The conventional wisdom on mortgages, debt and housing can be confusing: there is good debt and bad debt, pay down your mortgage as fast as you can, don’t pay it down, pay down your high interest rate debt first, never borrow from your 401(k) etc. As a financial expert however, we can look at all these things as a very simple question of going long or going short.
Let me explain in more detail. The stock market and options are hard enough for people to understand but when you get into things like swaps, you lose just about everybody. Yet millions of us are hedging and entering into swaps everyday without realizing it. Essentially, a swap can be broken down into two components: going long one asset and going short another. For example, a received fixed interest rate swap, which can be used to turn a floating rate asset to a fixed rate asset can be thought of as follows: the fixed rate receiver buys a bond which returns a fixed 3% but now shorts a floating rate bond, receiving the principal and paying the floating rate on that principal. Over time the 3% will remain constant but the floating rate may change. The receive floating rate swap is just the opposite: it’s like buying an underlying bond where you receive a floating 4% and pay a fixed 3% on the back end. The part you pay in each of these is essentially what you are shorting. The swap can be thought of as just going long one asset and short the other.
If you extrapolate this exercise to your life, you may realize we are long and short in many things in our daily lives. Something we are all long or short on (unless you live with your mom) is housing. If you rent and don’t have many assets, you are short the rental market, and probably not by choice. If you have enough to own a home and you have a mortgage, you have essentially entered a swap agreement like the one I described above: long housing and short the mortgage market. You will receive the return of home price appreciation or rental income if you rent it, or both. You will pay the rate that you received when you executed your mortgage.
The characteristic of housing that always amazes me in the US and Canada is that the government underwrites the whole mortgage market and gives us things many other countries don’t have available such as 30 year fixed rate loans. This allows the public an extremely handy tool to go long the housing market while locking in a fixed rate short of the mortgage market. For those that have the means to own a home, the mortgage market is like an options market for rates: you can exercise the option when rates are low and lock it in for long periods. Right now we are at what I feel may be close to the bottom of a 40 year secular bull market in dollar bonds. If you feel like I feel and that rates can’t go much lower, it will drastically affect the financial decisions I described in the beginning going forward.
Why You Should Refi Now if You Haven’t Already
Many investors attempt to time the equity market, but right now the trade of a lifetime may end up being timing the bond market to short for the next 30 years. In the early 2010’s I entered a mortgage thinking I would never pay it down as the rate was just too good. At 4.75%, I thought that anything under 5% was a steal and may not be seen again for a long time, if ever. To my surprise when the pandemic hit and the Fed bailed out markets, we started to see rates for primary homes below 2.5% in some places, essentially free money based on the long term average inflation rate.
It helps to take a step back and look at current rates from a historical perspective to see where we are and why this is such an opportunity. We all like to think of the Fed as having control over interest rates but the Fed can only influence rates in the short term, in the longer term, the Fed is subject to supply and demand as well as the expectations of investors. In fact, interest rates have seldom seen a 6 month period where they did not move at least 50 bps on the longer end of the curve. This means we shouldn’t take low rates for granted, there is always a risk in the medium and long term that they can go up.
It’s also worth looking at inflation versus spreads to understand how strange these times of low rates are. For decades, investors demanded a premium to inflation to hold bonds to compensate for the risk that inflation could overshoot. This average spread we witnessed in the 2010’s is bested only by a period of high inflation that was seen in the 70’s when the figure was often negative.
What this means is that we are sitting at a period of very low spreads as well as very complacent inflation expectations. There is always the chance that things could go lower: activity remains slumped, rates fall again and we can take out debt (or short bonds) at a lower rate but keep in mind there is a lower bound on this. The Fed does not seem to be keen on having negative rates which means we are at a floor and if that floor is maintained, the risk in the long term is that either spreads to treasuries or inflation will jump. This is why those that can need to lock in these mortgage rates and effectively short the bond market for the next 30 years.
Why it Should Be Fixed Rate
There have been some homeowners who have used adjustable rate mortgages (ARMs)in the past in the short term and then refinanced and locked fixed rates in a few years later for the long term. This was fine for the last few years when these types of mortgages offered a discount to fixed rate mortgages but recently 30 year rates fell even below the ARM rates, something which, to my knowledge, has not occurred before.
This all points to locking in a short on the mortgage bond market through taking a loan at a 30 year fixed rate and paying it down as slowly as possible. This assumes you use the proceed to purchase assets that will appreciate over the long term: stocks, private equity, art, classic sport cars etc. Some may feel that this may be best spent upgrading or fixing up their property but if rates and/or go up, it could soften the housing market and make home improvement a losing investment. Personally, I would prefer to use the proceeds from a refinance to diversify towards assets that have room to run: shares in value companies as well as emerging markets are currently my picks.
In fact, if you are ultra disciplined and responsible with your money and you believe this is a great time to lock in low rates, you should be doing everything in your power to take out low cost loans to pour into assets which will appreciate over the long term. To reiterate the point, we may hop along the bottom for a while in terms of rates but do you really think rates will continue to go lower as they have for the last 40 years as seen below via the 10 year treasury yields?
I don’t, and even if they plateau at these rates it won’t hurt asset prices and would justify not paying down debt in order to see your assets appreciate. If spreads do start to climb it makes things more tricky but doesn’t mean that growth won’t occur, investors will just likely crowd into trades that leave them the most immune from higher rates like the consumer staples and healthcare sectors that can pass on higher prices to consumers. I believe that the home price appreciation we have seen in the past year is a one time pop and more normalized rates could produce some softness in the market in the coming years. For now however, I expect to see prices continue to climb through the summer and into next year if the Fed holds things steady.
Short Trade
If you are really adventurous and agree with my logic on rates, you could apply this to any type of debt, assuming it’s a low rate and you can use it responsibly. Mortgage debt provides some of the lowest rates achievable for many people which is why I used in in the example here, but really any type of low rate collateralized loan will work in terms of shorting. Where I would not turn around and put the proceeds is into other low risk, fixed rate investments such as treasuries and short term fixed income, this would create a net hedging loss if you were to receive 1.5% and pay 2.4%, this is a risk on trade.
For my part, I am fully vested in this trade and have maxed out my housing borrowing at over half a million to put the cash to work while locking in low 30 year rates on my properties. Just because 30 year rates have bounced off of the bottom doesn’t mean there still isn’t a great opportunity at play here. For those with financial discipline, this long term short trade may make you rich.
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