Mortgage Rates and Future Stock Prices – Finding Alpha | CarTailz

Albert Pego

When it comes to debt, few people are more opposed to it than Dave Ramsey. He argues that people should avoid debt like the plague. Auto loans and student loans, lending instruments used by many people to access transportation and education, are banned.

Most people define good debt as debt that can improve your financial situation in the long run. While many people advocate student loans because of the increased earning potential, people like Ramsey still advise steer clear.

However, there is one type of debt that Ramsey allows: mortgage debt. He won’t argue that it’s “good debt,” but he will argue that sometimes a mortgage is necessary to get into a house. Those who borrow money for a home will typically see an increase in their net worth as equity in the home builds, along with higher home values. Most other financial experts would argue that this makes a home loan a kind of good debt.

Early Payout?

Many financial experts recommend stretching out a mortgage repayment for as long as possible. The lower monthly payments that come with the longer payback period should free up additional cash for investments. Even Ramsey, who hates debt with a passion, recommends saving 15% for retirement in the fourth of his seven “baby steps.” This is done before you start accelerating mortgage repayments. After you reach 15% of your income going into retirement, he recommends investing every available dollar toward paying off your mortgage.

The reason many personal finance experts recommend holding a mortgage for as long as possible has to do with the ability to build wealth faster by investing in a vehicle that yields higher returns over time. For example, Dave Ramsey is widely criticized for claiming that a “good growth stock mutual fund” produces an average annual return of 12%. While that may be a bit high, the average return for the S&P 500 over the long term has been closer to 10%. These returns were well above inflation and average mortgage rates.

The last 20 years have also tended to be characterized by low mortgage interest rates. Even the relatively low inflation that has been common over the past four decades has meant that the real cost of a monthly mortgage payment has declined in real terms over time as people repay previous loans with inflated dollars. This has allowed those who chose to invest in stocks to grow their wealth faster than those who chose to pay off their mortgages faster.

Low interest rates combined with rising share prices have made mortgage amortization unattractive. However, this could change in the future.

higher rates

Sticking with a 3% or 4% (or even 5%) mortgage in an inflationary environment where the effective interest rate is 1% or 2% can make quite good sense. Every dollar of debt paid off brings back an amount equal to the interest rate. Because of this, paying off a credit card with an 18% interest rate can have a big impact on the household budget. Paying off debt with a 3% interest rate doesn’t offer that much of a guaranteed return.

However, interest rates below 5%, which have been common since the Great Recession, have now been replaced by interest rates that have just surpassed 7% for the first time in more than two decades. This makes borrowing to buy a home more expensive. Despite higher borrowing costs resulting in fewer mortgage applications, many Americans will need a home when they move for a new job or a new life in retirement. A large percentage of these people will need a mortgage at the new 7% rate. The longer these rates go on, the higher the number of people who need to access credit that weighs on them.

How will these interest rates affect the calculus for accelerating mortgage payments in the future? The answer depends on how long they last. A recession will come at some point in the future. Many analysts expect it to happen in 2023. If the recession tends to dampen demand for goods and services, that will likely ease inflationary pressures. This could result in lower Federal Reserve interest rates, which would likely result in lower mortgage rates. In this scenario, those borrowing at 7% will likely refinance at a lower rate in a year or two to save money on interest costs while improving their monthly cash flow.

However, it cannot be taken for granted that this scenario will occur. Thirty-year mortgage rates in the 7% range (or higher) were common in the 1970s through the 1990s. Inflation was relatively low for part of this period, but mortgage rates remained relatively high.

Mortgage Payout vs Stocks

Paying off a mortgage with an interest rate of 7% or more suddenly becomes a more attractive scenario compared to investing in the stock market, which can be volatile. Stocks do not offer a guaranteed return. Between 1999 and 2009, the S&P 500 (SPY) was essentially flat (an average annual return of -0.9%). This lost decade was painful for investors and included two very deep recessions. Without dividends, the broad index lost money to investors for a decade.

Mortgage rates have generally been in the 5% to 7% range throughout the decade. Every dollar paid out early automatically yielded a return equal to the interest rate. Of course, those who invested at the bottom of the market in 2009 would have seen a much better return, surpassing this automatic return going forward. Sticking to a plan of saving 10% to 15% for retirement (the latter is Ramsey’s recommendation for saving for retirement before starting the mortgage prepayment) would have been beneficial in either case.

As people start weighing these scenarios, they may decide that the guaranteed return on the early payout makes more sense. This would become even clearer if interest rates remained relatively high for several years. Over time, more people would be locked into mortgages with higher interest rates. If this is the case, it’s entirely possible that fewer people will be interested in maximizing their investments in the stock market, which could result in lower average S&P 500 returns over the medium term due to reduced demand for stocks. Of course, this could be a good opportunity to shop at a discount.

Should higher mortgage rates depress stock prices for a few years, Ramsey’s advice to invest 15% of gross income in retirement and then invest whatever is available beyond that in the mortgage could make a lot of sense. Retirement savings would likely recover over the long term after buying stocks at a discount, while any additional “investment dollars” used to prepay a mortgage would automatically yield a 7% return. Once the mortgage is gone, cash flow would automatically increase, allowing for higher equity participation at an earlier age.

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