Buying a primary home is one of the single biggest financial decisions that a person has to make in their life. The decision is further complicated by the fact that this is also one of the few moments where everyone has the ability to leverage 4 to 1 their purchasing potential. This financial situation, like many others, can be seen as an opportunity or risk. Depending on the property you’ve determined to purchase and the cost you’re willing to pay, you have the potential to make a decent return on your investment (or, at the very least, significantly reduce your inflation exposure).
About three years ago, I made the truly scary decision to purchase a property. I happen to live in California where the real estate boom and bust cycles are exaggerated compared to the rest of the country and buying real estate is not a sport for the faint of heart! I felt that I locked in a relatively nice property with development potential that was fairly affordable. At the time we were buying the property, I had a bunch of simple metric to determine whether we would purchase the place or not. Was the PITI (principle interest taxes and insurance) near neighborhood rental rates? If it was then the place was affordable and we could buy.
At the end of 2010 we ended up with our first property and started with an initial loan of 4.25%. To make a long story short over the next three years we did two no cost refinances to lock in a 30yr, 3.5% loan for the place. These were fairly good deals and each helped me lock in a greater principal savings if mortgage rates rose in the future. Mortgages are like any other bond out there. They have a coupon payment associated with them (monthly PI payment), a term (typically 30 or 15 years), a face value (amount of the bond), and posted collateral (your house). The difference is that when you get a mortgage, you are issuing a bond to the bank against your house. If you invest in the bond market to any degree (by typically holding a bond fund) you are actually taking the role of the bank and acting as the lender/creditor and holding some other corporation/entity’s bond. It’s very difficult for an individual to issue bonds outside of a small business situation and this is one of the few times you get to do this. Locking in a low interest rate is advantageous for the issuer, because if the rate environment rises the lender takes the hit to the par value and you can consider the loss in par value as actual income. In fact, corporations can choose to report in their income statement gains or losses from fair value accounting of assets or liabilities and can record on their balance sheet assets or liabilities at fair value, as opposed to just at principal amount (FAS 157 covers these accounting rules).
What this means is that as interest rates rise, the face value of my mortgage declines and I have made money by locking in an interest rate below prevailing market conditions. Using a simple bond calculator and assuming a $500k loan, I can figure out the book value of my mortgage as mortgage rates rise. For a market rate of 4.5% (current) and a stated interest rate of 3.5% and 29 terms left, the bond calculator states that my $500k mortgage is only worth $420k. In one year and a 1% increase, I’ve made $80k if I was to buy this bond back. If interest rates rise to 5.5% by next year and assuming 28 terms left, the mortgage is only worth $361k. That means I have the chance of making another $79k by holding this mortgage. This is a significant earnings per $500k that a fair number of households will make over the next couple of years.
That’s all well and good, and I believe everyone understands that you will be making money off the bond as interest rates rise, but we might also be a bit more concerned in how much of a reduction in interest expense you gain by holding a lower than market rate mortgage as opposed to current rates. To figure this out I went to a mortgage calculator (http://www.mlcalc.com) and priced three $500k mortgages; one at 3.5%, another at 4.5%, and a third at 5.5%. I then calculated the total interest paid as a function of years for each loan and then calculated the interest expense saved by year. For the hypothetical $500k loan, you’re saving nearly $4k in the first year between the 3.5% and 4.5% loan and nearly $8k in the first year between the 3.5% and 5.5% loan. If you hold the loan to maturity you’ll save $83k on the 3.5% to 4.5% change and $170k on the 3.5% to 5.5% change. I also wanted to know how long it would take me to realize this savings and so calculated a rolling Interest Rate of Change for each rate change. The annual interest expense saved per year divided by the total potential interest saved is then plotted as a percentage over the life of the loan. After 30 years you’ve saved 100% of the potential interest expense and you can see (from the plot below) that they follow fairly similar rates of change. Also note you make 50% of your money back in the first ten years. So as rates rise, do your best to hold your mortgage for at least the next 9 years.