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Should You Ever Get a 50 Year Mortgage? — with Dr. Karsten Jeske
01:03:39
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- [00:00]
A
I believe that if you need a 50 year mortgage, you can't afford the house. But former Fed economist Dr. Karsteneska disagrees. So I invited him onto the show to have a debate. 50 year mortgage. I'm against it. He's for it. Let's see who wins. What started as a debate ended up turning into a deeply technical and highly nuanced masterclass in mortgage economics. And that's what you're about to hear. Welcome to the Afford Anything podcast, the show that knows you can afford anything, not everything. This show covers five financial psychology, increasing your income, investing, real estate, and entrepreneurship. It's double I fire. I'm your host, Paula Pant. I trained in economic reporting at Columbia, which means my training is how to interview an economist. And what do you know, we have one here with us today. Dr. Karsten Jeska is a former research economist at the Federal Reserve bank of Atlanta, where he participated in monetary policy briefings. That's a fancy way of saying he talked to important people about what the interest rate's going to be. He was also a visiting professor at Emory University, where he taught PhD level courses in macroeconomic theory, and he also taught undergrad classes in money and banking. And he spent a decade as the director of asset allocation research at Mellon Capital Management. And what you are going to hear is we, we tried to make it a pro con debate, but we, the debate didn't last. It just turned into an interview. But we started it with the hopes that it could be a debate. And then what ultimately happened was we unpacked. Well, he unpacked mortgage mathematics, behavioral economics, and the nuances of housing policy. So if you want to learn about duration, risk, term premiums, internal rates of return, convexity risk, we're going to unpack all of that in the coming hour. You are about to get an education that you will not be able to find anywhere else. Here he is, our favorite former Fed economist, Dr. Karsten Jeska.
- [02:07]
Karsten, thank you for joining again.
- [02:10]
B
Thanks for having me on.
- [02:11]
A
This is going to be fun. All right. The Debate is on 50 year mortgage, good or bad.
- [02:17]
B
Yeah, I wrote a blog post where I said it's at least not as bad as people want to make it. So that's as positive as I can get.
- [02:26]
A
I am firmly in the camp of if you need one, you can't afford it.
- [02:31]
B
Yeah, yeah.
- [02:32]
A
Which is a little bit just to explain my position, and we'll get into this debate right now. But to explain my position a bit further, a, I'm referring to owner, occupants, I'm not referring to rental property investors because if you're a rental investor, I can see the argument for if you want to maximize the potential amount of debt that you can take out from a financial institution, then I can see the argument for taking out a 50 year mortgage so that your debt to income ratio allows you to maximize the number of loans that you take out so that you can buy more properties. I see that argument from a rental investor perspective. But if you're an owner occupant, and that's what today's debate is going to focus on, if you need one, you can't afford it. Now that does leave space for people who want one but don't need it. And we'll touch on that. My central thesis really boils down to the statement that if you need one, you can't afford it. That's my central thesis that I'm here to defend.
- [03:35]
B
I agree. If you are so borderline that you don't qualify for the 30 year mortgage, 50 is the only you can afford, probably it could go sideways, right? And this was my point. So maybe keep this open as an option for very sophisticated investors who say, well you know, I don't need to pay off my mortgage anyways. Nobody pays off their mortgage anyways day. So it's, they move after 10 years and then you move to another place and get another mortgage. And even people keep mortgage into retirement these days. So that was definitely my point. I'm not saying that we should invent the 50 year mortgage to bring more people into the homebuyer pool that previously were not able to afford it. Right. We knew, we know how that ended in 2008, right? So say between 2002 and 2008 we brought in a lot of people into the homeowner pool who maybe should have stayed renters or at least stayed renters a little bit longer. The marginal borrower who can't afford the 30 year mortgage and then entice them to get the 50 year mortgage. But I always think that more options is better than fewer options. I also would say that some rental properties start out as initially owner occupied. And so imagine you move a lot for. I know some people who moved a lot for jobs. Everywhere they moved to, they bought a new house, got a mortgage on it and then after three to five years they move to the next job, but they keep that house, keep it as a rental. By that time they had accumulated enough for a down payment for a house in their new location. And then, well, if they had had a 50 year mortgage with less payments might have sped up their down payment savings. So I could be a devil's advocate and I could cook up all sorts of crazy scenarios of people that absolutely should not get a 50 year mortgage. But I can also show you some examples where maybe the 50 year mortgage, it expands your horizon. And by the way, the 50 year mortgage was actually marketed as that bad case. Right. We bring in more people that can't afford to buy right now. That's probably not the right route to go, but definitely for sophisticated actors that can afford either the 30 or the 50 and then they consciously pick the 50 year mortgage might not be a bad idea.
- [05:58]
A
I think the area where you and I are in agreement is when it comes to rental property investors because even owner occupants who become quote unquote accidental landlords and who have a plan of becoming rental property investors at a rate of one property every three to five years, I count them as rental property investors insofar as they have a portfolio of rental properties. And we hear all the time from people who say, I never want to hold a property that I'm not living in. Then there are plenty of people who feel that way. They don't want to deal with tenants, they don't want to deal with repairs. There are people who know that they don't want that. So I'm thinking specifically about owner occupants in the context of this 50 year discussion.
- [06:43]
B
Sure, sure.
- [06:44]
A
And to your earlier point where you talk about how nobody or very few people hold a mortgage to maturity, most people will move after seven to 10 years. One of the key differences between the 30 year and the 50 year is the amount of equity that you build during that time span. Because often an owner occupant will use the equity from the sale of their previous home to purchase their next home. They, you know, unlike the, the, the rental property investor, they haven't been accumulating a down payment over the span of those 7 to 10 years. So they're relying on the sale. It's oftentimes the offer is submitted contingent upon the sale of their previous home. And so with a 50 year, they're just not building equity in the way that they would and therefore they're not getting into that next home in the way that they otherwise could.
- [07:39]
B
I would agree with you just qualitatively, I don't think quantitatively it's that big a difference.
- [07:46]
A
Oh, okay, let's hear your numbers.
- [07:48]
B
So I did the calculations right. So you imagine you have a, a 30 year mortgage versus a 50 year mortgage. And I think I did something like a $500,000 initial mortgage. I actually put a little bit of a term spread on the 50 year mortgage. So you pay a little bit higher interest rate.
- [08:05]
A
How much of a term spread?
- [08:06]
B
I did 25 basis points. We can get into that in just a minute. Because that's actually also a bit of a touchy subject there. What should be the correct term spread? The $500,000 mortgage, you pay only something like $20,000 down with the 50 year mortgage and you pay $80,000 down with the 30 year mortgage after 10 years. Now much of the equity comes obvious. First of all, you should have gotten a home, say maybe a $625,000 home, right? So you already started with $125,000 in equity. And if you assume that your home at least modestly appreciates by say 2% a year, I think most of the home equity building comes from the home price appreciation. And then again, we are not home price speculators and we are not betting on 12% annual appreciation. I mean, I'm just saying that imagine your home price just goes up in line with inflation, something like 2.2 and a quarter percent. So if you factor that in just qualitatively, the 30 year mortgage builds more equity. But it's not 4x the equity as some people have calculated where they just look at the mortgage balance, the nominal mortgage balance, yeah, of course it's 20,000 versus $80,000. But you could also make the point that, well, the mortgage balance inflation has chipped away. In fact, from year one on, you're chipping away 2.25% of the mortgage balance. So inflation does a bigger trick on your mortgage balance than you paying it down with a 30 year or a 50 year mortgage. Now, a 15 year mortgage, I mean, you can definitely see that. So for example, if you plot the balance of the mortgage, whether it's 30 years or 50 years, right? It's this line that starts very flat and only towards the end it starts really tilting down. The 15 year mortgage, definitely that goes down almost, maybe not linearly, but it has a little bit of a tilt in it, has a little bit of this concavity in the mortgage balance over time. Between the 30 year and the 50 year, the mortgage pay down is not that much. And then of course you also save money from the lower payments, right? If you had invested that money at some reasonable investment return opportunity. Now of course, if, if you had just taken that money and taken it as some free money, right, like you find a $20 bill in your sofa cushion and you just blow the money on something where you don't really spend it reasonably and responsibly, that would be a different story. But imagine you take the savings from the mortgage into account, you invest that some way. That should also help you build some equity if you buy your next property in 10 years. So yes, I can see qualitatively you're right. Quantitatively the difference is not as big as some people want to make it once you look at the numbers, especially the after inflation numbers after factoring in some home price appreciation. So if you do the math right, it's not that big a deal.
- [11:03]
A
In your own analysis, didn't you find that after 10 years the 30 year would build $80,000 in equity versus the 50 year would build $20,000 in equity?
- [11:13]
B
Yes, absolutely.
- [11:14]
A
So that is a 4x difference, right?
- [11:17]
B
It's a 4x difference. So you're basically $60,000 short just due to the mortgage balance. But instead of having say a $420,000 mortgage, you have a $480,000 mortgage. So you take the inflation out of that equation. Now it's no longer so lopsided. I think it's something like for every dollar you pay down in real inflation adjusted terms for the 30 year mortgage, it's maybe only 70 cents on the dollar for the 50 year mortgage. So it's not as crazy as if you're looking at these nominal numbers. This is only on the mortgage side, right? You had lower mortgage payments, maybe you had invested that difference in the stock market or in some other productive way. Maybe you bought more rental properties along the way. I think it's really a very one sided and also short sighted analysis to just look at the pay down. So you build equity also hopefully through some property appreciation, not just the mortgage pay down.
- [12:19]
A
And your point is, if you invest the differential, then you're building equities, stock equities hopefully.
- [12:26]
B
When I say that, well, maybe you should entertain the 50 year mortgage, I still can see that maybe now is not the right time to do it. Just because now is not the right time doesn't mean that 50 year mortgage is always bad. For example, if you could have locked in a 50 year mortgage in early 2022, you would have had an even better way of investing that money potentially. And you would have a longer Runway and the inflation has a longer way of chip away from that mortgage balance over 50 years rather than 30 years. So maybe now we have a bit of this perfect storm, right, where mortgage rates are still pretty high. So the hurdle rate for my investment is also relatively high. If I want to look around and shop around for investments, where can I put this differential payment? Right, If I, yeah, I can afford the 30 year mortgage, but I lower my payment and I look around, where would I invest that? If you were to invest it in government bonds, that would be terrible because there the expected return is way too low. But even in equities, equities seem a little bit expensive and the Cape ratio or any kind of valuation ratio looks outrageously expensive. But we could have the exact opposite situation, the perfect storm, in a good way, maybe two to three years, we could have maybe another economic downturn where interest rates are going to be much lower again. And then also equity valuations are going to look very rich. Where so from both sides. They both point towards the 50 year mortgage. Right? Your investment opportunities are good and that rate at which you could leverage your investments is also going to be much cheaper. So all I'm saying is don't throw out the baby with the bathwater just because right now the 50 year mortgage is not the best instrument and vehicle. Maybe keep it as an option for later.
- [14:24]
A
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- [16:22]
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- [18:52]
If that were the case. If in a hypothetical world you were advising financial institutions, taking the lender side, would you then advise them to issue 50 year mortgages at our current interest rates? Let's say anything above 6%. But to stop issuing these mortgages once interest rates fall below maybe 4% or 3%?
- [19:11]
B
Well, I trust financial institutions that they are smart enough to hedge all these risks. I mean, for example, right now maybe institutions are not even too interested in issuing these mortgages anyways because they know in a few years they will be refinanced again, which could actually mean maybe now is a good time. Maybe the term spread is not that high right now because maybe they have to offer you pretty, pretty lean term spreads, a very small spread or maybe even no spread above the 30 year to get you in the door. Because if it's too expensive, who would want this 50 year mortgage? The general direction of interest rates is definitely going down, right? I mean we're expecting something like at least two or three more rate cuts from the Federal Reserve and eventually that's going to drag down the longer term rates as well. And by the way, most banks don't even want to keep mortgages on their balance sheet, right? I mean normally when you get a mortgage mortgage, the bank just originates the mortgage and then it's repackaged. And the people that buy these kinds of packaged mortgage products would be big institutional investors like sovereign wealth funds, endowments, pension funds. Obviously pension funds are a bit on the way out, but especially because pension funds, especially some of these more mature pension funds, they are basically just hedging their future payments. They are not accepting any new retirees anymore. There might be some pension funds that still would like to have very long range fixed income products to hedge their cash flows. The research I did for this blog post that I wrote, I thought well okay, so Treasuries, yes, sure, they go only up to 30 years, but what kind of corporate bonds and then what kind of other, any kind of bond, for example. We also have some sovereign bonds from so other countries that issue bonds, but they are dollar denominated. So how far do they go out? And there's some 100 year bonds. So I found some bonds with maturities in the year 2121 that were initiated four years ago in the year 2021. I think it's Norfolk Southern Railway. And you know, at least with the railways, maybe you could make the case. I Mean probably Railways should be around in 100 years. There's some other companies. I'm not going to name any names. Okay, you have a bond that expires in 40 years. I don't know what your business model is. That business model still going to be around in 40 years. But anyway, so there's some very long running bonds and there seems to be some appetite for that. And who is around in 100 years? Even if a newborn today bought this bond, I mean chances are that newborn will never get the payment back in the end, at least not during their lifetime. And of course the point is, well, people want to hedge very long term payment streams and these ultra long bonds are one way. Right. So it could be pension funds, probably not so much. Maybe big endowments and sovereign wealth funds. They still like to invest in very long dated bonds, especially US dollar, you know, it's a safe haven currency. There's probably also a lot of foreign demand for these very long maturity bonds. So I think there's definitely going to be some appetite for this from the institutional side.
- [22:31]
A
That actually leads to a question that's unrelated to the 50 year mortgage. But it's a question that I've had in my head for a long time and I know you worked at the Federal Reserve. I have no idea if you have any insight from that into the question I'm about to ask, but why is it that the United States does not issue hundred year bonds? I mean if I were to make a bet on something being around 100 years from now, I'd be willing to bet that the United States will be around in 100 years.
- [22:58]
B
Yeah, I'm surprised. I think we could, we could and we should. Of course now the train has left the station a little bit. Right. So we should have done this in the late 2010s but because there are some other countries that have these very long running bonds and by the way, somebody who had invested in that, say in the year 2018, 1900 year bond and interest rates go up by I don't know, even 200 basis points or 300 basis points since then. Yeah, I mean you definitely lost your shirt there just from the duration effect. But I would support that the US government could look into expanding that horizon and going to, I mean at least 50 years. So. Yeah, exactly for the point you brought up. Right. Because I mean we are obviously a country that will still be around in 100 years. So if we are not, then who else will be?
- [23:48]
A
Right. And if we are not, then we will have much bigger problems. Than my bond portfolio.
- [23:54]
B
Exactly. Yeah, yeah.
- [23:57]
A
So that leads back to what sparked this conversation, which was the term premium. And just to lay out to the people who are listening why we're discussing this on the mortgage market right now, there is a spread between the 15 year mortgage and the 30 year mortgage. According to Bankrate, the average spread between the 15 year versus the 30 year is just a little bit greater than a half point. 0.55, 0.55. We can just round that down to a half point. In much of the conversation around 30 year versus 50 year, there are some people who will apply that linearly and say, all right, well, if a half point is the spread between 15 and 30, then a half point's also going to be the spread between 30 and 50. Your argument is that it might not be linear. That might not be the case.
- [24:45]
B
Yeah. I mean, and this is not my opinion, right? So this is a lot of this amortization math doesn't really extrapolate linearly. The reason is that very small changes in the term premium, if you pile them up over 50 versus 30 years, that would have a huge impact. So if I were to apply something like another 50 basis point, and some people claim that the term premium is going to be 75 to 100 basis points, which is completely insane.
- [25:15]
A
That'd be insane.
- [25:15]
B
That is obviously not going to happen. So, because you could calculate, well, what is my internal rate of return of the differential cash flow between a 30 year mortgage and a 50 year mortgage, right? And so I have 600 rows of cash flows, right? And during the first 360, I have the differential payment, so something that I save. So it's a positive cash flow to me as a borrower. So I get a positive cash flow and then I get hit over the head for the next 240 months with the 50 year mortgage payment. Because the 30 year mortgage is paid off, I plot this cash flow, right? A relatively narrow cash flow for 360 months, and then 240 months, a very negative substantial cash flow of the 50 year mortgage payment. So we ask ourselves, well, what kind of an internal rate of return do I have to make this cash flow? Basically net present value of zero. And because this is such a long period and all of these very large payments are so far in the future, to set this net present value down to zero, when I sum it up, I have to clobber this with some really, really large internal rate of return, much bigger than the rate of return, say equal to the 60 year mortgage rate or the 30 year mortgage rate. And that effect is a lot smaller if we go from 15 to 30. And that's just because of geometric growth, right? So something where I apply some kind of a discount rate and I apply it over 10 years, 20 years, 30 years, that's going to have a smaller effect than when I apply it over 50 years. You need a lot, a lot, a lot, a lot smaller term premiums to squeeze this differential payment internal rate of return, which is something like a hurdle rate by the way, for both sides of the equation, right. For the borrower and the lender, right. Because the borrower has to ask himself or herself, is it worthwhile for me to have better cash flows for the first 30 years, but then I have a lot more cash flows later and then the lender too, right? So the lender gets less revenue, gets less interest income over 30 years, and then gets more interest income for the next 20 years. So what kind of investment return do I want over this horizon? And it turns out that very, very small spreads can create some huge internal rates of return. So for example, if you plug in something like a 75 or 100 basis point premium, it would create an infinite internal rate of return. So obviously lenders would like that. And here's the reason why lenders would like that. If you apply a term premium high enough, so actually the 50 year mortgage would have a higher monthly payment than even the 30 year mortgage, right? And then nobody would want that. Of course the lender would love this, right? You get more for 30 years and then you get even more for years 31 to 50. I mean that's, that's not going to happen every time you have to do these net present value calculations and internal rate of returns. Well, you have to have some positive and some negative cash flows. If everything is positive, then there is no internal rate of, or the internal rate of return would have to be infinity to press everything down to zero. So here again, right? So this kind of math over 15 years, 15 year mortgage versus 30 year mortgage. So you need much bigger term premiums to bring these differential payments into balance. And whereas over very long horizons, just a tiny term premium could create some fantastic profit opportunities for the lender and potentially would create some terrible hurdle rates for the borrower. So that was my point. And by the way, the bond market gives us some guidance here, right? So I, I looked up a few bonds of some corporations. I took the same corporation, but I looked at different expiration dates for their bonds, right? So at least I would have corporations where, you know, they have obviously it has the same credit rating. Just the maturity of that corporate bond is 20 years apart and they have very, very tiny term premium. And so corporate bonds are even much more extreme than mortgages, for example. Right. Because in a corporate bond you get only the interest payment and then at the end you get the big lump sum payment. Right. So delaying that by 20 years, from a finance math point of view, that's a much bigger deal than spreading out your mortgage amortization for 30 versus 50 years. This is where I came up with that rough estimate. Yeah, probably somewhere between 20 and 25 basis points would be a fair term premium for that longer mortgage. If you're really sure that you hold the mortgage that long. Right. And so, for example, if it's paid back early, the lender gains, right. You get more interest and it's paid back. So you don't have to stretch it out as of course, I mean, there could be obviously some lenders who say, no, no, but I wanted this, right, Because I'm a pension fund, I like to hedge the payment over the next 30, 40, 50 years because this is how long I expect my retirees to live. But again, I mean to say, if I were a private lender and I did a mortgage and somebody paid me something like 25 basis points more for the 50 year mortgage, I would love to get those 25 basis points extra because I'm sure that this person is going to move after 10 years and pay back the mortgage. And I pocketed the, the 25 basis points extra and I'm not even going to go that far. So it's this 25 basis point term premium was only calibrated for something where you don't have any prepayment risk. If you have a prepayment risk, that would make it even more important that, well, we can't have something like a 50 basis point or even 75 basis point term premium. It would be, nobody would go for that on the borrower side at least nobody rational. Even though obviously lenders would probably make a lot of money if they offered that.
- [31:06]
A
But with the prepayment risk, and that was exactly what I was about to ask about next. With prepayment risk as a lender, you're in a situation in which if rates fall, then the borrower can refinance, but if rates rise, then the borrower holds, which that seems like asymmetric risk from the lender's perspective. Right. Because the lender suffers from duration risk if rates rise and then loses out if rates fall.
- [31:38]
B
Right. And by the way this risk is even worse in the corporate bond market, right. Because most, maybe not most, but many, many corporate bonds also are callable, right. So there might be a little bit of hurdles, right. I don't think they can be called right away. There's probably some schedule after which you can call the bonds. It might be a little bit more complicated than for the average mortgage borrower. But as most corporate bonds are also call. And then on top of that it's this issue, right? You have only interest, these are interest only loans. And then you get the big payment of the principal back at the, at the end of the mortgage and the borrower has this fantastic heads I win, tails you lose, right? So if interest rates go up, that's great, I'm going to keep this. And because interest rates are higher, probably inflation is really high. Inflation is going to chip away the mortgage balance. Especially as a corporation, there's never the risk of kind of moving, right? So they can keep the bond for as long as they want. There's no issue if you ever move your headquarters to a different state that you have to pay back all of your corporate bonds. You can keep them and then if interest rates go down by enough then you just refinance. And by the way they face the same fixed costs. So they have some cost of issuing a bond. Well, you have to pay some big financial institution to rally the investor masses to buy up your bond. And there's some cost just like a mortgage borrower. Any refi is going to be costly. You might have an inspection and a credit check and some legal fees. You take that, you just multiply that by maybe a thousand or so and then you get the cost that some of the corporate borrowers face. Yes, but yeah, there's this asymmetry and it's basically the lenders are on the hook for the risk, but then again they also want to be compensated for. That is basically called the convexity risk. The convexity means that there is this non linearity in the mortgage pricing. So you lose if interest rates go up, but you should gain if interest rates go down. But you don't gain as much as you hope because the thing could be prepaid, which by the way you don't have in Treasuries, right? So treasury bonds, at least to my knowledge, they are not called. That's why if interest rates go down and you have this very, you have a 5% treasury and interest go down to 1%, you made a ton of profit along the way. At the same time, it's priced into the bond. And lenders will know this and they want to be compensated for that. And corporations could potentially get better rates if they didn't have that prepayment option. So in an efficient market, it's obviously nobody's being taken advantage of here, right? I mean there's on both sides, on the lender and borrower side, these are very sophisticated actors. So they know what they're doing.
- [34:30]
A
The attractiveness or unattractiveness of a 50 year mortgage, much of this is going to come down to what is that term premium? Because if that term premium is a quarter point, it's a very different conversation than if it's 75 basis points. But it strikes me that with a 50 year mortgage, there's more time for rates to move against investors. There's more time for the, the convexity problem to rear its ugly head from a lender's perspective. And so it stands to reason that a lender would want to be compensated well for that.
- [35:04]
B
Right. And to alleviate some of these fears, right. So I did the calculations. For example, you can calculate something, what's called a duration, right? So bonds have a duration, they have a maturity, which is when they're paid off. The duration is this mathematical concept, right, where you calculate and they had the duration for the bond pricing. A duration has at least two interpretations, right? One is the duration is over what period on average is the loan paid off. So you look at all the payments, not just the final payment. And the other very intriguing interpretation is that the duration is something like a, it measures the interest rate sensitivity of the present value of the loan. And that means that if interest rates go up, right? So you discount at a higher rate. So that means the loan value goes down. So it measures how risky this investment is if you have fluctuations in interest rates. So just to throw out some numbers there, so even some of these bonds that I looked at, right, so there are bonds that have maturity 20 years and 40 years, their duration was really only 12 and 16 because I mean there are some payments are flowing already early on. And so on average the loan is roughly paid after much less than the whole 20 or 40 years. And then if you do the same thing with the mortgage, you have even surprisingly low duration. So I think I calculated something like somewhere between 11 and 14. So 11 would be the duration for a 30 year mortgage and 14, so only three years longer would be for the 50 year mortgage. So if you calculate the interest sensitivity of the price of that loan. Yeah, I mean you go from 11 to 14, I think it was 10.7 versus 13.7. So it obviously has to be higher because it's a longer maturity loan if you increase the mortgage. But it doesn't mean that a 50 year mortgage, the price risk due to interest rate fluctuations doesn't have to be 50 over 30. That doesn't have to be 67% higher risk. It's actually, it's only 25% more risk for from interest rate fluctuations. So these are risks and people would want to be compensated for that. But most people buy bonds because they tend to be a good diversifier of your equity risk. And then by the way, each individual mortgage of course also has some credit risk built in. So imagine we take this big pool of mortgages, it's not just one borrower. So you diversify away a little bit of this idiosyncratic risk where somebody loses a job and can't pay the mortgage and then they get angry and they pour concrete down the pipe and make sure that the bank doesn't get the house at full value either. Let's assume that is already all averaged out and we make this basically almost like a relatively safe government bond minus a little bit, maybe a 1%, 1.5% or 2% chance of maybe some mortgage delinquencies along the way. Way. Lots of people like these kinds of fixed income investments because they behave in a way that has some nice correlations with your other risky assets. Right. So the bond risk seems to be at least uncorrelated, sometimes even negatively correlated with your equity risk. Obviously there's risk and there's duration risk and interest rate risk. Many times the interest rate risk is actually a good risk to take on. And there might be even some people who say, well I, I love the interest rates risk so much. How can I get more of this? And of course, whereas in isolation, obviously everything's more risk should deserve a bigger premium. So in the big scheme, just having more interest rate risk doesn't necessarily mean that you get terribly penalized for that because it's a risk that people actually seek to hedge other risks. So either say imagine you're a private investor and you have your equity portfolio out. Maybe you want to have only 75% equities and 25% bonds because if equities go down in a recession, bonds have some potential to go up and hedge some of that risk. Or say you are a pension fund or any kind of an institutional investor where you want to hedge some nominal or sometimes real future cash flows. Then you would also like bonds and you, you wouldn't really care too much about the interest rate risk. Because if interest rates go up, yes, interest rates go up. That means your portfolio goes down. But if interest rates go up, then the future discounted cash flows that that you owe, they might also go down. So you actually like that kind of risk. So it's a risk that is a good risk to take for a lot of actors.
- [39:53]
A
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- [41:24]
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- [42:43]
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- [44:01]
Help take control of your retirement your way. Bolden is for informational and education purposes only and does not constitute investment advice.
- [44:17]
I want to return back to the attractiveness of a 50 year loan for the average owner occupant. And one of the main points that gets brought up, particularly in mainstream media when we read about the 50 year mortgage is the massive differential in interest that the average owner occupant would pay if they were to hold this to maturity. You make the point in your argument that paying interest isn't bad. Elaborate Right.
- [44:47]
B
So at least if you read between the lines, you sometimes see that people get offended that over time, the longer the mortgage is, the more of your payment goes towards the interest and not paying down the principal. I'm not offended by that. Because you can't just take the sum of your payments. Because the sum of your payments, you're comparing apples and oranges, right? Because a payment of say $3,000 for your mortgage today is very different From a payment $3,000 20 years into the future. There's a time value of money. Everything needs to be discounted back into today's dollars. And if I take all of these payments and I discount every one of these payments back at the mortgage rate and I sum them all up, by definition, I get the mortgage principle. So every mortgage has you pay exactly the principal and then everything that you pay in nominal dollars in addition is interest. But yeah, I mean, if I discount it down, there's nothing offensive or abusive about paying more in interest. For example, at today's interest rates, even the 30 year mortgage, right, at something like 6% or a little over 6% in some cases over 30 years, you would pay more in interest than principal. And then with the 50 year mortgage, I think it's probably something like a 2 to 1. So out of every dollar, you probably pay only 33 cents of principal and 60, 66 or 67 cent of interest. I don't think there's any magic line that you cross, you know, where if you go from more interest than principal, then, I don't know, the universe blows up or something like that. For example, going Back to that one bond that I described, there was a 100 year bond. It pays an interest of 4.1%. The principal is paid after 100 years and through that time, right, 4.1 times 100 you paid. For every $100 loan, you paid $410 in interest and only $100. That's what the principal pay down is at the end. So it's actually, it's actually 4.1 to 1. So more than 20% of your payment goes towards the interest in that corporate bond. And I'm sure that the company that did that is actually quite happy because they locked in a 4.1 rate on a corporate bond 100 years into the future in 2021, when interest rates were really low. So this is in no way abusive. The discussion reminds me a little bit of this discussion and I'm sure you have talked about this. When people do the crossover points of Social Security where they Say, well, I'm looking at the total number of payments that I get and I do this up to my life expectancy and if I claim at 62 versus 67 versus 70, and here are the crossover points. And a little bit of my soul dies every time when I see that. And by the way, very mainstream people publish this. I've seen this on the webpages of Fidelity and maybe Vanguard too, where basically commit these crimes against mathematics. Right. It's not the total number. You have to do discounted sums. You have to. An actuarial analysis would actually do the survival probability weighted cash flows and then also discounted at just the right discount. It shouldn't be an equity market expected return, it shouldn't be a cash return. It should probably should be somewhere in between. So that is the proper way to do it. There's a net present value analysis and if we do a net present value analysis of any kind of mortgage, you never pay any interest because the discounted value of all the payments always comes back to be the principal. So I'm not particularly bothered. But as definitely is a very effective and cheap shot at the 50 year mortgage. If you say, oh my goodness, you pay so much in interest over the years, but for people like us it's not very convincing that if that's your only point, then I think that I want the argument in that case.
- [48:52]
A
All right, what do you make of the argument that, you know, right now the average age of the first time homebuyer nationwide is 40, right? Hit 40 for the first time. If we take. And of course most people don't hold one singular mortgage for their entire life, but if you were to buy a home at the age of 40 and hold it for 50 years, you'd be 90 when that mortgage is paid off. That creates a best case scenario, assuming no early payments or prepayments. It creates a best case scenario, assuming you never move and only hold one mortgage, of having that home paid off at the age of 90. And then for the average person who tends to move every seven to 10 years and who sells their home, cashes out the equity, uses it to buy the next home and then restarts the amortization clock, they would necessarily be restarting with very little equity and then restarting the amortization clock over and over and over to such an extent that ultimately they would at the end of their life have built very little equity and maybe have a huge debt that they would pass on to their heirs.
- [49:56]
B
Right. So again, my same point applies again, so we have to take into account not just the nominal but also the real mortgage balance. So your property hopefully has increased a little bit. You build some equity there. I view this also with a bit of worry that people get mortgages when even today, right? Forget about the 50 year mortgage, right. If you are close to retirement, there are some people that are still getting a new mortgage at age 50 or 55 or 60 and it's again a 30 year mortgage. So in some way, even today, with today's financial technology, there are some retirees that, well, they are homeowners on paper, but they are really renters and they are renting a house from the bank. And in some cases it may make sense, right? So for example, you could be a retired government employee and you get pretty reliable cash flows and you just say, well, I'm not going to pay down my mortgage, right? I just budget for what I pay for my mortgage in retirement and I keep paying that down and then be done with it. Because you know, whether my kids get. So I'm talking from the perspective of other people. So I have one daughter and by the way, I don't have a mortgage. Imagine I were in that situation and I say, well you know, if my daughter gets the house free and clear when I die versus my daughter gets the house and there's still a little bit of a mortgage on it, chances are she's not going to stay in this house anyways. It will be sold at the closing table. We take the mortgage balance off. It's still pretty neat home equity left after that. Imagine if I had invested the incremental payments, so not having a mortgage, I would have to sell more of my assets. And if I have the mortgage, maybe my assets actually appreciate faster than the mortgage interest rate. So there's some chance that your kids will still get something. And it's not even clear whether the mortgage versus no mortgage inheritance is bigger because whatever your mortgage does or whether you have a mortgage or do have a mortgage might also have an impact on your financial risk. I mean, sometimes people do these calculations. So one person has a mortgage and the other one doesn't have a mortgage. And then you look at what happens after 20 years. Well, that's not the issue. The question is if I'm close to retirement, should I liquidate some of my assets and get rid of the mortgage and then be mortgage free in retirement and that would lower my financial assets. So it's to do a fair comparison. It's not 100% clear that with the mortgage or without the mortgage, it's Better for the heirs. I personally don't have a mortgage. How do I not have a mortgage when I retired? When just five years before retirement, I just did my last refinance as actually there was another nice interest rate trough in late 2012, I don't know if you remember. So I locked it in there and I did the paperwork in early January 2013, almost exactly five years before I retired and sold my place. And five years later I have no mortgage. So did I pay down my mortgage over 5 years? Did I have a 5 year mortgage if there is even such a thing. And of course I don't. Right. So basically what I did was I lived in a very expensive area. I lived in San Francisco, right middle of downtown. I sold the place, of course I had some home equity then the mortgage obviously was paid down a little bit. But then again the big impact on my equity came not from the mortgage pay down, it came from the property appreciation which wasn't insane. It wasn't insane. I think I had something like a maybe 5 1/2% annual property appreciation. So it's more than inflation and it was a good time to own property in San Francisco. If I had bought a little bit later, I could have bought a little bit more at the trough then I could have probably done something like double digit annual return on the property price. But when I bought it was not the ideal time, but I still made it.
- [53:52]
A
What year did you buy?
- [53:53]
B
I bought in 2008 which was a bad year to buy in San Francisco and I could have waited maybe until rock bottom prices in early 2010. That way I would have had better pricing. So bought in 2008, sold in 2018 and I walked away with enough equity and then I bought a place in a much cheaper area in Washington state, not in Seattle, which is also quite expensive and not in Portland, Oregon either, but across the river from Portland, Oregon.
- [54:21]
A
Oh, Vancouver, Washington, is that right?
- [54:23]
B
Exactly. Vancouver, Washington is just a little bit away from where I live, which has nothing to do with the Canadian border. Right. We are at the, the southern corner of Washington State and it's, it's actually named after Fort Vancouver. Right. Vancouver was some, I think lieutenant or somebody who explored this area. Yeah, it's actually the Washington Vancouver was founded before the Canadian Vancouver, but of course Canadian Vancouver is much bigger now. So I bought a place here and now have no mortgage. Not everybody was as lucky as I got when I retired. But you can definitely extrapolate that to other retires. Right. So you retire, you move, you're living Very close to the city, maybe you move a little bit away, you don't have to clog up the freeways in the big metro areas. Maybe move out to where it's a little bit quieter and then buy a cheaper place. And that is probably the much better way of going from mortgage to no mortgage, from working to retirement, but then diligently paying down your mortgage. Because I don't know anybody anymore who has a mortgage from 29 years ago and they're just about to make their last payment of their 30 year mortgage. I mean that's totally unheard of because of refinances and job moves and other reasons to move, especially right before retirement. I, yeah, I think the best way to go mortgage free is to just scale down your house or move to a smaller place, cheaper place that's much more reliable nowadays.
- [55:51]
A
Although scaling down your house is sometimes difficult in an environment in which home prices are appreciating rapidly. And the premise behind this question, I guess the unknowable, is at what rate will home prices continue to appreciate? But I can certainly tell you from my own parents experience attempting to move, or they did move, but moving in their 80s to a home that was more mobility friendly, nothing fancy, but just a home that's more mobility friendly, one story rather than two stories, so they don't have to use the stairs. Because home prices had appreciated so much, even moving to a further out location, a quote unquote worse location, even despite doing that, they still actually ended up paying a premium.
- [56:40]
B
That exact issue also crossed my mind because I looked around in our area and so we live closer to Portland in a very good school district. And once our daughter is done with school, why don't we move to a cheaper place further out? Well, I wouldn't call it countryside but somewhere less desirable. And I mean you'll be surprised that if you move further out, less urban and it's kind of not even suburban, more exurban prices really don't go down because well, you also have more land and then the houses are much bigger than ours. That can be a challenge.
- [57:20]
A
And in the era of remote work, you know, you've got higher demand in those areas, at least from knowledge workers.
- [57:26]
B
Yeah. So it may not work for everybody. It definitely worked for me. Moving from San Francisco to Washington state. It's not going to work. Moving from St. Louis to Kansas City, I mean that's, you probably have the same prices or potentially higher prices.
- [57:42]
A
Right. And so that goes back to then the common criticism of the 50 year mortgage, which is you could spend your whole life never building much equity and ultimately end up saddling your heirs with debt.
- [57:53]
B
Oh no. I mean, first of all, debt would require that your home, also the home value goes down to zero, which I hope it doesn't. So there's still a home value behind the mortgage. And it's not about settling your heirs with debt. It just means that you have a little bit less equity. I think it's still, for example, we have the step up basis for heirs so they can inherit a property and basically the capital gains are forgiven. There's still a lot of attractiveness, not just homeownership, but homeownership as an estate planning tool. And you know, if you have a little bit of a mortgage, I think most of the time the heirs will just sell the home and pay off the mortgage. And I mean, if I had the choice, do I rather want to inherit a house with the mortgage or without a mortgage? Of course I want a house without the mortgage. But for most people we have to do a real horse race or the side by side comparison, right? Do I want to inherit a house with a mortgage plus a big equity portfolio which by the way also gets a nice step up basis or maybe the people that gave you the money pay down the mortgage and have a much smaller equity portfolio. So it's really depends on what's the path of equity returns over the next few years. I think if we do a real fair comparison, some of this discussion is a bit fear mongering, right? I mean, you're going to leave debt to your heirs and even with the 30 year mortgage, right. Lots of people are still going to get brand new mortgages when they move in retirement. So I think just having a little bit of a leveraged life is that's just the lifestyle we have here in the United States. And so I grew up in Germany and it would be totally unthinkable for 50 year olds still to get a new mortgage. You settle down, you build a house, you pay down the mortgage, you stay there pretty much forever and that's it. So this is, it's a lot less leverage, a lot less money and liquidity sloshing around there. But I mean, it's just the way Americans roll, I think.
- [59:55]
A
Right. And in part that's the price that we pay for mobility.
- [59:59]
B
Right.
- [60:00]
A
And that leads to another objection to the 50 year mortgage. And this is actually one of the main objections that I have on a societal level. Could this mortgage contribute to rapidly inflating home prices by virtue of getting more people Unqualified borrowers into the market who then consume supply, which further curtails the supply issue. It's a demand side solution, essentially.
- [60:27]
B
Yes. And if we deal only with the demand and we make it easier for buyers to afford stuff without doing anything on the supply side. Yes, I absolutely think that is a huge concern.
- [60:39]
A
Oh, we're in agreement.
- [60:42]
B
Especially in the big metro areas. Right. There's constraints. You can't just invent new land around San Francisco or New York City or Seattle. Right. You have some constraints on how far you can build.
- [60:55]
A
Manhattan is literally an island.
- [60:57]
B
Yes, that's right. And so these are just geographic and physical constraints, but I think they're also man made constraints. So there are rent control. Right. I remember some tweets just a week or so ago that had to do with that and that hampers supplying new homes. By the way, why does rental market have to do anything with owner occupied? Obviously if more people could afford to rent and if more landlords built nicer and bigger and cheaper homes for renters, it would take off a little bit of the pressure of people trying to look around and buy houses. So it's really from almost every direction we are constraining the housing market to work properly. We have renter control. And then it's any kind of building codes. Right. The building codes become more involved every year because politicians say, oh, wouldn't it be better if we build houses that have all of these additional features and they're all really nice but they're making new construction a lot more expensive. I don't know if people ever think that way, but they should also take into account some of the building codes and as a zoning and the delays.
- [62:07]
A
During construction, the permitting process.
- [62:10]
B
Yeah, I think it's just from identifying a lot of land to the people actually moving into the subdivision there. I think it probably takes five years or so.
- [62:20]
A
It takes a very long time. And yet there's setback requirements, there's density limitations.
- [62:24]
B
It gets very rural after a while. But I mean, so we have some areas where the lots have to be 5 acres minimum. Right. So it's not, not 0.5 but 5 acres minimum. And it's just because the people that live there, they don't want multifamily. They don't want a subdivision where people live door to door and window to window. And you look out your bedroom window and then six feet away is somebody else's bedroom window. There are some areas where it's intentional. We don't want very high density living here. And yeah, so Everything contributes to that. And then because we have these constraints now, if you make it cheaper to get the mortgage, and by the way, it's not cheaper, is only relaxes your cash flow and you bring in more potential buyers. Because the constraint and the concern would be that, well, you're just driving up the price because everybody is just lining up and they say, okay, well I was able to get a $600,000 mortgage if it's 30 years now I can get, I don't know, I'm just making up the number a $650,000 mortgage because it's a 50 year mortgage. So I'm just going to bid up the price to 600. But then everybody else does the same thing and you are not building more. Only one person can get that new house. The people that benefit from that are the existing homeowners. So for example, you are renting, right? But you have rental property. So in some sense you are a net landlord. And I am a net landlord in the sense that I own this place and then I have some real estate rental investments. So for us it's actually good if we bring in more people and just drive up prices because you're basically taking away from poor people and giving it to rich people that already own real estate. The average person who gets into the housing market, I don't know if it's really beneficial to them to tie that 50 year mortgage to your leg. Yes, I absolutely agree that we shouldn't only do the 50 year mortgage. And for example, I think that the 50 year mortgage, right, for me to be a big fan of it, there should probably be some underwriting constraints. You should be able to qualify for the 30 year mortgage and then you can also have the 50 as an option. If you can't afford the 30 and you only get the 50, it would contribute to just driving up prices. And so I think that is a valid concern. But then again, I also say that just because one method doesn't solve the problem entirely and it's just a small improvement, doesn't mean that we shouldn't consider it. This is a bit concerning that this could have zero effect on building more stuff. I mean, for example, it could have the effect on that if we make this 50 year mortgage more available to the commercial side, right? So if you're a landlord and we push more landlords into the 50 year mortgage and they pick this up and maybe they are the first ones to implement it and the early adapters, maybe it would have an impact on the supply side where landlords Say okay, now it's more attractive for me to build homes and I have a long horizon and I'd rather have a 50 year horizon than a 30 year horizon. That means I have, I can build my next property faster because the cash flow is a little bit lower for me, that is the one chance I see. But without solving the supply side that's working only on the demand, I mean it is doomed to fail just like any other, any other policy that only looks at the demand. Right. Like rental control. Oh yeah, let's control rents and then everything is going to work out and of course it's not right. So we all know why if we, we studied economics.
- [66:01]
A
Right? Yeah, and that's exactly a major piece of my objection to it as well. It is a demand side solution to a supply side problem that will have the likely have the net effect of only driving prices up.
- [66:14]
B
Yeah, I agree with that.
- [66:16]
A
All right. We have found a couple of points of agreement.
- [66:20]
B
Yes, for sure.
- [66:23]
A
Well, thank you for having this discussion, Carsten.
- [66:25]
B
You bet. Glad I could come on the program or this debate.
- [66:28]
A
I should say thank you for this debate.
- [66:31]
B
Yeah, either way it's always my pleasure.
- [66:34]
A
Carsten, where can people find you if they would like to learn more from you?
- [66:37]
B
I have a blog earlyretirementnow.com and I write about retirement related topics. But of course anything finance related I sometimes weigh into and just like this one, try to play devil's advocate there a little bit. I'm on Twitter too but if you go to my blog you can find the ways different routes to contact me.
- [66:59]
A
Well, thank you for joining. The debate with Karsten over the 50 year mortgage was intended as a debate. It actually really turned more into an interview style episode. You know that's what happens when I talk to Carsten. He is one of my favorite people to talk about economics with. So thank you for being part of this community. I hope that you enjoyed this discussion slash debate. If you enjoyed today's episode, please do three things. First, share this with friends, family, neighbors, colleagues. Share it with the people in your life because that's how you spread the message of F ii r e. Second, subscribe to our newsletter affordanything.com newsletter and finally hang out with the community affordanything.com community. It's where you can find like minded folks who share your fascination with all things finance. Thank you again for being part of the Afford Anything community. I'm Paula Pant, this is the Afford Anything podcast and I'll meet you in the next episode.
- [67:57]
Oh, is there any Fed gossip.
- [68:00]
B
Oh, no. I mean, I'm, I'm not connected anymore. But the gossip is that they will pause and.
- [68:08]
Makes me a little bit nervous. I mean, this is basically why the market is a little bit jittery right now. So there may be a pause in the rate cuts in December, which makes me wonder, why would they pause? Well, we don't have the data, but out of caution, if the reason why you did the rate cuts at the beginning is because you're worried about a slowdown, and now we have less data, so probably still do the rate cuts, what difference does it make if you reach the, say, the 3% or whatever the landing point is supposed to be? If you reach the landing point by one or two meetings early, if there is a slowdown and then we lose the data and we don't observe the data for a while and say, oh, no, we should stop lowering rates now. That's a really dumb thing to do. Right? So you take the foot off the gas, right? Oh, and now, oh, now we are literally driving in a car, right? You take the foot off the gas. You want to slow down because you're worried about something bad happening. And now you get into the fog. They said, okay, no, I'm no longer taking the foot off the gas. I'm going to keep the foot on the gas because there's fog. I don't even know what's going on. And no, I mean, you should still take the foot off the gas if you have less information now. So it's really, really weird stuff going on at the Fed. So I think this is going to have some. It reminds me of 2018. Remember that 2018 where it was a Fed meeting in December. Everybody said, okay, it's kind of, we got this in the bag. And then Jerome Powell comes out swinging and sounding really hawkish, and then sends the market off into the Christmas break with everybody was total confusion and people are scared that the Fed is going to be way too hawkish. And it was basically a total meltdown. Right? The days before Christmas, 2018 was very bad in the stock market. I'm concerned that something like that is going to happen again.
- [70:03]
They're going to say, oh, yeah, I mean, we're not really sure about the slowdown anymore. Well, so you're afraid about inflation now, again, as very, very strange. What's going on?