Contrary to common wisdom in media the reasons why I think that taking mortgage at higher interest rates may make more sense are that:
- 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.
- 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).
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:
- 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.
- 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:
- 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).
- if interest rates stay the same then you can keep taking advantage of $1,500 arbitrage.
- 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:
- Am I misestimating Muni Bond default risks? Or overestimating post-tax yield back in 1990 due to potentially different tax code back then?
- 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".
- 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?
- 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
- First leg is physical home (you are long this leg in hopes to resell your home for more than when you bought);
- 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);
- 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.