Paying 4-4.5% mortgage & earning 0-1% on savings

Because they need a place to live?

Because the mortgage is a 30-year fixed rate at historical lows and the savings is at a short-term rate at historical lows?

Doesn't answer the question. If you are in that situation, would it not make more sense to prepay the mortgage?

They might have the view that rates will be rising. During the 90's the 10-yr averaged about 6.0%. If people think they can (eventually) flip their money market/demand deposits into longer-duration treasuries in the mid/high single digit %'s, they will be happy to keep a 4-4.5% mortgage if this plays out.

Not saying it's a good idea -- just one possible answer to your question. People also value liquidity as you noted.

RS, do you really not know the answer? I am happy to explain it to you if you are looking to understand something you don't understand, but not to get into some argument. It's pretty basic stuff.

Opportunity cost for other investments.

What if you lose your job? It is illogical to not have a rainy day fund. The last thing you want to do in this market is be forced to sell. If you have a year's worth of maintenance and mortgage, you can live a while on unemployment while you look for another job

Cash does have the virtue of optionality, but at some point the negative carry makes little sense. When the borrower carries equally large balances, the negative carry is just too large to ignore. Short term rates would have to rise hundreds of basis points to make this strategy work.

dcorreale, I started the post saying(allowing for rainy day fund). I agree maintaining a rainy day fund trumps the discussion, but assuming you have that need satisfied...

Well, in that case, I would pay off my mortgage, but mainly because I am risk adverse. Once you pay it off, it becomes much more difficult to get it back, most likely at much higher rates. A reasonable person could hold onto that money believing there will be a better investment down the line. Of course, the more time it takes to find this investment, the higher hurdle rate needed

My premise is that people over-value opportunity cost and fail to properly consider the negative carry.

well you could buy long term munis at 4%

but you're the one who has been shouting about inflation. over and over and over and over again.

if you believe that inflation is inevitable, then along with it will come severe increases in interest rates.

so why not sit with a long term fixed obligation and hold your cash until such time as inflation actually occurs.

Isn't the spread between 30-year fixed and savings always about 3% to 4%? Why would the answer to this question be different in any other interest rate environment?

wellheythere.
You are alluding to the steep yield curve.

Because compartmentalizing money is a method of money management that people find effective, even if it isn't always the most "rational" approach?

Here are the reasons.

1) Credit risk. Say you have $1M place. With a mortgage, you put $200K down and limit your losses to just that. If the shit hits the fan (job loss, drop in value of home, whatever), you sit in your home for 3 years without paying anything while the foreclosure process moves forward (probably worth $100K).

2) Short-term interest rates will be higher in the future. The 4% vs. 0% thing is just temporary. The market is trading in such a way where you can lock in 3-4% short-term interest rates 5 years out.

3) Inflation risk. Cash is protected against unexpected inflation. A 30-year fixed rate is not. As CC points out.

4) Liquidity premium. Just as people value the optionality of cash, so do lenders.

"well you could buy long term munis at 4%"
While only offered as an alternative, this may prove to be a very foolish suggestion. Before long these same muni bonds could be yielding a lot more. So far QE2 hasn't kept the yield curve moving in the right direction.

1)You wish to be long put risk to the bank and have the option of default? We've already established the rainy day fund is outside htis discussion, and if you default on your home and have cash, the lender has the option of seeking a deficiency judgment. If you have the cash, the bank can ask for it.
2)Temporary can be a long time. Today's libor forward curve doesn't breach 4% until 2015. Your answer implies massive volatility
3)Cash is not necessarily protected against inflation. You're assuming real rates of return are always available which is false.
4) I agree with this, but stated, my premise is that you are over-valuing the liquidity premium(optionality).

PMG, I agree on the muni example. Today a 30 year mortgage is around 4.75-5., which is roughly 3% after tax, but to do that you need to invest for ten years. The duration doesn't match but is close enough.
My example had someone borrowing long, and investing short.

1) In a non-recourse, the bank cannot go after your assets. In a one-shot state, they rarely do. Even here, there are ways of protecting your assets. For example, a retirement account. Or a home in Florida declared as a homestead. Also, it may rain longer than you anticipated. These are the reasons why lenders charge more than 30-year treasuries. If you feel differently, maybe you should lend your money out for mortgages at treasury rates and see what happens.

2) The point here is that you should be comparing the 30-year rate to, say, 5 years at 0% plus 25 years at 4%. Not just the first year at 0%.

3) I didn't say that cash is protected against inflation, just that it's protected against changes to expected inflation.

4) I'm not valuing anything. The market is. Most of the difference you're looking at now vs. a few years ago is #2.

1)NY is recourse. And if you shield the money in a retirement account you can't touch it without significant penalties.

3) Cash historically is a very underperforming "asset". Only does better than all other asset categories over short periods of time(market disruptions,panics, corrections, etc). Since cash is liquidity and represents zero duration, don't expect to get much in return for it.

Schooled.

If you lose your job, you can get a loan modification. If your mortgage becomes upside down, you will get Harp relief.

Not getting money at 4.5% interest rate is a big mistake.

So If I have a million dollars in the bank and lose my job, my lender will reduce the payment on my 350,000 mortgage?

inonada:

Curious what you would do here. Say a person is carrying a 30yr conforming mortgage of $[x] at 4.5%, and is fortunate enough to have liquid assets of 2x. After allowing for the rainy-day fund, as Riversider notes, what do you do?:

A) pay down the mortgage
B) stay in cash and wait for rising short-term rates (with negative carry until then)
C) try to beat the cost of the mortage. i.e., invest the cash in longer-term bonds or equities.
D) do some combination of b) and c), for diversification

The practical problem is that while (B) may be the most prudent approach, a lot of people don't have the patience and will go for (C) and end up with too much risk on the asset-side, on both their liquid assets and the illiquid apartment equity. So they pay down the mortgage. Rational or irrational?

Waiting may not be trivial. Fed floored short term rates close to two years ago.

My personal view: strike a balance. Some cash, some bonds, some equities. (Or commodities in the last category, or whatever is your pick to reach a bit for return.)

Per my example above, perhaps 1x cash, 0.5x bonds, 0.5x equities. In other words, I see no reason to hold cash balances well in excess of the mortgage balance.

BUT - if you can't live with investment losses, then redeploying *some portion* of the riskier assets to pay down the mortgage is not a bad way to sleep at night, IMO.

My main point here is not to make a particular choice, just explain why people would make different choices & the market prices accordingly.

To answer your question seg, I have to start applying my personal risk preferences. I'd personally first sell the apt (assuming we're talking NYC).

Putting that option aside, the decision between paying down the mortgage and investing in long-duration bonds depends on a few things. Is it recourse vs. non-recourse? This speaks to the value of the credit risk component. Do I have 10% equity or 50% equity? If the latter, the credit risk component is pretty worthless. What is the tax situation and effective interest rates? Is my loan of the right duration (i.e., am I paying a 30-year rate for what I think will be a 5-year loan), and if not can I refinance? In short, I think the mortgage vs. long-term bond question can be answered without getting into too much detail about a person's risk preferences.

When you start talking cash vs. mortgage/bond vs. stocks, it gets into a person's risk preferences. Here, there are no right answers for everyone.

My own take is if you are in the above situation, you pay down your mortgage which creates more available cash flow each month so you can save even more and buy more stocks, bonds, commodities, or investment properties. Accumulating debt has not traditionally been a very good way to generate long term wealth.

Accumulating debt as not been a good way to generate long term wealth.

I disagree completely. The ROI and cash on cash is far greater with debt (leverage) than all cash.On investment properties it is actually a big no no. The true purpose of investment properties is DEBT ACCUMULATION. It has actually little to do with real estate, just that banks will loan on real estate and little else (except LBOs). Which by the way tells you that your porfolio is so risky that banks won't lend on it.
But why is good debt accumulation good?: simply it is a very long, inflation protected and tax protected,put against the purchasing power of the borrowed currency. That is the true core of real estate investment properties.
For those who shun that investment, having a fixed mortgage is not a bad thing. Ever wondered why housing is the biggest asset of most older americans? Because inflation destroyed their mortgage leaving them the house.
And today the mortgage rates are NEGATIVE, artificial completely, whereas true inflation is north of 5%. The fed is actively destroying the value of the USD to the benefit of....debtors (thebiggest one being the US govt).
Investments cannot be evaluated properly just taking into nominal rates as opposed to real rates. I am not even mentioning the probable future.(severe inflation, much higher rates, which will lock a lot of people not qualifying for mortgages, stuck as renters when rates are going up10%/year, whereas those smart low rate mortgage holders will be making out like bandits on a post inflation post tax basis).
Locking a low rate now will be the best investment for most americans, while bonds/stocks wil be devastated by the inflation

living debt free is a very dangerous proposition in a fiat currency environment

The thousands of Americans going through bankruptcy and foreclosure might argue otherwise.

how many of those people fit the criteria that you specified?

overextension of lifestyle in a real estate bubble was not the point of the thread was it? I though we were talking intrest rate differential/ good debt/bad debt.
My discussion was all things being equal.For example let's say you have 5mil in assets: Joe has no debt and 5 mil in SP500 and bonds and Steve owes 5 mil on a small builiding and owns 10mil of precious metals.
Smae net worth: 5mil.
I would marry Steve any minute.Joe seems secure, but on a purchasing power basis, after tax,after inflation he will fare very poorly over a 10year horizon.
That's my take.I don't know the future , just probabilities based on the current situation (QE to infinity)

nicercatch: If New York were a non-recourse state and you have 5 mil in assets, then (ignoring the headaches/moral issues of strategic defaults) it would be perfectly rational and probably very lucrative to build a mini-real estate empire by buying 5-10 invesetment properties by putting $500k to $1M equity in each. And levering up big time.

But- NY is recourse, right? Doesn't seem to work. Not without putting all 5 mil at risk on every one.

For your second example, buying precious metals with margin debt seems like gambling. You may be right in the long term but could get wiped out in the short-term.

NY commercial should be secured non recourse.Steve owns 10Mil of metals (no leverage here, none).So even if the 5mil is recourse residential the risks are virtually none.
Btw I didn't mention NY nor margin. just asset/debt/rate/inflation positioning

Inonada,
Your response shows growth.

Thanks, I think.

I'm still puzzled by you, though. Uncle Sam was offering you a 30-year loan at a 2.5% after-tax rate. The market is pricing 30-year inflation at 2.5%, which you think is stupidly low. Yet you take your cash and effectively buy a 30-year bond yielding 2.5% with it? Your cash is now effectively locked into yielding 2.5% for the next 30 years, barely keeping up with the inflation numbers that you think are too low.

I'm not making any claims as to what the outcomes will be. I just don't get how one goes from "inflation is vastly understated / underestimated" to "buy long-term fixed bonds". In fact, the only way I know of profiting from unexpectedly high inflation, if you think CPI is bogus (as you do), is to short long-term bonds.

Re-read the discussion . I've laid out the full argument.
---------------------
And about buying bonds.
Cash pays nothing, Bonds and Stocks are over-valued. Bonds return nominal principal, stocks do not.
If stocks came down I'd be more bullish on them. Just picked up some munis (intermediate term) this week. I got more yield than I would have a month ago. I don't think I got a great deal, just that I'll most likely do better than stocks on a risk adjusted basis. We'll see what happens in six months when I have an opportunity to put more money to work.

inonada, what if the mortgage rate was at 8%?

In today's environment? Pay it down at least to the point where you can refinance, I would think. Unless you're underwater and non-recourse / have no other assets. Then, probably walk away.

inonada, I meant in a future environment where mortgage rate is at 8%. Of course that means other rates would be higher as well. In other words, in a future environment where the rates are expected to be lower as oppose to the current environment where the rates are expected to rise.

Inonada: that should be "don't walk away", live rent-free until them sheriffs show up.

Right-o, nyc10023.

Sunday, I disagree with the notion that "rates are expected to rise" in the current environment. Short-term rates, sure: you can just read it off the forward yield curve. But long-term rates, not so much: forward long-term yields (say years 5-30 from now) are not that different from 30-year yields. If it was expected, it'd be priced in.

RS, just want to check on something with you. Suppose you have a bought a 30-year bond and yields move up by 2% because the market decides that inflation is going to be higher or whatever. Do you know what happens to the value of your bond?

Yes, it generates stupid questions

Nice attempt at deflection 'cause you don't know the answer.

inonada, when I wrote "rates are expected to rise", I only meant it as current rate being historical lows and therefore it is likely to go up whether it be 1yr or 3yrs from now.

My question was in reference to your statements: "Yet you take your cash and effectively buy a 30-year bond yielding 2.5% with it? Your cash is now effectively locked into yielding 2.5% for the next 30 years..."

So I wanted your thoughts on what if the same OP question was posted say x-years from now when mortgage rate was at 8% instead of 4-4.5% and the subject of the future post will be "Paying 8% mortgage & earning 4% on savings"

You really don't know, do you RS? Wow. Look, I'm not trying to be an a-hole. Do yourself a favor: figure out the answer.

there must be a relevant you tube. just keep searching, you'll find it and then you can post it.

https://registration.ft.com/registration/barrier?location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2Fe550f996-0304-11e0-bb1e-00144feabdc0.html%23showclipthis

investing in any kind of bonds at this stage of the currency system is...suicidal.

That's why RS said "stupid question." He/she/it doesn't know (or, more accurately, doesn't want to acknowledge) the answer.

You really don't know, do you RS? Wow. Look, I'm not trying to be an a-hole. Do yourself a favor: figure out the answer.

Yes, you are. If you don't know the answer, I suggest you run a price yield and observe the duration and convexity of your scenario. What are you 12?

w67thstreet makes good points all around.

Sunday, I think at 4% short-term rates and 8% mortgage rates, the answers are much the same in terms of why the spread exists and why people might choose one path (cash) over the other (pay down mortgage). The part of the yield curve that is most unusual at this point in time from a historical perspective, IMO, is that real yields are extremely low. The difference between short-term real yields and long-term real yields are not that unusual: it's about 4%. The weirdness is that we're looking at -2% vs. +2%, not +2% vs. +6%. So from a relative perspective, the decision between investing at short-term yields vs. long-term yields might not be all that different.

But I don't know really, just shooting from the hip.

"If you don't know the answer, I suggest you run a price yield and observe the duration and convexity of your scenario."

I have no clue what that means. I understand all the words, but together they make no sense to me.

Thanks inonada. I just thought that perhaps with the two scenarios being at different end of the cycle (one with rates going up and one going down), maybe there's a difference. Of course the rates could theoretically go much higher than 8%. In any case, I would likely take different actions in one scenario vs. the other.

I rarely play the game of guess-who, but I am very curious as to RSer's identity.

1) How old are you? My intuition says below 35.
2) Are you still in school, do you work? MBA student? Junior finance type?
3) How much of your money (earned) have you invested, ever?
4) Do you own, and if so, did you earn your downpayment?

So, my intuition says that you have not worked for very long, if at all, and that you probably have not had the opportunity to invest your own (earned) money. Because your questions are very "weird".

See, I was totally with RS on the "what happens when when yields move up 2%" question. OF COURSE he knows the answer to that, one would think. His questions are sometimes weird, but they're generally not that dumb and I don't think the premise of this post was a bad one. It has stimulated some discussion.

But to echo everyone else, damn what a gem: "If you don't know the answer, I suggest you run a price yield and observe the duration and convexity of your scenario."

Seriously, RS -- WTF are you talking about here?

premise of this thread, I meant

It's a fine post, a fine thing to discuss, but the guy is inconsistent. You think inflation is understated and will spike? OK, but then why put your cash in fixed income securities that have low inflation priced into them? When I ask a question, he speaks tongues.

It could be either abject stupidity, or he could just be pulling our chain. His prediliction for trying to BS his way out of shit makes me think the latter. But it could be the former.

Nevertheless, putting it all together, I've got a pretty good idea on the answers nyc10023's questions.

1) How old are you?
Old enough to know what I'm saying, young enough to say it with conviction.

2) Are you still in school, do you work? MBA student? Junior finance type?
I am in the school of life. I work to live, but I don't live to work.

3) How much of your money (earned) have you invested, ever?
A good bit.

4) Do you own, and if so, did you earn your downpayment?
Did Lloyd Blankfein "earn" the money to buy the apartment he "owns"?

I think RS is 14 because only a 14-year old would say "what are you, 12?"

Inonada: funny, haha.

RSer does not have a consistent point of view, and the way he/she phrases his/her questions leads me to think that these are questions that are asked without any "real life experience" managing his/her money or anyone else's money for hire. I wouldn't be surprised, given the posting history, if RSer is a precocious 10yo posting in Milwaukee or something. Kinda like a RE wannabe in the fashion of the Park Avenue Peerage dude or PerezHilton-before-he-made-it-big.

As for the big Lloyd, I think he paid cash, so yeah, he owns. If he earned it, well, IMO, he's earned it more than others in his position.

10023 -- I like the kid in Milwaukee comment, although he/she/it is a bit older (14-16), but still precocious. If you listen closely enough, you can hear his/her/its mom yelling at him/her/it to pick up his/her/its clothes. Kind of like Wayne in his basement with Garth, but slightly smarter.

Slightly, yes. But smarter, no.

No Ino's comments showed silliness on her part.
She knows I am debt averse, which is a totally. No sane person would mortgage their real estate on a belief. If you're wrong, you owe a ton of money in interest payments. The comment asking me to explain to her the duration (loss) that would result from a treasury during a rising rate environment was pointless. Furthermore any bonds I own are laddered positions held to maturity. I'm not a hedge fund that marks to market or plans to sell. If rates go up as I suspect they will, I'll roll the maturing bonds into ones at higher rates...But because of my bias that rates don't provide enough real return, I keep my durations short. It is a Morton's fork choice though, choosing between medium term rates that dont properly compensate for inflation risks and keeping everything in cash earning zero.
You keep advocating taking out a mortgage on an existing property and playing the inflation theme.
While I can appreciate that as rational for buying a home in the first place, its no reason to re leverage after paying off debt. Either way, if higher rates do eventually reflect an increased premium for inflation risk, then I'll obtain those rates next year when stuff rolls over.

I agree with Riversider and inonada at the same time. Is that even possible? I believe so.

did you also do a convexity analysis?

If the debt were callable, then I would have.
I would have also looked at the option cost and effective duration, and done some scenario analysis, you?
If it were mortgage debt, I would have looked at prepayment duration as well.. Anything else?

when you ran the convexity analysis---did you check the standard deviation?

or...did you assume that the standard deviation on the convection analysis would conform to the duration of a standard deviate?

cc, no, I just ignored all the terms I didn't understand. It's pretty clear after that.

so...is it fair to say that the convexity analysis returned the null set?

LOL
Sunday, none of this stuff is rocket science actually duration just means change in price. convexity is a derivative of that function and shows the changes in duration across the path, prepayment duration is sensitivity to people paying their mortgages faster or slower, and option cost is the difference between oas and z spread(non-conventional yield spread assuming a spread added to all the points on the curve).

Scenario analysis just means looking at different views of the world and seeing how that impacts the trade/idea.

cc, you're on a roll with this one.

Yes, she is. I think she likes this convexity thing

Unfortunately half the state treasurers in this country don't understand duration, convexity, or credit risk. That's what really scares me. There's a reason Goldman makes so much money.

sure do.

let's see.

not rocket science.

according to you, duration means change in price. and convexity is more gibberish related to more gibberish.

Yes!

cc, what would you do without Rs?

be a lot happier.

much, much happier.

so much happier, you cannot imagine.

Simple question Riversider: if you looked at 2 bonds with different convexity, how would you use the convexity to make an investment decision to buy one versus the other?

cc, you are very lucky. Not many people have the potential to achieve an imaginable increase in happiness with such minor effort... Click the "ignore this person" link and if that's not enough, just stop logging on to streeteasy.

but, i want to log on. without riversider.

...and that is why so many people are unhappy. Happiness really is just a choice for most people, yet most choose to live unhappily.

help me out.

what's your advice?

get over it?

Seg,
Complicated question. For my own portfolio I tend avoid callable debt. But outside that it would depend what my fund objective was and my bias. If I was looking to maximize a return based on declining rates and two bonds had equal duration but one had less convexity. then that's easy go with the gamma.
If two bonds similar duration, OAS(CALL RISK) and one doesn't have a directional bias then kick the tires and see which one has more option cost.
Really depends on strategy.

Sunday,
You are wise.

ah sunday.

have you joined the riversider, licc, julialg lovefest?

cc, I have julialg on ignore.