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Contrary to common wisdom in media the reasons why I think that taking mortgage at higher interest rates may make more sense are that:

  1. Almost all mortgages are callable by borrower. Hence, if you took mortgage at high interest rates, then borrower would always have this extra right to renegotiate better interest rates just in case interest rates went down. Borrower is less likely to be able to leverage this opportunity when mortgage was taken at historically low interest rates.
  2. Based on historical data the Municipal Bond Arbitrage (by "shorting" your mortgage and "longing" Muni bonds) looks like a better opportunity in high interest rate environment because proportional spread between both yields is lower and more of tax savings can be leveraged. Though, as it was pointed in one of the answers most of Muni bonds are callable as well, but to my knowledge the rules are not that good as on mortgages (e.g. muni bond refinancing can happen on previously specified dates only).

As an example, let's go back to 1990. The mortgage rates were close to 10% and Muni Bonds were yielding 7.5%. Let's assume you already had $100,000 in savings account and a home costs $100,000.

If you wanted, you could have paid for home with cash. However, you could also take mortgage and invest your cash in Muni Bonds.

Now, if you invest that money in Muni bonds yielding 7.5% and take mortgage for $100,000 at 10%, then, assuming 30% federal and 10% state tax:

  1. incoming interest payments from Muni bonds pre-tax would be $7,500. Since Muni bonds are tax exempt at federal and state level, then post-tax income would still remain at $7,500.
  2. outgoing interest payments from mortgage pre-tax would be $10,000. Since mortgage payments are tax deductible at federal and state level, then post-tax it would be ~ $6,000 (assuming 30% federal and 10% state tax).

This means $1,500 Muni Bond arbitrage opportunity back in 1990 which was high interest rate environment.

Now following scenarios can unfold after 1990:

  1. if interest rates go lower, then you can refinance your mortgage and cut outgoing interest payments. Incoming interest payments from Muni bonds would stay the same (assuming they are not callable by borrower).
  2. if interest rates stay the same then you can keep taking advantage of $1,500 arbitrage.
  3. if interest rates keep going up, then you can still keep taking advantage of $1,500 arbitrage.

What am I missing here? Some things that crossed my mind:

  1. Am I misestimating Muni Bond default risks? Or overestimating post-tax yield back in 1990 due to potentially different tax code back then?
  2. I made assumption that buyer already has enough cash to buy a home. If buyer does not have this cash then he can't do the Muni Bond Arbitrage anymore. Though I think this would somewhat hint that people in low interest environment are taking mortgage not because "it makes financial sense", but because "they act in irrational fear of missing out".
  3. Have the times changed and such Muni Bond arbitrage would not be possible anymore in 2018 because if mortgage rates would go back to 10%, then Muni Bonds this time would stay only at 6% (e.g. because markets have become more efficient and reduced arbitrage opportunities). How about other bonds in this case?
  4. Anything else that I may be missing?

Update#1 (To explain benefits of mortgage refinancing):

The arbitrage trade I described above could be viewed as a three leg trade, where

  1. First leg is physical home (you are long this leg in hopes to resell your home for more than when you bought);
  2. Second leg is Muni Bonds (you are long this leg too, because it is nice to have bond that yields more than current interest rates);
  3. Third leg is mortgage debt (you are short this leg. Once you get rid of this leg you don't have debt obligations anymore).

The market value of Second and Third leg moves together with interest rates and cancel out each other (because one is short, the other is long). By granting borrower rights to refinance he can basically eliminate any losses on the Third shorted leg at lenders expense who has to accept that this borrower won't pay anymore high interest rates on his mortgage.

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    So you're better off getting a high interest mortgage because maybe in the future you can refinance for a lower rate? Why not just start with the low rate? The arb opportunity is an interesting thought but most people with mortgages are borrowing the money because they HAVE to. – quid Feb 1 '18 at 23:53
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    (1) When it's time to buy a house, you buy it. You don't wait years to purchase based on the hope of a higher rates so that you can take advantage of an arbitrage. You presented an interesting premise but when it comes to something like buying a house, I would adhere to the theory of SH*T HAPPENS so avoid trying to squeeze out a few bucks while risking home security. – Bob Baerker Feb 2 '18 at 0:12
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    (2) Default is a risk, perhaps very small but who would have ever dreamed that Blue Chip bastions like Lehman Brothers and Bear Stearns would vaporize? Or that Enron would buy stable utility Portland General and all pensions would vaporize as well. And then there's always the chance that tax law is changed (deductions?). Buy the house and be debt and risk free. – Bob Baerker Feb 2 '18 at 0:12
  • @quid 1) The arbitrage trade I described could be viewed as a three leg trade, where First leg is physical home (you are long this leg); Second leg is Muni Bonds (you are long this leg too); Third leg is mortgage debt (you are short this leg). The market value of Second and Third leg moves together with interest rates and cancel out each other. Unless borrower refinances and effectively eliminate losses on the 3) shorted leg. This refinancing is only possible if interest rates were initially high. – Hans Solo Feb 2 '18 at 0:52
  • @quid 2) Based on historical data it seems that Muni yield to Mortgage interest rate ratio looks better in High interest environment. For example In 1990 it was 3:4. In 2010 it was 2:3. The higher this ratio gets the more home buyer gets in mortgage interest deductions and muni bond interest exemptions. – Hans Solo Feb 2 '18 at 1:02
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No.

The hole in the plan is that not only is there some small risk in bonds (Orange County 1994?), but also bond issuers can and do refinance just like mortgage holders can when interest rates drop.

Original answer:

Whether or not there may be some investment opportunity that is sufficiently low risk and high yield to be worth mortgaging your primary residence does not depend on absolute interest rates, but on the difference between the yield and the mortgage rate.

  • Thanks for the answer. However, based on historical data it seems that Muni yield to Mortgage interest rate ratio consistently looks better in High interest rate environments. For example In 1990 it was 3:4. In 2010 it was 2:3. The closer this ratio gets to 1:1 the more home buyer can receives in mortgage interest tax deductions and muni bond tax exemptions. In other words Muni Bond arbitrage looks more attractive in high interest environment. Also, feel free to chime in on the first point where borrower looses the rights to refinance if mortgage was taken at historically low interest rates. – Hans Solo Feb 2 '18 at 1:14
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    "borrower looses the rights to refinance" Borrower has no need to refinance. Refinancing is a nice option to have if rates are lower than when you took out the mortgage. You don't need it if they're not. – Rupert Morrish Feb 2 '18 at 1:34
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Anything else that I may be missing?

I can't speak to municipal bond arbitrage, but this piece caught my eye:

outgoing interest payments from mortgage pre-tax would be $10,000. Since mortgage is tax deductible at federal and state level, then post-tax it would be ~ $6,000 outgoing payment.

Many people do not get full benefit from mortgage interest deduction. For example, I found a return I prepared where about $10k in mortgage interest was paid, the total itemized deductions were only $15k, the standard deduction that year was $12.6k (married), so the $10k in mortgage interest only benefited them $600 (federal, so a little more with state).

This is pretty typical from what I've seen, and under the new law even fewer people will benefit from itemizing, making the interest deduction less valuable than ever. There are also limits to how much mortgage interest you can deduct (only interest from first $750k of mortgage debt as of 2018) and an itemized deduction phase out for high-income households. Might be a sweet spot in the middle, but can't just assume full deduction benefit just because it's deductible.

  • Good point. However, in high interest rate environment it is easier to go over the standard deduction cap. Imagine 750K loan and 10% interest rate on mortgage. That would total 75K in interest payments. Whereas today at 4% that would be ~30K and subsidy to buy home with mortgage looks less tempting because there is not much difference from standard deduction. I think this a actually supports my thesis that taking mortgage in high interest rate environment is better. Of course mortgage over 750K is different story as you pointed out. – Hans Solo Feb 2 '18 at 4:04
  • Easier to get into the itemizing range, but unless you had other deductions that would get you even with the standard deduction, a portion of the mortgage interest would have no benefit. If married filing jointly next year, that's a chunk at 24k standard deduction. – Hart CO Feb 2 '18 at 4:28
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    @HansSolo: "But I can deduct it on my taxes" is never a justification for throwing away money. Tax deductions reduce the net cost of e.g. charitable contributions, but they are still a net cost. – Ben Voigt Feb 2 '18 at 5:58
  • @BenVoigt For majority of cases contributing to 401(k) is a good idea, because you can "deduct it from taxes", right? Now irrelevant from whether you have mortgage on house or bought house with cash you will still have property taxes that can be deducted. If property tax amount already approaches standard deduction amount then everything else being the same I don't see how optimizing for mortgage interest deductions is different than optimizing for 401(k) deductions. Again 401(k) probably is good idea across majority of population while interest deduction is for lesser population. – Hans Solo Feb 2 '18 at 19:35
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    @HansSolo You risk is a change to the tax code that negates the benefit you've hinged your investment strategy on, but you're right. – Hart CO Feb 2 '18 at 19:43

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