When I was a boy, one of the rules I was taught to live by was to never hurry to a whooping. That meant that when the school bully threatened me with beating me up as I got off the bus, that perhaps, rather than try to fight him, the best thing to do was just not get off the bus! Go a little further to another stop and get off there instead. The extra walk would be worth missing the whooping!
The same is true in our financial life. Have you noticed that recently the banks have started to really push short-duration loans? Fifteen years, ten years, or even less? To me, knowing that the Fed is likely on the move with interest rate hikes, locking in a shorter rather than a longer loan may be like hurrying to a whooping. How?
There are several issues to consider here. For example, what’s the opportunity cost of paying off a loan sooner rather than later? Is it possible that with today’s still historically low rates, you could potentially earn more by investing the difference between the shorter loan payments and the longer loan payments? This would be especially true if the loan interest is deductible, where the net cost of borrowing is reduced. This is not to say that there is no risk in investing, but then again, if the true cost of borrowing is less than 4%, over the life a 30 year loan, for instance, that rate may not be that hard to beat, even with limited risk.
And then there’s the issue of control. Who has more control? The person who pays cash for a property, or the person who keeps their cash invested and uses leverage? Again, depending on how they invest their money, the person with more direct access to their equity (the person using leverage and remaining invested in an external fund) will likely have more access to money both for emergencies and opportunities in the future.
Of course, if you are someone who is likely to just spend the difference (between the payment of the shorter vs the longer note), then this example wouldn’t work, and you may be better off simply taking a shorter note, where at least your equity payments were reducing your leverage. One technique to avoid this possibility is to calculate up front that difference and automate the savings into an investment account, rather than leaving the difference in a cash account that is likely to be spent. Once the contribution to the investment account is made, many people are likely to leave it there to potentially grow.
So, if you’re in the process of figuring out if the bank is offering you a whooping, consider some of these ideas, or give us a call to talk it through with a Dumont Financial advisor. After all, who wants to get whooped?
These are the opinions of Brian S. Dumont and not necessarily those of Cambridge. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.