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Homeowners should take a total-balance-sheet view when evaluating options for their mortgage.
The 30-year fixed rate mortgage in the U.S. is one of the best financial deals available anywhere in the world, providing a government-subsidized interest rate, generous tax breaks for many borrowers, and a valuable refinancing option. Since its introduction in 1934, it has played a central role in the growth of American homeownership.
For many households, the decline in interest rates since the 1980s has also prompted a recurring set of financial planning questions related to their mortgage: Should I prepay the loan? Does it make sense to make extra principal payments? Should I refinance and when? Should I extract equity from my home with a bigger or second loan? Should I tap the equity in retirement through a reverse mortgage?
The recent upturn in mortgage rates and inflation, to the extent it foreshadows a longer trend, will raise a different set of questions: Does it make sense to prepay an existing below-market-rate mortgage? Should I opt for an adjustable-rate loan for a home purchase? Am I building equity in my home? What should I do with an existing reverse mortgage line of credit?
The answers to all these questions depend on the risk tolerance, goals, and time horizon of each client. But in each case, they should be answered by focusing on the entire household balance sheet.
Balance-sheet perspective
A total-balance-sheet perspective is critical because without it, risk-return decisions will be incomplete. For example, there is a tendency to characterize a mortgage as a “negative bond” and compare the interest savings on the mortgage to the return on bonds. But this is not taking a full-balance-sheet perspective: Paying down a mortgage is not equivalent to investing in bonds, as I’ve described here.
Similarly, there is a new trope emerging that if you were lucky enough to lock in a low rate on your mortgage, you have a “hedge” against inflation because your payments and loan balance decrease in real terms. But that ignores the asset side of the balance sheet, which is subject to the same inflation. What is being hedged? Somebody who is paying 3% on a mortgage while having assets parked in cash at 1% because they are nervous about the market is not hedging against inflation – they are losing 2% even before the further erosion of their net worth by inflation. Somebody who had a 60/40 portfolio and a 3% mortgage so far in 2022 … well, you do the math. Maybe the home appreciated enough to offset that debacle.
A mortgage is attractive leverage and a below-market mortgage is very attractive leverage – but it is still leverage. It increases risk. To benefit from leverage, the return on the borrowed money must exceed the cost of debt. A key question is where the borrowed money is deployed. For a young household with few financial assets and lots of human capital, the mortgage is literally financing the home and is likely a good deal because a smaller proportion of each paycheck will be required to make the payments (assuming pay increases with inflation and they want to stay in the home). For a household with significant financial assets, the answer is not as clear cut.
The balance-sheet perspective provides a holistic view by focusing on both the assets and the debt financing those assets. It also forces a crucial time perspective. If the 60/40 portfolio is meant for retirement many years hence, it’s a reasonable assumption that the 3% hurdle rate will be met; liquidating the 401(k) to pay down the mortgage probably doesn’t make sense. If the portfolio is meant for current consumption, the answer may not be the same. Funding current consumption with a mortgage magnifies the short-term risk to net worth; on the asset side of the balance sheet. neither positive portfolio returns nor home price appreciation are assured in the short term.
Fortunately, a fixed-rate mortgage probably won’t land you in immediate trouble. The return on a house or portfolio fluctuates in the short term. but if you don’t have to sell you may be okay. The most common trap for investors is borrowing short and investing long. With a 30-year mortgage you are borrowing long and investing short. You won’t get a margin call on your house. But as the great financial crisis showed. you can end up upside down.
These risk considerations should also factor into the other questions that might come to the forefront with higher interest rates and inflation. For example, there has been a sharp pickup in adjustable-rate mortgages. Homebuyers are turning to ARMs to keep payments low and stay competitive in the hot real estate market. Is this a wise move? What happens to home equity if house prices decline 10% and the mortgage rate resets 2% higher? Will there be any equity left? What is the net worth after adjusting for inflation? Does the household’s income support the potentially higher payments?
Inflation can benefit borrowers because it erodes the real value of debt. But what it does to wealth has to be evaluated in the context of a household’s total balance sheet.
Peter Hofmann, CFA, is with Fieldmark Advisors, a registered investment advisor based in North Salem, N.Y.
