No matter how old you are, at some point or another, you will have heard someone talk about ‘The American Dream’. This is an ideal that has been the inspiration of countless films, TV shows, books, art, and more. It has been the subject of countless rousing speeches from politicians and business leaders, and the drive for generations of people. This dream has had such a wide appeal that it’s drawn people to our shores from around the world in pursuit of the very same goal.
What the ‘American Dream’ is has changed over time, and doesn’t mean the same thing for everyone. However, one thing that has seemingly been ingrained as part of this ideal for almost everyone is owning their own home.
Which makes sense. Having a place to call your own, a place where you can be yourself, and point to it and say “that’s mine”. It all sounds pretty great, doesn’t it?
Well, in pursuit of this dream, we’ve all had to go through the same process. We start with scrimping and saving, working and sacrificing, all so we can get a mortgage. This necessary evil opens the door to our dream…but can also trap us financially for decades.
This is probably why I have heard senior people in organizations often refer to homeownership by a younger associate as ‘Golden handcuffs’.
Too much House, not enough Money
In their excitement, people often make the mistake of buying too much home. By this, I mean the people who get the largest property possible for their budget, regardless of whether it’s the most practical property for them. In doing so, they get tied into a long mortgage that sucks a majority of their income and drains their liquidity.
This explains why, if you have a mortgage, someone in your life at one point or another has given you the ‘advice’ to pay your mortgage off as soon as possible. This is advice that has been passed down through generations with the best intentions. To be fair, this is good advice in the right context.
In the context (as witnessed by the below chart) of when our parents and grandparents were buying their homes, this was great advice. If your parents bought a house in the ‘90s for example (Oh to be young right?), the interest rates were around 8%. During the ‘70s and ‘80s, rates reached as high as 18% - some of the highest in American history. When the rate on your mortgage is that high, it makes sense to clear that debt as soon as possible, as it's not probabilistic that you can earn a better return on your money in other investments. In context, this advice is sound enough based on the numbers.
Today, interest rates are hovering around 3.2%. Additionally, up to the first $750,000 of mortgage interest is tax deductible. Meaning, assuming you are in the 30% marginal tax bracket, they could potentially drop as low as 2.2% after-tax.
Additionally, the current inflation rate is about 7%. This means that mortgage rates are currently lower than inflation - a phenomenon that hasn’t happened since the mid-'70’s, but back then mortgage rates were hovering around 8.5-9.5%!
This means people are using an old school mentality and not adjusting to current data. They’re using historical attitudes in a modern context - when has that ever worked out well?
This reminds me of one of my favorite Mark Twain quotes, “There are lies, damned lies, and statistics.” In short, numbers don’t lie. Only people do - even if they aren’t doing it deliberately. This advice may have made sense for your parents because they were paying rates of around 8%.
However, in today's climate, the gap has changed.
Please bare with me, as I geek-out for a second…Historically speaking, the gap (or, spread) on the S&P 500 (US equity proxy), MSCI EAFE (non US developed market equity proxy) vs. Barclays US Aggregate (US fixed income proxy) return has been about 5%. Meaning, a reasonable return expectation for equities at the current 2% yield to maturity on the Barclays US Aggregate would be ~7%. If prevailing mortgage rates are about 3.2%, this means the gap between a reasonable long-term equity portfolio return and your mortgage is about 3.8%/annum. Got that?
This gap, provided that you have the cash flow and proper balance sheet structure to support your mortgage, presents a window for you to seek to earn money while paying off your mortgage at the same time.
Mind the Gap
We’ve just come out of bonus season, one of the best times of the year. Let’s say that you got a $30,000 bonus, and a pay increase of $1,000/per month. Going on the old advice, you’ll probably be looking to put all of this extra cash straight into your mortgage. Assuming current rates, you’ll be paying down a rate of 3.2%, leaving that money tied up in your house (making you less liquid), and handing it to the bank.
If you were to go off the current numbers presented above, it would paint a slightly different picture. If you were to invest that bonus, and the monthly salary increases, you would start with $31,000. Over 30 years, with the same $1,000 contributed to the investment, compounding at 3.8%/year, you’ll have an extra ~$766,600. All, while paying off your mortgage at just 3.2%. Instead of paying down on your mortgage, you’re earning money on your money!
Similar math works in situations if you do a cash out refinance .
To gain a deeper perspective, I discussed with a veteran in the industry, Shmuel Shayowitz, President of Approved Funding, a Mortgage Banker in Bergen County, NJ. His business has been in his family for over three decades, with billions in mortgage financing. Shmuel stated, "Many have heard the old adage, that their home is likely the largest asset they will accumulate in their lifetime. This might indeed be the case, but what so many fail to consider, is that their mortgage will most likely be the most significant liability they ever incur as well. How you manage that debt can potentially be the difference of tens of thousands of dollars over the duration of your homeownership. A mortgage should be treated as a vehicle in which one optimizes their home financing to build wealth and maximize home equity.
Just as not all mortgage solutions are alike, so to, not all financial advice should be alike."
What this boils down to is one question - can I earn more than 3.2% on my money? For your parents, they were looking at aiming to earn more than 8% at a minimum on theirs - historically speaking, not as likely. Surpassing 3.2% is potentially more realistic, given the historical numbers presented above.
Unlocking the Golden Handcuffs
This historic window is potentially likely to close soon though, as the expectation is for the FED to raise interest rates 3X in 2022 and 2023.
So, could this be the year that you make money with your mortgage? Or will it be another year where you hand your cash over to the bank as quickly as possible, while simultaneously reducing your liquidity?
This all depends on you and your current circumstances. This may not be possible for everyone, but before the window closes, surely it’s worthwhile to know if you can jump through in time?
As I mentioned in my last post, I don’t deal in cookie-cutter advice. This is because it’s not always as sweet as the name suggests. What I do instead, is look at your numbers, and the numbers the world is giving me, and draw the most logical conclusion for your finances.
So, is this the right time for you to rethink your approach to your mortgage? There is only one way to find out.
This piece contains general information that is not suitable for everyone and was prepared for informational purposes only. Nothing contained herein should be construed as a solicitation to buy or sell any security or as an offer to provide investment advice. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. Past performance does not guarantee any future results. For additional information about Julius Wealth Advisors, including its services and fees, contact us or visit adviserinfo.sec.gov.
Publication 936 (2021), Home Mortgage Interest Deduction - IRS.Gov
Cash-out mortgage refinancing: How it works and when it’s the right option - Bankrate.com - Nov 2021
- Fed leaders predict 3 interest rate hikes in 2022, 2023 - Money Scoop - Dec 2021