September 5, 2020
My Dear Reader,
In recent years, and throughout this pandemic, we’ve seen mortgage rates decline steadily and that is a great side effect to the long term effects of our complex economy. In thinking and theorizing on this subject for this week, I reached out to experts in a couple of different fields, because I felt as though it was prudent to look at declining rates from all angles. First, I want to use the example of two brothers each buying a house worth the same value. This will give us insight as to how declining interest rates have affected consumers and actually worked in their favor.
One of the essential financial principles we have discussed is opportunity cost. When a home is bought with cash or paid off in the shortest amount of time, the lost opportunity cost can be astounding. For instance, let’s take two brothers, Orville and Wilbur, who both think they are in the right. Each brother is going to buy a $500,000 home in Florida. Orville decides to get a fifteen-year mortgage, so he can pay off his home faster and then invest the money that he would have been spending on his mortgage. His brother Wilbur decides to get a thirty-year mortgage and invest the difference that he saves per year over Orville. To make it simple, both have a $500,000 loan with a flat 5 percent interest rate. Orville will pay $3,953 to the bank every month and Wilbur will pay $2,684. If we assume there were no market crashes at all and both earned the current average rate of return at 7.91 percent Orville will make $1.3 million in the fifteen years after paying off his house. Not a bad sum. His brother Wilbur will invest $1,269 every month, as this is the difference between the brothers’ interest payments. Wilbur will have made $1.8 million by the time his house is paid off. Put simply, it’s because Wilbur has a fifteen-year head start on his brother, and the better the market does, the larger the gap becomes. Now that we understand the financial principles laid out at the beginning, does it make sense to get a short term mortgage? I believe that a longer loan duration will not only allow inflation to work in our favor, but it will also give us greater flexibility, as less money will be used for debt service. Inflation will also be able to work in our favor, so the actual debt will be worth less and less, giving us more and more money in our pockets.
But how does this affect the Real Estate market itself? I am not a real estate professional, obviously, so to remedy this issue, I reached out to Elizabeth Kirby with Keller Williams Realty and she recounted how her business ebbed and flowed through the pandemic.
“It was quite a smack, but not the devastation of 07/08. I have had record numbers coming to open houses and also record number closings. Record low-interest rates coupled with the unrest of people stuck in their homes and having so much out of their control I feel has fueled the market. Also, having some states that are in such a state of unrest has made the Tennessee market that much more palatable to out of towners as well. I am seeing a recurrence of 3 years ago but with better rates.”
It can be hard to judge the overall real estate market just by living in Tennessee, but I believe that Elizabeth is absolutely right when it comes to external factors and their effects on Tennessee real estate and the resurgence of the US economy, at least in part. Part of what still worries me, is the fact that that the solution seems to be worse than the problem. While low rates are certainly boosting the local real estate economy, safer positions over time have been significantly damaged. With the recent economic turmoil and Federal Reserve rate cuts in response, the yield on bonds has considerably decreased, coinciding with the low mortgage rates. The yield is essentially the metric that determines how much a consumer makes by buying a bond, and the bond choice can determine the long term effects of any financial plan. But in recent years, some of the largest pension plans, ones run by public institutions, have started to move away from bonds and put more money at risk. This begs the question of why?
Pension plans are supposed to stay relatively safe so that the people that they serve can know that they’ll be there when they retire.
With Junk Bonds negative yields also in the news, and in order to make sure we’re on the same page I’ll throw out a simple definition of a junk bond. As the name implies these are bonds that are not up to the same standard that typical government or corporate-issued bonds are. However, because of this, they have a typically higher yield than other bonds. So when these bonds start going negative, we can safely assume that regular bonds are going to have a negative yield shortly. It could mean that there will be trouble down the road for those who have a slightly safer portfolio position, and for those who use junk bonds to act like little “morganizers” The incentive to purchase the debt on the performance of a company becomes less and less attractive. We can see this trend play out among the larger portfolios that many Americans rely on.
To wrap up this discussion, I reached out to Brian Adams, to talk about the added effect of inflation, due to government spending, and he made this point:
“Government debt has soared to levels not seen since World War II, as countries world-wide boost spending to battle the new coronavirus. Among advanced economies, debt rose to 128% of global gross domestic product as of July, according to the International Monetary Fund. In 1946, it came to 124%. Real rates can’t go higher because our debt service would be impossible This is why we are in a low / no rate environment until GDP rises enough to grow out of our debt problem”
Essentially we’re stuck with low mortgage rates and no safe place in many traditional funds. This is great for those who may want to be aggressive, but not so for those who want to play it conservatively.
To Your Creation and Potential,