible, make payments so that the balance declines each month.

Credit scores are also tricky. On one hand, a decent credit score is necessary for basic tasks like renting apartments or opening bank accounts. On the other, I’ve seen many financially destructive things done in the name of establishing credit or building credit history. In my experience, credit history will naturally build up over time with things like car loans and a credit card with reasonable limits. There’s no reason to focus on gaming your score.

For some debt, it might make sense to keep the low-interest debt and invest any extra money in the markets. Keep in mind that we may not get another 20 years of 10 percent stock market returns, but there’s a good chance the market will outperform a 2.5 percent mortgage in the long term. Investing in things like 401(k) plans with an employer match should probably be prioritized even above paying off non-mortgage, low-interest debt. Ask your financial advisor about both opportunities and risks in your particular situation. It’s important to look at the big picture.

Many lives have been ruined by overwhelming debt, while I’ve never heard anyone complain about being debt-free, even if it’s not optimal. If in doubt, it’s probably never completely wrong to just pay your debts off if you can.

Have a question or topic you’d like to see covered in this column? Contact the author at ggard@telarrayadvisors.com. Gene Gard is Co-Chief-Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions.

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A Regular Person’s Guide to Capital Allocation

Creating money for the future (Micheile Henderson | Unsplash)

Politicians and philosophers might disagree on how capital should be allocated, but they agree it’s the lifeblood of our economy and society. Regular people don’t usually consider themselves capital allocators, but that sort of mindset can be useful when running your personal budget.

Most simply, capital is money that makes more money. When money flows out of your bank account, it’s either for an expense (like an operating expense in business) or a capital expenditure. A capital expenditure is money that isn’t gone forever — it hangs around in another form that you hope will create money for the future.

Here are a few ways to apply capital thinking to your budget:

• Markets. The purest way to turn income into capital is to invest it in the markets. Today’s investment portfolios are a modern miracle — they have incredibly low costs to enter and strong prospects to provide a real return that outpaces inflation over time (despite inevitable fluctuations).

• Real Estate. Real estate can work, but it’s not a capital-accumulation panacea. Buying a house with a typical down payment is highly leveraged and therefore risky. An owner-occupied dwelling produces no income and instead produces significant expenses like interest, insurance, and general upkeep that can soak up capital as quickly as it becomes equity. There are lots of reasons to own vs. rent, but hoping for a quick financial windfall is not a good reason to buy.

• Vehicles. Cars quickly destroy capital via depreciation. Businesses buy vehicles to make money and embrace the tax benefits of their depreciation as a small benefit to the necessary cost of doing business. Families don’t get to deduct depreciation, and a vehicle for a family usually represents nothing more than a way of getting around. Buying fewer vehicles and using them less — by living closer to work and school, for example — will make a huge positive impact on household capital accumulation over time.

• Human Capital. College feels like an expense, but the right degree can make huge changes in lifetime capital accumulation. Not just any degree from any university will help, though — discernment is necessary these days to understand the exact purpose, utility, and value of a program. For-profit colleges have exploited many students, and even the most prestigious universities can produce graduates with significant debt and minimal opportunity, knowing they might have been better served on a different path.

• Hobbies. What’s better, running or scuba diving? Scuba diving requires training, equipment, travel, and storage space, while running requires shoes and clothes you probably already have. Even the most avid gearhead would spend far less on running than diving, and an avid runner probably enjoys the hobby just as much as a diver. Strategically finding less expensive hobbies you truly enjoy can make a huge difference when it comes to accumulating capital.

• Collectibles. Speculative collectibles might seem to pay for themselves, but by the time baseball cards, NFTs, or limited-edition anything looks like a profitable hobby, it’s probably far too late. If a major part of your hobby involves looking at price guides and auction listings to see if you’re making money, you probably won’t find the windfall at the end of the rainbow you’re expecting.

Looking at spending and saving this way might seem overly clinical but can be eye-opening once you get used to this mindset. Working people trade their time for income. Any opportunity to steer income away from expenses into capital activities that actually store and create value will bring about a day when capital can be used to free up your time — everyone’s only truly nonrenewable resource.

Have a question or topic you’d like to see covered in this column? Contact the author at ggard@telarrayadvisors.com. Gene Gard is Chief Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions.