Mortgage Rates Are Rising: Should You Extend Your Mortgage Amortization?
KEY POINTS
Mortgage rates are rising and forcing borrowers to extend their amortization periods
Present value and inflation are the keys to unlocking the hidden value of your amortization
Longer amortization periods free up cash flow to pay down other types of debt
Mortgage Rates and Central Banks
The year 2022 has been marked by central banks around the world raising their respective interest rates at the fastest pace seen in years. Economists expect rates to continue increasing, albeit at lower increments, and slowly come to a pause or an end at some point in 2023.
For example, during 2022 (at the time of this writing), the Fed raised rates from a range of 0.25% to 0.50% to a range of 4.25% to 4.50% (U.S. Federal Funds Rate). A key rationale for such rate increases is the need to bring down inflation that has topped 8%: substantially above the Fed’s target rate of approximately 2%. The combined impact of interest rates and inflation soaring simultaneously has forced families to cancel discretionary expenditures (e.g., vacations, sporting events, concerts) while making painful tradeoffs between non-discretionary expenditures (e.g., food, clothing, medicine).
As per the Federal Reserve¹, 64.9% of U.S. families own their own home. Approximately 2/3 of homeowners have debt secured by their home and approximately 1/3 own their home without any secured debt.
This high degree of home ownership and debt combined with rising interest rates has placed mortgages at the forefront of family’s financial priorities. The rise in interest rates has created uncertainty and anxiety due to the speed and size of such rise. The financial shock is amplified due to society’s relative complacency related to interest rates resulting from Central banks keeping interest rates at historically low levels for an extraordinarily long duration. Such policy decisions were greatly influenced by a combination of the Global Financial Crisis in 2008 and the COVID-19 pandemic in 2020.
Debt profile of a nation
Debt secured by residential property is not the only debt keeping families awake at night. The following table highlights the percentage of families holding various types of debt and the amount of such debt.
¹ Federal Reserve Bulletin
Debt secured by residential property represents the highest amount of debt by type; however, it typically attracts a lower interest rate than other forms of debt.
How can you manage multiple forms of debt in a manner that creates the most robust financial legacy possible?
Let’s start by unpacking the mortgage process.
How to negotiate your mortgage renewal
Individuals often commence the mortgage process armed with a set monthly payment they can afford. In our post How to Make a Budget That Works For You we provide insights into multiple approaches to budgeting that can help determine such affordability.
Borrowers then dive into the process with the hope of finding a combination of an interest rate (fixed or variable) and amortization period that can accommodate their set monthly payment.
This process can be very stressful, whether you engage directly with your financial institution or if you enlist the services of a mortgage broker. We recommend our post How to Choose a Financial Advisor - A Definitive Guide if you decide to engage a professional advisor.
Mortgage brokers will provide varying degrees of service. Regardless of the level of service provided, you should approach them fully armed with a deep understanding of how mortgages work and how they ultimately impact your long-term financial goals and related legacy plan.
For instance, you will be presented with various interest rates that will fluctuate based on their nature (fixed rate or variable rate) and the mortgage term over which period such interest rates will be in effect.
Mortgage Rates
The interest rate you pay will have a substantial impact on your cash flows and your long-term net worth.
Can you influence the interest rates the bank offers to you?
Short answer: yes.
Long answer: yes, but it takes time.
As described in our blog posts How Can Your Credit Report Increase Your Net Worth? and Financial Literacy - Credit Scores, your credit score has a significant impact on the interest rates offered to you by financial institutions. We modelled a sample mortgage and demonstrated how you could increase your net worth over $200,000 by dramatically increasing your credit score. We recommend a long-term dedicated approach to monitoring your score and managing the variables that drive your credit score.
Mortgage Amortization Period
Influencing the interest you pay takes time. Whereas, you have substantially more control over the amortization period applied to your mortgage.
To clarify, your amortization period is different than your mortgage term. You may choose a 30 year amortization period and a 5 year mortgage term. Your amortization period is the amount of time it will take you to fully pay off your mortgage. Your mortgage term is the period of time your mortgage agreement and interest rate are in effect. In this example, you would need to renew your mortgage at the end of the 5-year period.
The combination of rising rates and inflation discussed above has forced many families to extend their mortgage amortization periods to lengths not anticipated just a few short years ago. This results in maintaining a manageable monthly payment; however, it often translates to little if any interest being paid down with each payment. The eventual renewal of the mortgage will likely result in a reset of the amortization to the original period. Such reset will create a larger monthly payment requirement.
On the surface, a longer amortization period appears lower your monthly payment, but increase your overall interest costs over the life of the mortgage.
This is correct.
Is there more to the story?
Of course, there is more to unpack.
Mortgage Amortization, Inflation, and Present Value
The heading above gives a hint to the complexity of choosing an amortization period. It also sounds rather academic and intimidating.
We will break it down into easy-to-understand steps that clearly illustrate longer amortization periods may be a financially prudent course of action, under the right circumstances.
First, we need to provide a background on inflation and present value.
Inflation erodes wealth. It causes a given product or service to cost more tomorrow than it does today. Therefore, when inflation is present, $100 in the future will be worth less than $100 today.
For example, assuming an inflation rate of 2.04%, $100 received one year from now would have a present value of $98. Conversely, $98 invested today at 2.04% would be worth $100 one year from now.
Comparison of Two Mortgages - 30yr vs 15yr Amortization
This concept has a dramatic impact on how we compare two different amortization tables (e.g., 30 vs 15-year amortization tables). Such tables have cash flows extending several years into the future. To compare two different mortgages, we need to discount the future cash flows to the present day.
Before we begin, we need to ensure we are comparing apples to apples. As illustrated in the chart below, we chose amortization periods of 30 years and 15 years with monthly mortgage payments of $652 and $852 respectively. This creates a $200 difference in monthly cash flows. We must account for the $200 difference that exists from years 1-15.
As illustrated in the table above, families hold multiple forms of debt in addition to a residential mortgage and such other forms of debt often attract higher interest rates than a residential mortgage.
Therefore, we will model the $200 excess cash flow in the 30-year scenario paying down a $20,928 non-residential loan over 15 years with an interest rate of 8%. The interest, monthly cash flow, and 15-year period calculate to give us the $20,928 principal balance.
To maintain the apples-to-apples comparison, we need to model the same $20,928 non-residential loan under the 15-year scenario. Under this scenario, the monthly cash flow is fully utilized to service the residential loan. Therefore, the $20,928 loan is modelled to grow at 8% a single repayment at the end of year 15.
Financial Model
The model produces the following chart based on a $100,000 mortgage.
Interest Paid Comparison – Non-Discounted
At a high level, $81,332 additional interest is paid under the 30 year model versus the 15 year model. Some borrowers would simply weigh this net cost against the benefit and/or need of a lower monthly payment, and make their decision accordingly.
Unfortunately, this analysis does not consider inflation and the ability to pay down non-residential debt with the lower monthly payment under the 30 year scenario.
Let’s see how these additional variables impact the model when discounted to their present value.
Present Value – Mortgage Interest
We will stay focused on the total interest paid for another moment. Above we noted the 30 year scenario paid $81,332 in additional interest. However, this is not an apples to apples comparison as the monthly interest payments were not discounted to their present value.
We chose 3 different inflation rates for discounting purposes: 2%, 4%, and 8%. We chose 2% as it approximates the Fed’s target inflation rate. The 4% rate represents an approximation of the average U.S. inflation rate over the past 50 years. The 8% rate was chosen to further illustrate the impact of rising inflation rates. The rates chosen do not represent the author’s opinion or forecast of future inflation trends.
In present value terms, an inflation rate of 8% decreases the variance between the two scenarios from $81,322 to $27,139. The 30 year scenario is still more costly, but the variance dropped significantly when viewed from a present value perspective.
Present Value - Non-Residential Debt Considered
As noted above, the 30 year scenario has $200 per month of higher cash flows during years 1-15. Therefore, we will review the impact of utilizing this $200 monthly cash flow to pay down a non-residential principal loan balance of $20,928.
In present value terms, an inflation rate of 8% decreases the variance between the two scenarios to such a degree that the 30 year scenario has a lower present value costs of $1,193.
Conclusion
This post unpacked a lot of quantitative concepts: inflation, present value, and amortization. We consider it prudent that borrowers should consider much more than that the variance in monthly payments when choosing an amortization period. We hope the concepts illustrated will form part of your discussions with your professional advisors when considering how to best structure your various forms of debt. When managed correctly, your decisions pertaining to debt can have a positive impact on your long-term legacy goals.
REFERENCES
¹ Federal Reserve Bulletin Vol. 106, No. 5, September 2020. Changes in U.S. Family Finances from 2016 to 2019: Evidence from the Survey of Consumer Finances CLICK FOR REPORT
Disclaimer
The inflation rates modelled are not forecasts and for illustrative purposes only. The non-residential loan in the 15 year scenario being repaid fully in one lump sum payment is not indicative of normal market lending conditions and is modeled with such assumptions for illustrative purposes only. The model ignores taxation and the potential tax deductibility of the interest payments made. The model presented is complex and should be discussed with your professional advisors.