WEBVTT 00:00:00.000 --> 00:00:03.180 Welcome back to the Deep Dive. Today we are really 00:00:03.180 --> 00:00:05.660 getting into the foundations of modern personal 00:00:05.660 --> 00:00:08.960 finance. We're tackling a concept that on the 00:00:08.960 --> 00:00:11.480 surface seems so straightforward. Deceptively 00:00:11.480 --> 00:00:13.859 so. Right. The fixed rate mortgage. But what 00:00:13.859 --> 00:00:15.939 we found is that it contains this surprising 00:00:15.939 --> 00:00:18.640 amount of financial mathematics, some really 00:00:18.640 --> 00:00:23.140 compelling history and wild global variations. 00:00:23.140 --> 00:00:26.140 It really is that three letter acronym, FRM, 00:00:26.199 --> 00:00:29.469 that millions of homes are built on. And yet, 00:00:29.530 --> 00:00:32.729 as we synthesize the material, we just kept coming 00:00:32.729 --> 00:00:34.789 back to the fact that the very definition of 00:00:34.789 --> 00:00:37.810 fixed is, well, it's not universal at all. Not 00:00:37.810 --> 00:00:39.789 even close. So if you're tuning in thinking this 00:00:39.789 --> 00:00:41.689 is just a quick chat about a static interest 00:00:41.689 --> 00:00:44.909 rate, you are in for a serious look at how time, 00:00:45.109 --> 00:00:48.369 inflation, and just plain geography can completely 00:00:48.369 --> 00:00:51.229 transform this one product. So our mission today 00:00:51.229 --> 00:00:53.869 is to provide you, the listener, with a kind 00:00:53.869 --> 00:00:55.929 of comprehensive shortcut. We want to move way 00:00:55.929 --> 00:00:58.090 beyond the basic dictionary definition. Absolutely. 00:00:58.490 --> 00:00:59.950 We want to get into the origin story. I mean, 00:00:59.969 --> 00:01:01.710 why was this loan even invented in the first 00:01:01.710 --> 00:01:03.609 place? And then the precise mechanics of the 00:01:03.609 --> 00:01:06.930 calculation. The math. The inherent risks that 00:01:06.930 --> 00:01:09.810 come with, you know, 15 or 30 years of supposed 00:01:09.810 --> 00:01:13.390 stability and how the entire concept just shifts 00:01:13.390 --> 00:01:16.069 the moment you cross a national border. So let's 00:01:16.069 --> 00:01:18.090 start at the absolute core because that definition, 00:01:18.329 --> 00:01:21.409 even the simple one, is crucial. A fixed rate 00:01:21.409 --> 00:01:23.750 mortgage is a mortgage loan where the interest 00:01:23.750 --> 00:01:26.450 rate stipulated on the note remains constant. 00:01:26.920 --> 00:01:29.000 It's fixed. Fixed for the whole time. For the 00:01:29.000 --> 00:01:32.319 entire agreed upon term of the loan, no changes. 00:01:32.560 --> 00:01:34.680 And that right there is the immediate benefit. 00:01:34.719 --> 00:01:36.599 It's the fundamental reason this product exists 00:01:36.599 --> 00:01:39.079 and why it dominates markets like the U .S. and, 00:01:39.140 --> 00:01:41.599 as we found out, Denmark of all places. It's 00:01:41.599 --> 00:01:43.920 all about budgetary predictability. Exactly. 00:01:44.140 --> 00:01:46.640 Because that interest rate is fixed, your monthly 00:01:46.640 --> 00:01:49.079 payment is fixed, and the loan duration is fixed. 00:01:49.219 --> 00:01:51.459 It's a trifecta of certainty. And that level 00:01:51.459 --> 00:01:53.840 of certainty allows for long -term financial 00:01:53.840 --> 00:01:56.959 planning, that is. Right. Well. It's just impossible 00:01:56.959 --> 00:01:59.180 with most other loan products out there. That 00:01:59.180 --> 00:02:01.299 certainty really is the benchmark, isn't it? 00:02:01.319 --> 00:02:03.480 When you look at the whole landscape of borrowing, 00:02:03.659 --> 00:02:06.680 the sheer variety is staggering. The FRM just 00:02:06.680 --> 00:02:09.539 stands out for that complete fixation. It provides 00:02:09.539 --> 00:02:12.560 a kind of bedrock of security. especially in 00:02:12.560 --> 00:02:15.139 a housing market that can be incredibly volatile. 00:02:15.419 --> 00:02:17.539 And I think it's important to frame the FRM by 00:02:17.539 --> 00:02:21.159 looking at its competition, both now and historically. 00:02:21.759 --> 00:02:23.580 We're not just talking about the modern adjustable 00:02:23.580 --> 00:02:26.539 rate mortgage, the ARM, where the rate floats 00:02:26.539 --> 00:02:29.639 or tracks an index. No, the history is key. The 00:02:29.639 --> 00:02:33.219 FRM was a truly revolutionary answer to the, 00:02:33.300 --> 00:02:36.500 frankly, dangerous instability of the balloon 00:02:36.500 --> 00:02:38.240 payment mortgage. I've heard of these, but they 00:02:38.240 --> 00:02:40.849 sound terrifying. They were. It was a structure 00:02:40.849 --> 00:02:43.430 that forced borrowers to face this massive lump 00:02:43.430 --> 00:02:45.710 sum payment at the end of the term. You'd pay 00:02:45.710 --> 00:02:48.530 interest for a few years and then, boom, the 00:02:48.530 --> 00:02:50.469 whole principle was due. And if you couldn't 00:02:50.469 --> 00:02:52.650 pay it? It often led to widespread financial 00:02:52.650 --> 00:02:55.210 collapse, foreclosures everywhere. And even today, 00:02:55.370 --> 00:02:58.229 the FRM offers security against much riskier 00:02:58.229 --> 00:03:00.289 products that, believe it or not, still exist, 00:03:00.530 --> 00:03:02.870 like the negative amortization mortgage. Oh, 00:03:02.909 --> 00:03:05.509 that's literally the opposite of the FRM's safety. 00:03:06.000 --> 00:03:09.000 it's a scary concept it is in a negative amortization 00:03:09.000 --> 00:03:11.719 loan your required monthly payment doesn't even 00:03:11.719 --> 00:03:14.180 cover the full interest that's due for the month 00:03:14.560 --> 00:03:16.860 So your loan balance actually goes up over time, 00:03:16.960 --> 00:03:19.360 even while you're making payments. Exactly. You're 00:03:19.360 --> 00:03:21.780 digging yourself deeper into debt every single 00:03:21.780 --> 00:03:25.759 month. The FRM, by contrast, is engineered from 00:03:25.759 --> 00:03:28.560 the ground up for disciplined, complete debt 00:03:28.560 --> 00:03:31.199 retirement. Indeed. We are really unpacking a 00:03:31.199 --> 00:03:34.000 product that was built for stability and for 00:03:34.000 --> 00:03:37.479 long -term planning. And every single feature 00:03:37.479 --> 00:03:40.199 of it, from its mathematics to its standardization, 00:03:40.439 --> 00:03:43.889 it all reinforces that one central goal. OK, 00:03:43.969 --> 00:03:46.250 so to really understand a fixed rate mortgage, 00:03:46.509 --> 00:03:48.509 we have to look under the hood. There are these 00:03:48.509 --> 00:03:51.189 four constant variables that lock the loan in 00:03:51.189 --> 00:03:54.650 place and allow for that calculation of the fixed 00:03:54.650 --> 00:03:56.909 monthly payment. What are those four pillars? 00:03:57.069 --> 00:03:58.889 Right. These are the constants that the lender 00:03:58.889 --> 00:04:01.389 uses to define your entire amortization schedule. 00:04:01.590 --> 00:04:03.830 So first, you have the amount of the loan. That's 00:04:03.830 --> 00:04:06.189 the principle, what we call PLRs1, the initial 00:04:06.189 --> 00:04:08.229 capital you borrowed. Simple enough. Second, 00:04:08.370 --> 00:04:10.599 the interest rate. or Tweedles. That's the percentage 00:04:10.599 --> 00:04:13.419 of being charged. Third, and this one is sneakily 00:04:13.419 --> 00:04:16.540 important, is the compounding frequency. What 00:04:16.540 --> 00:04:18.699 do you mean by that? It just defines how often 00:04:18.699 --> 00:04:20.740 the interest is calculated and then add it back 00:04:20.740 --> 00:04:23.560 to the principal. And fourth, of course, is the 00:04:23.560 --> 00:04:25.600 duration of the loan or no dollar, the overall 00:04:25.600 --> 00:04:28.329 term, usually in months or years. That third 00:04:28.329 --> 00:04:30.790 point, the compounding frequency, is so critical 00:04:30.790 --> 00:04:32.930 because it immediately shows how the rules can 00:04:32.930 --> 00:04:35.990 change globally, even for the exact same concept. 00:04:36.250 --> 00:04:39.050 In the U .S., we just assume monthly compounding. 00:04:39.050 --> 00:04:40.990 It's the standard for all the examples you see. 00:04:41.149 --> 00:04:42.970 But the research highlights that in a market 00:04:42.970 --> 00:04:45.709 like Canada, for instance, interest is typically 00:04:45.709 --> 00:04:48.730 compounded semi -annually, so every six months. 00:04:48.930 --> 00:04:50.970 So what does that actually mean for the borrower? 00:04:51.350 --> 00:04:54.220 It's a subtle change. But it means that even 00:04:54.220 --> 00:04:57.120 if a U .S. borrower and a Canadian borrower got 00:04:57.120 --> 00:05:00.060 the exact same nominal interest rate, say 5%, 00:05:00.060 --> 00:05:02.680 the internal math of their loans, and therefore 00:05:02.680 --> 00:05:05.360 the actual amount of interest they pay, will 00:05:05.360 --> 00:05:08.319 be different. Because the frequency of that compounding 00:05:08.319 --> 00:05:11.319 fundamentally alters the path of the debt. It's 00:05:11.319 --> 00:05:13.639 one of those details that has a huge impact over 00:05:13.639 --> 00:05:16.160 25 or 30 years. Okay, so now that we have the 00:05:16.160 --> 00:05:18.160 constants, let's talk about the giant vulnerability. 00:05:18.990 --> 00:05:20.810 The thing that's created precisely because the 00:05:20.810 --> 00:05:24.069 loan is fixed for, say, 30 years. Inflation risk. 00:05:24.209 --> 00:05:26.990 Inflation risk. This is where that simple idea 00:05:26.990 --> 00:05:29.529 of stability gets really complicated really fast. 00:05:29.769 --> 00:05:32.110 It really does. It creates the core paradox of 00:05:32.110 --> 00:05:35.220 the FRM. When a borrower commits to a fixed dollar 00:05:35.220 --> 00:05:38.639 payment for up to three decades, they are introducing 00:05:38.639 --> 00:05:41.560 this massive variable into the equation. Which 00:05:41.560 --> 00:05:43.959 is the future real value of that dollar. Precisely. 00:05:43.980 --> 00:05:46.160 The lender is vulnerable if the dollar loses 00:05:46.160 --> 00:05:48.699 value, and the borrower is vulnerable if the 00:05:48.699 --> 00:05:51.500 dollar unexpectedly gains value. Let's break 00:05:51.500 --> 00:05:53.500 down the two main scenarios that really show 00:05:53.500 --> 00:05:56.660 this inflation paradox. First, the high inflation 00:05:56.660 --> 00:05:59.399 scenario. This is the borrower's dream scenario, 00:05:59.699 --> 00:06:02.620 really. If inflation rises unexpectedly and sharply, 00:06:02.819 --> 00:06:05.939 let's say it jumps from 2 % to 8%, the person 00:06:05.939 --> 00:06:08.000 with the fixed rate mortgage benefits tremendously. 00:06:08.259 --> 00:06:11.040 Why is that? Because inflation erodes the real 00:06:11.040 --> 00:06:13.420 present value of those fixed loan repayments. 00:06:13.459 --> 00:06:15.759 You're paying back the debt with dollars that 00:06:15.759 --> 00:06:17.920 have way less purchasing power than the dollars 00:06:17.920 --> 00:06:19.959 you borrowed years earlier. So your debt is shrinking 00:06:19.959 --> 00:06:23.649 in real terms. Exactly. The real debt burden, 00:06:23.829 --> 00:06:26.410 especially measured against your income, which 00:06:26.410 --> 00:06:30.529 is hopefully rising with inflation, shrinks dramatically. 00:06:31.509 --> 00:06:34.250 It's a mechanism that effectively transfers wealth 00:06:34.250 --> 00:06:36.730 from the lender to the borrower during periods 00:06:36.730 --> 00:06:39.810 of high, unexpected inflation. That is just a 00:06:39.810 --> 00:06:42.279 stunning realization for a lot of people. The 00:06:42.279 --> 00:06:44.980 stability you bought is actually a massive hedge 00:06:44.980 --> 00:06:47.560 against a rising cost of living. It absolutely 00:06:47.560 --> 00:06:50.079 is. But the tradeoff, the flip side of that coin, 00:06:50.220 --> 00:06:53.040 is the second scenario, the low interest rate 00:06:53.040 --> 00:06:54.680 scenario. And this is where the borrower can 00:06:54.680 --> 00:06:57.300 get hurt. If economic conditions improve or if 00:06:57.300 --> 00:06:59.860 inflation suddenly drops, and that leads to significantly 00:06:59.860 --> 00:07:02.079 lower interest rates across the whole financial 00:07:02.079 --> 00:07:04.220 market. So let's say new mortgages are being 00:07:04.220 --> 00:07:07.160 issued at 3%, but you're locked in at 6%. You're 00:07:07.160 --> 00:07:09.879 worse off, much worse off. You're locked into 00:07:09.879 --> 00:07:12.370 an uncompetitive higher rate. and potentially 00:07:12.370 --> 00:07:15.029 for decades. You bought that certainty. But in 00:07:15.029 --> 00:07:17.050 this scenario, certainty means you're missing 00:07:17.050 --> 00:07:19.769 out on all this cheaper capital. You'd have to 00:07:19.769 --> 00:07:22.529 pay a massive refinancing cost to access that 00:07:22.529 --> 00:07:24.810 lower rate, which could wipe out a lot of the 00:07:24.810 --> 00:07:27.610 potential savings. And this brings us right to 00:07:27.610 --> 00:07:30.329 the general market principle about the cost tradeoff. 00:07:31.069 --> 00:07:34.319 Lenders, they're not dumb. They understand they're 00:07:34.319 --> 00:07:37.259 absorbing 30 years of inflation risk when they 00:07:37.259 --> 00:07:39.759 issue an FRM. So they price that risk in from 00:07:39.759 --> 00:07:43.040 the start. Of course. And that's why FRMs almost 00:07:43.040 --> 00:07:45.839 universally charge a higher starting interest 00:07:45.839 --> 00:07:49.319 rate compared to comparable adjustable rate products 00:07:49.319 --> 00:07:53.019 or ARMs. So the premium you pay on day one, that 00:07:53.019 --> 00:07:55.199 slightly higher rate, it's literally an insurance 00:07:55.199 --> 00:07:57.259 premium. That's the perfect way to describe it. 00:07:57.319 --> 00:08:00.160 You are paying the lender for the peace of mind 00:08:00.160 --> 00:08:02.839 that they, not you, will bear. the financial 00:08:02.839 --> 00:08:05.420 pain if rates jump dramatically over the next 00:08:05.420 --> 00:08:07.759 few decades. And this inherent trade off, it 00:08:07.759 --> 00:08:09.740 informs a really critical piece of scholarly 00:08:09.740 --> 00:08:11.639 advice that came up in the sources. Yeah, this 00:08:11.639 --> 00:08:14.040 was fascinating. The data suggests that as a 00:08:14.040 --> 00:08:16.600 general rule, borrowers should generally prefer 00:08:16.600 --> 00:08:19.660 adjustable rate over fixed rate mortgages unless 00:08:19.660 --> 00:08:22.680 interest rates are low. OK, that's a powerful 00:08:22.680 --> 00:08:24.720 insight. Let's unpack that. Well, if current 00:08:24.720 --> 00:08:27.240 rates are historically high, the potential for 00:08:27.240 --> 00:08:29.379 them to fall is much greater than the potential 00:08:29.379 --> 00:08:31.480 for them to keep climbing indefinitely. Right. 00:08:31.579 --> 00:08:34.720 What goes up must come down eventually. In that 00:08:34.720 --> 00:08:38.399 scenario, flexibility, the ARM, offers the greatest 00:08:38.399 --> 00:08:42.980 potential reward. But if rates are already near 00:08:42.980 --> 00:08:46.259 historic lows, the risk of them increasing dramatically 00:08:46.259 --> 00:08:48.899 is much higher than the risk of them falling 00:08:48.899 --> 00:08:51.169 further. So that's when you buy the insurance. 00:08:51.309 --> 00:08:53.110 That's when the FRM, the expensive insurance, 00:08:53.450 --> 00:08:56.129 becomes a really smart, necessary hedge. Okay. 00:08:56.169 --> 00:08:58.429 So when a borrower is thinking about the true 00:08:58.429 --> 00:09:00.730 cost of their mortgage, they have to look at 00:09:00.730 --> 00:09:03.549 three long -term components. First is the original 00:09:03.549 --> 00:09:05.269 loan principle, the P dollar. And you've got 00:09:05.269 --> 00:09:07.990 all the expenses, taxes, insurance, closing fees, 00:09:08.129 --> 00:09:10.610 all of that. And the third, and this is where 00:09:10.610 --> 00:09:12.789 the real leverage is, is the total interest that 00:09:12.789 --> 00:09:15.169 you'll pay over the life of the loan. That's 00:09:15.169 --> 00:09:17.529 the number that can be... Truly staggering. And 00:09:17.529 --> 00:09:19.889 that leads us to a fascinating piece of analysis 00:09:19.889 --> 00:09:21.470 from the source material, what we're calling 00:09:21.470 --> 00:09:23.889 the rate term puzzle. We all tend to obsess over 00:09:23.889 --> 00:09:25.590 the interest rate, right? Completely. It's the 00:09:25.590 --> 00:09:27.549 headline number. But the sources present these 00:09:27.549 --> 00:09:30.210 compelling examples showing that the duration 00:09:30.210 --> 00:09:33.210 of the loan, that no dollar variable, can be 00:09:33.210 --> 00:09:36.110 exponentially more important than the rate, $3. 00:09:36.649 --> 00:09:40.149 Absolutely. The research offers a shocking... 00:09:41.279 --> 00:09:43.659 completely counterintuitive revelation about 00:09:43.659 --> 00:09:46.379 the total final dollar cost of the loan. Okay, 00:09:46.440 --> 00:09:48.179 so listen to this because this one really made 00:09:48.179 --> 00:09:51.279 me stop and think. A loan structured at 2 .5 00:09:51.279 --> 00:09:55.120 % interest for 30 years results in the exact 00:09:55.120 --> 00:09:58.519 same final total dollar cost as a loan at 5 % 00:09:58.519 --> 00:10:02.009 interest for 15 years. It's wild, isn't it? It's 00:10:02.009 --> 00:10:04.370 insane. And to show this isn't just a weird anomaly, 00:10:04.610 --> 00:10:07.750 they give another example. A loan at 5 % interest 00:10:07.750 --> 00:10:11.190 for 30 years has the exact same total cost as 00:10:11.190 --> 00:10:14.450 a loan at 10 % for 15 years. Let that sink in. 00:10:14.690 --> 00:10:16.809 Double the interest rate. But because you cut 00:10:16.809 --> 00:10:18.909 the term in half, you pay the exact same amount 00:10:18.909 --> 00:10:20.909 of money in the end. I have to pause there. I 00:10:20.909 --> 00:10:22.690 mean, I spend so much time focusing on trying 00:10:22.690 --> 00:10:24.710 to shave half a percentage point off the rate. 00:10:24.769 --> 00:10:26.570 But you're telling me that doubling the interest 00:10:26.570 --> 00:10:29.129 rate from 5 % to 10 % doesn't increase my total 00:10:29.129 --> 00:10:30.950 debt burden as long as I cut the term in half? 00:10:31.169 --> 00:10:32.990 That is precisely what the financial mathematics 00:10:32.990 --> 00:10:35.129 show. It means long -term expense is disproportionately 00:10:35.129 --> 00:10:37.090 weighted toward the term length, the dollar. 00:10:37.409 --> 00:10:38.850 So the time is more important than the rate? 00:10:39.029 --> 00:10:41.509 Much more important. If you can significantly 00:10:41.509 --> 00:10:43.750 reduce the duration of time that the principle 00:10:43.750 --> 00:10:47.029 is outstanding, you completely neutralize what 00:10:47.029 --> 00:10:49.429 appears to be a massive percentage rate hike. 00:10:49.789 --> 00:10:52.629 But why? What is it about that time factor that 00:10:52.629 --> 00:10:55.330 gives it such overwhelming weight? It's the raw 00:10:55.330 --> 00:10:58.330 power of compound interest applied over decades. 00:10:58.850 --> 00:11:03.129 In that 30 -year scenario, the interest is compounding 00:11:03.129 --> 00:11:06.690 on the outstanding principal balance 360 times. 00:11:06.870 --> 00:11:10.389 By cutting the term to 15 years, you are slashing 00:11:10.389 --> 00:11:13.129 the number of compounding periods in half down 00:11:13.129 --> 00:11:15.990 to just 180. Even if the interest rate you're 00:11:15.990 --> 00:11:18.070 paying each period is much higher, the simple 00:11:18.070 --> 00:11:19.929 fact that you stopped that compounding clock 00:11:19.929 --> 00:11:22.169 so much earlier saves you an astronomical amount 00:11:22.169 --> 00:11:24.629 of money. So when a new borrower is sitting down, 00:11:24.730 --> 00:11:26.850 they should be prioritizing finding the shortest 00:11:26.850 --> 00:11:29.350 possible term they can actually afford, even 00:11:29.350 --> 00:11:31.129 if it means accepting a slightly higher headline 00:11:31.129 --> 00:11:33.730 interest rate. The math says yes, because the 00:11:33.730 --> 00:11:35.789 time savings will dramatically outweigh the rate 00:11:35.789 --> 00:11:37.909 difference over the life of the loan. It just 00:11:37.909 --> 00:11:41.129 reveals this profound financial truth, doesn't 00:11:41.129 --> 00:11:44.289 it? The monthly payment is all about affordability 00:11:44.289 --> 00:11:47.950 today, but the total cost of the debt is overwhelmingly 00:11:47.950 --> 00:11:50.710 driven by the term length. Which means the 30 00:11:50.710 --> 00:11:53.210 -year mortgage, while it offers the lowest monthly 00:11:53.210 --> 00:11:55.570 burden and is the most popular for that reason, 00:11:55.690 --> 00:11:58.370 is often the most expensive path to homeownership 00:11:58.370 --> 00:12:01.350 in the long run. By a lot. Okay, so now that 00:12:01.350 --> 00:12:03.929 we understand the math and the risk baked into 00:12:03.929 --> 00:12:06.610 the FRM structure, let's look at its revolutionary 00:12:06.610 --> 00:12:10.289 history. This product, as we know it, was essentially 00:12:10.289 --> 00:12:12.610 invented in the United States. That's right. 00:12:12.730 --> 00:12:15.769 And it was invented as a solution to a massive 00:12:15.769 --> 00:12:18.529 economic problem. So we need to go back in time 00:12:18.529 --> 00:12:20.970 a bit. We need to go back to the 1920s and early 00:12:20.970 --> 00:12:24.629 1930s. The prevailing form of mortgage back then 00:12:24.629 --> 00:12:26.470 was the balloon payment mortgage we mentioned 00:12:26.470 --> 00:12:28.460 earlier. The one where you pay the whole principal 00:12:28.460 --> 00:12:30.679 at the end. Exactly. It was a non -amortizing 00:12:30.679 --> 00:12:32.620 loan. You only pay the interest every month. 00:12:32.700 --> 00:12:34.919 And the entire principal was due as a lump sum 00:12:34.919 --> 00:12:37.919 after, say, five to ten years. That sounds inherently 00:12:37.919 --> 00:12:40.460 risky, especially during an economic downturn. 00:12:40.620 --> 00:12:43.159 It was devastating. Just imagine the Great Depression 00:12:43.159 --> 00:12:46.240 hitting. Your five -year term expires in 1932. 00:12:46.759 --> 00:12:50.019 You're required to pay the entire principal back, 00:12:50.240 --> 00:12:52.940 but you have no equity built up. And the entire 00:12:52.940 --> 00:12:55.399 banking system is collapsing. So there's no way 00:12:55.399 --> 00:12:58.220 to get a new loan. Banks. weren't lending, you 00:12:58.220 --> 00:13:01.860 couldn't refinance. This refinancing risk caused 00:13:01.860 --> 00:13:04.960 widespread foreclosures, not because people couldn't 00:13:04.960 --> 00:13:07.000 make their monthly interest payments, but because 00:13:07.000 --> 00:13:09.539 they couldn't possibly meet that one final balloon 00:13:09.539 --> 00:13:12.039 payment. Wow. So the instability of the housing 00:13:12.039 --> 00:13:14.419 market in the 1930s, where entire neighborhoods 00:13:14.419 --> 00:13:16.799 could be wiped out by a single balloon payment 00:13:16.799 --> 00:13:19.600 default, that created the urgent need for a better 00:13:19.600 --> 00:13:21.600 product. And that's where the Federal Housing 00:13:21.600 --> 00:13:24.000 Administration, the FHA, became instrumental. 00:13:24.480 --> 00:13:26.399 They helped develop, and this is the crucial 00:13:26.399 --> 00:13:30.639 part, standardize the FRM by insuring these new 00:13:30.639 --> 00:13:34.059 fully amortized loans. So the FHA insurance gave 00:13:34.059 --> 00:13:36.539 lenders confidence. Total confidence. They knew 00:13:36.539 --> 00:13:38.120 they wouldn't lose everything if the borrower 00:13:38.120 --> 00:13:40.620 defaulted, which finally allowed them to offer 00:13:40.620 --> 00:13:43.379 these lower -risk, long -term, fixed products 00:13:43.379 --> 00:13:45.200 to the public. And this was really the birth 00:13:45.200 --> 00:13:47.820 of the fully amortized loan structure as we know 00:13:47.820 --> 00:13:50.860 it. It was. The loan was engineered from the 00:13:50.860 --> 00:13:54.129 start to be completely paid off. principal and 00:13:54.129 --> 00:13:57.350 interest by the end of the term. This broke that 00:13:57.350 --> 00:14:00.529 terrible cycle of successive loans and constant 00:14:00.529 --> 00:14:03.610 high stakes refinancing that had defined the 00:14:03.610 --> 00:14:05.690 previous generation of homeownership. It was 00:14:05.690 --> 00:14:08.830 a massive societal shift towards financial security. 00:14:09.090 --> 00:14:12.429 And those classic U .S. terms, the 15 year and 00:14:12.429 --> 00:14:14.669 30 year mortgages, they became the foundational 00:14:14.669 --> 00:14:17.190 model for decades. The gold standard, really. 00:14:17.330 --> 00:14:20.049 But the U .S. model isn't static. The research 00:14:20.049 --> 00:14:22.710 notes that in really high cost housing areas, 00:14:22.830 --> 00:14:25.129 you know, especially along the coast. Where a 00:14:25.129 --> 00:14:27.330 standard 30 year term still leaves the monthly 00:14:27.330 --> 00:14:29.230 payments completely out of reach for average 00:14:29.230 --> 00:14:32.009 families. In those areas, we are seeing these 00:14:32.009 --> 00:14:34.429 controversial new variations pop up. We're talking 00:14:34.429 --> 00:14:36.830 about the emergence of 40 -year and even 50 -year 00:14:36.830 --> 00:14:39.850 mortgages. 50 years, that's a lifetime. It's 00:14:39.850 --> 00:14:42.190 a painful realization of the affordability crisis. 00:14:42.690 --> 00:14:45.029 Lenders are using the only lever they have left, 00:14:45.169 --> 00:14:47.629 the dollar variable, the duration, to make the 00:14:47.629 --> 00:14:49.590 monthly payment small enough for the borrower 00:14:49.590 --> 00:14:51.809 to qualify. But as we just discussed with the 00:14:51.809 --> 00:14:54.399 rate term puzzle. While this achieves affordability 00:14:54.399 --> 00:14:57.399 today, it dramatically increases the total cost 00:14:57.399 --> 00:15:00.399 of interest over the lifespan of the loan. By 00:15:00.399 --> 00:15:02.399 hundreds of thousands of dollars, potentially. 00:15:02.919 --> 00:15:05.500 It's solving an immediate problem by creating 00:15:05.500 --> 00:15:08.340 what is essentially a generational debt burden. 00:15:08.539 --> 00:15:10.940 OK, so let's take that benchmark, the 30 -year 00:15:10.940 --> 00:15:14.159 fully fixed loan, and travel the world. Because 00:15:14.159 --> 00:15:16.080 the moment you step outside of the U .S. and 00:15:16.080 --> 00:15:19.039 a few other specific countries, the term fixed 00:15:19.039 --> 00:15:23.259 rate mortgage suddenly becomes, well... It really 00:15:23.259 --> 00:15:26.000 does. Let's start with our neighbors to the north, 00:15:26.159 --> 00:15:28.879 Canada. Their system is fundamentally different. 00:15:29.019 --> 00:15:31.539 How so? In Canada, while the mortgage maturity 00:15:31.539 --> 00:15:34.600 period is commonly 25 years, the rate itself 00:15:34.600 --> 00:15:36.840 is typically only locked for a maximum of 10 00:15:36.840 --> 00:15:39.240 years. Often it's only 5. Wait, so what happens 00:15:39.240 --> 00:15:41.480 after 10 years? The Canadian homeowner must, 00:15:41.700 --> 00:15:44.620 by necessity, renegotiate and refix their rate 00:15:44.620 --> 00:15:46.600 two or three times over the life of their mortgage. 00:15:46.820 --> 00:15:49.519 That introduces some serious stress. The certainty 00:15:49.519 --> 00:15:51.360 of your payment is only guaranteed for the first 00:15:51.360 --> 00:15:53.960 few years. Exactly. At the end of that 10 -year 00:15:53.960 --> 00:15:56.159 term, they face what is essentially a financial 00:15:56.159 --> 00:15:59.039 crossroads. They have to absorb whatever the 00:15:59.039 --> 00:16:00.620 prevailing interest rates are at that moment. 00:16:00.759 --> 00:16:03.320 They trade long -term security for what is often 00:16:03.320 --> 00:16:05.840 a slightly lower rate during that initial fixed 00:16:05.840 --> 00:16:08.519 period. Now contrast that instantly with Denmark. 00:16:08.919 --> 00:16:11.620 Denmark stands out as one of Europe's true anomalies. 00:16:11.740 --> 00:16:14.580 The 30 -year FRM, the American gold standard, 00:16:14.720 --> 00:16:18.179 is the... default standard form of home loan 00:16:18.179 --> 00:16:21.039 there. Their system is built for that exact same 00:16:21.039 --> 00:16:23.899 long -term stability the FHA engineered back 00:16:23.899 --> 00:16:26.360 in the 1930s. So it's not just an American thing. 00:16:26.539 --> 00:16:28.960 No, it's a Danish thing too. Okay, shifting to 00:16:28.960 --> 00:16:30.980 Asia, let's look at Singapore. What does fixed 00:16:30.980 --> 00:16:33.539 rate mean there? In Singapore, the interest rate 00:16:33.539 --> 00:16:36.179 is fixed only for a very short initial period, 00:16:36.419 --> 00:16:38.320 usually just the first three to five years of 00:16:38.320 --> 00:16:40.470 the loan. And crucially, after this short fixed 00:16:40.470 --> 00:16:43.129 period expires, the loan automatically converts 00:16:43.129 --> 00:16:45.730 to a variable floating rate structure. So in 00:16:45.730 --> 00:16:48.370 Singapore, the FRM is just an introductory product. 00:16:48.590 --> 00:16:51.169 It's used to provide stability during the homeowner's 00:16:51.169 --> 00:16:53.830 crucial early years of ownership. And after that, 00:16:54.009 --> 00:16:56.009 the borrower takes on all the rate risk themselves. 00:16:56.490 --> 00:16:59.850 That's it. And we see a similar, though slightly 00:16:59.850 --> 00:17:02.789 different pattern in the United Kingdom. The 00:17:02.789 --> 00:17:05.789 UK, right. In the UK, when they use the term 00:17:05.789 --> 00:17:09.200 fixed rate mortgage. They are almost always referring 00:17:09.200 --> 00:17:12.000 to an adjustable rate mortgage where the rate 00:17:12.000 --> 00:17:14.700 is just locked for a short introductory period, 00:17:14.920 --> 00:17:17.460 usually between two and five years. Two to five 00:17:17.460 --> 00:17:19.599 years. That's barely enough time to settle in. 00:17:19.660 --> 00:17:22.019 What happens when that fixed period ends? Because 00:17:22.019 --> 00:17:24.759 of that short lock -in period, the UK market 00:17:24.759 --> 00:17:27.099 is characterized by incredibly high rates of 00:17:27.099 --> 00:17:30.279 refinancing. Borrowers tend to switch products 00:17:30.279 --> 00:17:33.140 every few years, jumping from one fixed introductory 00:17:33.140 --> 00:17:35.539 product to the next. So they're playing a continuous 00:17:35.539 --> 00:17:38.680 game of financial musical chairs. That's a great 00:17:38.680 --> 00:17:40.759 way to put it. Hoping they lock in a new rate 00:17:40.759 --> 00:17:42.940 before the market spikes. This raises a really 00:17:42.940 --> 00:17:46.279 important question. Why? Why does the UK market 00:17:46.279 --> 00:17:49.299 favor this short -term fixation over the long 00:17:49.299 --> 00:17:51.359 -term certainty we see in the US and Denmark? 00:17:51.619 --> 00:17:53.839 The answer is structural, and it's tied to the 00:17:53.839 --> 00:17:56.420 history of their primary lenders, the building 00:17:56.420 --> 00:17:59.380 societies. Building societies. Like credit unions. 00:17:59.700 --> 00:18:02.480 Sort of. Historically, they've been required 00:18:02.480 --> 00:18:05.140 to fund at least 50 % of their lending capital 00:18:05.140 --> 00:18:08.460 through deposits from their members. This means 00:18:08.460 --> 00:18:10.579 they are largely borrowing money short term. 00:18:10.720 --> 00:18:12.440 And if they're borrowing money short term, but 00:18:12.440 --> 00:18:15.140 they're lending it out long term at a fixed rate, 00:18:15.259 --> 00:18:17.680 that creates a huge problem if the central bank 00:18:17.680 --> 00:18:20.039 raises rates. Precisely. It creates what's called 00:18:20.039 --> 00:18:22.900 an asset liability mismatch. Think of it this 00:18:22.900 --> 00:18:26.089 way. They are paying a fluctuating short -term 00:18:26.089 --> 00:18:28.750 rate to their depositors. That's their liability. 00:18:29.230 --> 00:18:32.150 But they are earning a fixed long -term rate 00:18:32.150 --> 00:18:34.589 from their borrowers. That's their asset. And 00:18:34.589 --> 00:18:36.910 if the liability cost goes up but the asset income 00:18:36.910 --> 00:18:39.309 stays flat, they're in trouble. Big trouble. 00:18:39.549 --> 00:18:41.710 If their short -term borrowing costs suddenly 00:18:41.710 --> 00:18:44.769 spike, if they have to pay depositors 5 % interest 00:18:44.769 --> 00:18:47.410 but their fixed loan is only earning them 4%, 00:18:47.410 --> 00:18:49.769 their business model is instantly unprofitable, 00:18:49.789 --> 00:18:52.109 maybe even insolvent. Okay, that explains why 00:18:52.109 --> 00:18:54.390 lenders in the UK would prefer variable rates. 00:18:54.569 --> 00:18:56.849 It transfers that interest rate risk right back 00:18:56.849 --> 00:18:58.589 to the borrower, which helps the lender balance 00:18:58.589 --> 00:19:00.869 their books against market changes. And that 00:19:00.869 --> 00:19:03.930 lender preference, over time, it filters down 00:19:03.930 --> 00:19:06.430 to consumer preference. You couple that with 00:19:06.430 --> 00:19:08.789 the common desire for the lowest possible initial 00:19:08.789 --> 00:19:11.690 monthly payment, and the short -term fixed loan 00:19:11.690 --> 00:19:14.049 became the dominant market structure in the UK. 00:19:14.430 --> 00:19:16.710 Our final stop on the world tour is Australia, 00:19:17.009 --> 00:19:19.430 which offers a fascinating hybrid. Their market 00:19:19.430 --> 00:19:21.630 includes what they call honeymoon mortgages. 00:19:21.890 --> 00:19:24.630 Right. These are introductory products with really 00:19:24.630 --> 00:19:28.450 short periods, sometimes only a year. And what's 00:19:28.450 --> 00:19:30.829 unique is that the fixed element might not even 00:19:30.829 --> 00:19:33.410 be a fixed rate per se. What is it then? It could 00:19:33.410 --> 00:19:35.289 be a fixed reduction in the interest rate for 00:19:35.289 --> 00:19:37.890 that period. So you might get a fixed 1 % discount 00:19:37.890 --> 00:19:40.609 off the standard variable rate, but only for 00:19:40.609 --> 00:19:42.640 the first year. And the Australian product is 00:19:42.640 --> 00:19:45.160 often highly flexible, which seems contradictory 00:19:45.160 --> 00:19:48.319 to the whole fixed rate concept. It is. The Australian 00:19:48.319 --> 00:19:51.059 mortgage model often combines these introductory 00:19:51.059 --> 00:19:53.700 rate structures with some powerful, flexible 00:19:53.700 --> 00:19:57.059 features. The most common is the ability for 00:19:57.059 --> 00:19:59.039 borrowers to overpay their mortgage principal 00:19:59.039 --> 00:20:01.819 without any penalty. Which, as we know, saves 00:20:01.819 --> 00:20:05.200 a ton on interest. A ton. But here's the kicker. 00:20:05.440 --> 00:20:09.309 They are also allowed to... redraw those overpayments 00:20:09.309 --> 00:20:11.769 later if they need access to that capital for 00:20:11.769 --> 00:20:13.750 an emergency or an investment. So it's like a 00:20:13.750 --> 00:20:16.289 line of credit built into your mortgage. In a 00:20:16.289 --> 00:20:18.670 way, yes. The Australian system provides this 00:20:18.670 --> 00:20:21.650 short -term incentive, but it integrates a flexibility 00:20:21.650 --> 00:20:24.230 that lets the borrower manage their own risk 00:20:24.230 --> 00:20:26.869 and liquidity against the rigidity of that initial 00:20:26.869 --> 00:20:30.049 fixed structure. It just underscores your earlier 00:20:30.049 --> 00:20:32.049 point, doesn't it? In global finance, you have 00:20:32.049 --> 00:20:35.910 to always ask, how fixed and for how long? Because 00:20:35.910 --> 00:20:38.170 the answer changes drastically depending on the 00:20:38.170 --> 00:20:40.369 historical context and the prevailing regulatory 00:20:40.369 --> 00:20:42.390 pressures of that country's financial system. 00:20:42.549 --> 00:20:44.430 All right. Let's pivot back to that central choice 00:20:44.430 --> 00:20:47.809 facing any borrower in any market. Fixed versus 00:20:47.809 --> 00:20:50.730 adjustable. We've established that the FRM is 00:20:50.730 --> 00:20:53.029 usually more expensive than the ARM, at least 00:20:53.029 --> 00:20:55.589 initially. Right. But we need a deeper dive into 00:20:55.589 --> 00:20:57.789 the why of that cost difference because I think 00:20:57.789 --> 00:20:59.990 it helps frame the entire risk transfer mechanism. 00:21:00.490 --> 00:21:03.509 The fundamental reason that long -term FRMs are 00:21:03.509 --> 00:21:05.710 priced higher than short -term or adjustable 00:21:05.710 --> 00:21:08.849 products is all explained by a financial concept 00:21:08.849 --> 00:21:11.710 called the yield curve. Okay, let's unpack that. 00:21:12.009 --> 00:21:14.470 What does the yield curve tell us about interest 00:21:14.470 --> 00:21:17.190 rates? The yield curve is basically just a line 00:21:17.190 --> 00:21:20.430 on a graph. It plots the interest rates or yields 00:21:20.430 --> 00:21:24.089 of bonds or loans that have the same credit quality 00:21:24.089 --> 00:21:26.710 but different maturity dates. And generally, 00:21:26.710 --> 00:21:29.470 in a normal... healthy economy, that curve slopes 00:21:29.470 --> 00:21:32.109 upward. Meaning? Meaning the longer the term 00:21:32.109 --> 00:21:33.990 of the loan, the higher the interest rate offered. 00:21:34.650 --> 00:21:37.509 Lenders require more compensation, a premium, 00:21:37.650 --> 00:21:40.509 to lock up their capital for 30 years versus 00:21:40.509 --> 00:21:43.069 locking it up for, say, one year. Because time 00:21:43.069 --> 00:21:45.609 is money. Time is risk, specifically interest 00:21:45.609 --> 00:21:47.829 rate risk and inflation risk. Lenders have to 00:21:47.829 --> 00:21:49.630 be compensated for that extended uncertainty. 00:21:50.109 --> 00:21:52.710 So the higher starting rate on the FRM isn't 00:21:52.710 --> 00:21:54.789 arbitrary at all. It's just a reflection of the 00:21:54.789 --> 00:21:57.279 standard upward slope of the yield curve. We 00:21:57.279 --> 00:21:59.039 should probably quickly mention the rare exception, 00:21:59.259 --> 00:22:01.819 though. Of course. That would be the inverted 00:22:01.819 --> 00:22:04.119 yield curve, which is when short -term rates 00:22:04.119 --> 00:22:06.799 become higher than long -term rates. It sometimes 00:22:06.799 --> 00:22:09.519 signals that a recession might be coming. But 00:22:09.519 --> 00:22:12.380 the default expectation, the one that justifies 00:22:12.380 --> 00:22:15.660 the FRM's higher starting cost, is that time 00:22:15.660 --> 00:22:18.819 and duration equal greater expense. So this higher 00:22:18.819 --> 00:22:21.480 starting rate on the FRM is therefore the price 00:22:21.480 --> 00:22:25.180 you pay for a complete risk transfer. You, the 00:22:25.180 --> 00:22:27.839 borrower, are handing all of that interest rate 00:22:27.839 --> 00:22:30.779 risk over to the lender. That's it. If rates 00:22:30.779 --> 00:22:33.900 rise dramatically, the ARM borrower faces escalating 00:22:33.900 --> 00:22:36.859 payments, but the FRM borrower's payment remains 00:22:36.859 --> 00:22:39.059 completely constant. The fundamental decision 00:22:39.059 --> 00:22:42.119 then becomes... Are you willing to pay a known 00:22:42.119 --> 00:22:45.200 premium today for total certainty over three 00:22:45.200 --> 00:22:47.740 decades? Or are you willing to accept the risk 00:22:47.740 --> 00:22:50.480 of future rate hikes for the potential to save 00:22:50.480 --> 00:22:52.960 money if rates fall or stay stable? It's a decision 00:22:52.960 --> 00:22:54.940 that's impossible to make perfectly because you'd 00:22:54.940 --> 00:22:56.980 have to predict the future. However, financial 00:22:56.980 --> 00:22:59.279 economists have studied this decision extensively 00:22:59.279 --> 00:23:01.759 over long periods. What does the data tell us 00:23:01.759 --> 00:23:04.490 about who wins this gamble most often? The findings 00:23:04.490 --> 00:23:07.069 revealed through these really comprehensive studies 00:23:07.069 --> 00:23:09.509 are genuinely surprising to a lot of people. 00:23:09.750 --> 00:23:12.650 The majority of borrowers who choose adjustable 00:23:12.650 --> 00:23:16.450 rate mortgages, the riskier product, end up saving 00:23:16.450 --> 00:23:18.869 money in the long term compared to their fixed 00:23:18.869 --> 00:23:21.470 rate counterparts. OK, that is a critical finding 00:23:21.470 --> 00:23:23.809 for anyone listening who is considering a mortgage. 00:23:24.109 --> 00:23:26.410 The data suggests that for the average borrower, 00:23:26.490 --> 00:23:29.849 statistically, flexibility pays off. It does, 00:23:29.990 --> 00:23:32.869 but... And this is a very important, but we have 00:23:32.869 --> 00:23:35.329 to immediately balance that finding. Okay. The 00:23:35.329 --> 00:23:37.990 same studies clearly conclude that a significant 00:23:37.990 --> 00:23:41.730 subset of ARM borrowers ends up paying significantly 00:23:41.730 --> 00:23:44.750 more. sometimes dramatically more than if they 00:23:44.750 --> 00:23:46.630 had just chosen the fixed rate product. And when 00:23:46.630 --> 00:23:48.630 does that happen? It happens when rates spike 00:23:48.630 --> 00:23:50.690 unexpectedly and then stay elevated for longer 00:23:50.690 --> 00:23:52.869 than the borrower can withstand. That's what 00:23:52.869 --> 00:23:56.089 often leads to default or forced sales. And this 00:23:56.089 --> 00:23:58.309 is where we have to bring in the real world context 00:23:58.309 --> 00:24:01.410 of risk realization. Yeah. The ARM was the product 00:24:01.410 --> 00:24:03.630 that played a central role in the 2008 financial 00:24:03.630 --> 00:24:06.569 crisis. A huge role, especially when it was combined 00:24:06.569 --> 00:24:09.380 with some very lax underwriting standards. Right. 00:24:09.640 --> 00:24:12.099 In the run up to 2008, a lot of people were sold 00:24:12.099 --> 00:24:15.640 these teaser rate ARMs. The initial low rate 00:24:15.640 --> 00:24:17.960 only lasted two or three years before it reset 00:24:17.960 --> 00:24:20.519 or adjusted to a much higher, often crippling 00:24:20.519 --> 00:24:22.720 interest rate. They took the risk, but the spike 00:24:22.720 --> 00:24:24.680 in rates was combined with falling home values. 00:24:24.859 --> 00:24:27.859 A perfect storm. It left them unable to refinance 00:24:27.859 --> 00:24:31.079 or sell. The risk that's inherent in an ARM that 00:24:31.079 --> 00:24:33.880 a catastrophic payment increases, it was realized 00:24:33.880 --> 00:24:36.680 for millions of people. and it led to widespread 00:24:36.680 --> 00:24:40.039 financial ruin. That history is why this choice 00:24:40.039 --> 00:24:42.859 is so profound. The choice for you, the listener, 00:24:43.000 --> 00:24:45.220 it balances the high probability of saving some 00:24:45.220 --> 00:24:47.700 money, that's the majority outcome, against the 00:24:47.700 --> 00:24:50.059 low probability, but incredibly high impact, 00:24:50.339 --> 00:24:53.599 risk of catastrophic financial distress. That's 00:24:53.599 --> 00:24:55.559 the minority outcome. So the ultimate conclusion 00:24:55.559 --> 00:24:58.160 for the listener facing this fixed versus adjustable 00:24:58.160 --> 00:25:00.460 choice is really a psychological and a practical 00:25:00.460 --> 00:25:02.480 one. How so? If current rates are historically 00:25:02.480 --> 00:25:05.519 low, the FRM is probably worth the higher premium 00:25:05.519 --> 00:25:08.299 because the risk of future rates increasing is 00:25:08.299 --> 00:25:10.480 quite high. If current rates are historically 00:25:10.480 --> 00:25:13.619 high, the ARM offers the best potential for savings. 00:25:13.819 --> 00:25:16.160 But only if you have a high tolerance for risk 00:25:16.160 --> 00:25:19.019 and a really substantial financial buffer to 00:25:19.019 --> 00:25:22.259 absorb a temporary or even a long -term spike 00:25:22.259 --> 00:25:24.480 in your payments. It forces you to define your 00:25:24.480 --> 00:25:27.500 personal risk appetite. The FRM is the financial 00:25:27.500 --> 00:25:31.039 safe harbor. The ARM is the high -risk, high 00:25:31.039 --> 00:25:33.119 -reward vessel. So we've talked conceptually 00:25:33.119 --> 00:25:36.559 about that fixed monthly payment, $6 ,000 now. 00:25:36.759 --> 00:25:38.980 Now we get to move into the engine room, the 00:25:38.980 --> 00:25:40.980 actual mathematics that generates that exact 00:25:40.980 --> 00:25:43.309 number. This is where the principles of finance 00:25:43.309 --> 00:25:46.329 meet calculus, ensuring that after exactly $9 00:25:46.329 --> 00:25:49.269 payments, the remaining debt is precisely zero. 00:25:49.509 --> 00:25:52.190 The fixed monthly payment is the result of a 00:25:52.190 --> 00:25:54.349 very precise formula that calculates the amount 00:25:54.349 --> 00:25:57.160 needed to fully amortize the loan. It is the 00:25:57.160 --> 00:25:59.240 one constant payment that ensures the principal, 00:25:59.480 --> 00:26:02.200 plus all the accrued interest, is paid off exactly 00:26:02.200 --> 00:26:04.759 by the final day of the loan's term. Okay, let's 00:26:04.759 --> 00:26:06.720 clearly define the three necessary inputs for 00:26:06.720 --> 00:26:08.319 the calculation. These are the characteristics 00:26:08.319 --> 00:26:10.279 we mentioned earlier. First, we have P dollars 00:26:10.279 --> 00:26:12.240 of principal, the amount you borrowed. Then we 00:26:12.240 --> 00:26:14.900 have no dollars, the number of monthly payments. 00:26:14.960 --> 00:26:17.440 So that's the term of the loan. In months, for 00:26:17.440 --> 00:26:20.819 our classic 30 -year FRM example, no dollars 00:26:20.819 --> 00:26:24.299 is 30 times 12, so 360 payments. And the most 00:26:24.299 --> 00:26:27.319 important variable to get right is $3, the monthly 00:26:27.319 --> 00:26:29.980 interest rate. People often confuse this with 00:26:29.980 --> 00:26:33.119 the advertised annual percentage rate. Or APR. 00:26:33.200 --> 00:26:35.200 And they absolutely should not. That's a huge 00:26:35.200 --> 00:26:37.519 mistake. If the yearly nominal interest rate 00:26:37.519 --> 00:26:41.319 is, say, 6 .5%, you must first convert that to 00:26:41.319 --> 00:26:44.420 a decimal, so .065, and then divide it by 12 00:26:44.420 --> 00:26:47.339 to get the monthly interest rate, $3. That's 00:26:47.339 --> 00:26:49.220 the actual number used in the compounding math. 00:26:49.400 --> 00:26:51.420 If you miss that step. The entire calculation 00:26:51.420 --> 00:26:53.339 is off by an order of magnitude. It's completely 00:26:53.339 --> 00:26:55.039 wrong. Okay, let's walk through this specific 00:26:55.039 --> 00:26:56.799 example from the source material to make this 00:26:56.799 --> 00:26:59.000 intimidating math a bit more tangible for everyone 00:26:59.000 --> 00:27:00.319 listening. Let's do it. We'll use the numbers 00:27:00.319 --> 00:27:03.599 provided. A principal. P dollars of $200 ,000, 00:27:03.819 --> 00:27:06.880 a fixed yearly nominal interest rate of 6 .5%, 00:27:06.880 --> 00:27:10.480 and a term of 30 years, so $1 to $360 payments. 00:27:10.819 --> 00:27:14.680 So if we input $2, which is 0 .65 divided by 00:27:14.680 --> 00:27:19.380 12, and no dollars, which is 360, and $200 ,000 00:27:19.380 --> 00:27:22.019 into the amortization formula, which is basically 00:27:22.019 --> 00:27:24.380 the present value formula for an ordinary annuity, 00:27:24.480 --> 00:27:26.680 just rearrange to solve for the constant payment 00:27:26.680 --> 00:27:29.759 zero. The calculation spits out a very precise 00:27:29.759 --> 00:27:32.039 fixed monthly payment of those dollars of those 00:27:32.039 --> 00:27:37.180 $1 ,264 .147. And that single number, $1 ,264 00:27:37.180 --> 00:27:40.460 .146, is the foundation of the borrower's entire 00:27:40.460 --> 00:27:42.599 30 -year commitment. It's what keeps the whole 00:27:42.599 --> 00:27:45.140 structure in equilibrium. Right. And while professionals 00:27:45.140 --> 00:27:47.099 will just use the PMT function in a spreadsheet, 00:27:47.440 --> 00:27:49.779 understanding the derivation of the formula is 00:27:49.779 --> 00:27:51.759 what perfectly illustrates the amortization process 00:27:51.759 --> 00:27:54.500 itself. The derivation shows three key components 00:27:54.500 --> 00:27:56.519 of how the loan actually works over time. The 00:27:56.519 --> 00:27:58.160 first is just the simple dependent structure. 00:27:58.440 --> 00:28:00.779 Yes. The formula clearly shows that the LARs 00:28:00.779 --> 00:28:03.359 cannot exist without $2 and non -LARs. If the 00:28:03.359 --> 00:28:05.339 amount you borrow goes up, your monthly payment 00:28:05.339 --> 00:28:07.339 goes up. If the rate goes down, the payment goes 00:28:07.339 --> 00:28:09.240 down. If you extend the term, the payment goes 00:28:09.240 --> 00:28:11.440 down. But the total cost goes way up. Exactly. 00:28:11.599 --> 00:28:13.579 It shows that instantaneous link between those 00:28:13.579 --> 00:28:16.180 three inputs and the required payment. The second 00:28:16.180 --> 00:28:18.519 and most critical component is how the amount 00:28:18.519 --> 00:28:21.829 you owe changes every single month. This is the 00:28:21.829 --> 00:28:24.990 heart of amortization. So let's look at the remaining 00:28:24.990 --> 00:28:27.210 principle after the very first month, which we'll 00:28:27.210 --> 00:28:30.549 call P $. P $ is simply the principle you started 00:28:30.549 --> 00:28:34.630 with. P $ plus one month of interest accrued 00:28:34.630 --> 00:28:37.190 on that full amount minus your fixed monthly 00:28:37.190 --> 00:28:41.069 payment, $2. So every month that fixed payment 00:28:41.069 --> 00:28:43.329 tiler arrives and that payment gets split into 00:28:43.329 --> 00:28:45.990 two parts. Immediately. The first part of your 00:28:45.990 --> 00:28:48.049 tiler payment covers the accrued interest for 00:28:48.049 --> 00:28:50.720 that month. You can think of this part as renting 00:28:50.720 --> 00:28:52.960 the bank's money for that month. And the second 00:28:52.960 --> 00:28:55.559 part, whatever's left over, that goes toward 00:28:55.559 --> 00:28:58.359 reducing the actual principal you owe. That's 00:28:58.359 --> 00:29:00.440 the buying component. That's the equity you're 00:29:00.440 --> 00:29:02.960 building. And because the interest in the early 00:29:02.960 --> 00:29:05.259 years is calculated on a very large outstanding 00:29:05.259 --> 00:29:08.059 principal, the vast majority of your fixed payment 00:29:08.059 --> 00:29:10.299 in the first few years goes toward interest. 00:29:10.599 --> 00:29:12.960 And only a tiny sliver goes toward principal 00:29:12.960 --> 00:29:16.079 reduction. A tiny sliver. The analogy holds. 00:29:16.670 --> 00:29:18.829 In the early years, you were basically just renting 00:29:18.829 --> 00:29:22.009 the money. But as the years go by, the outstanding 00:29:22.009 --> 00:29:25.150 principal slowly decreases, which means the amount 00:29:25.150 --> 00:29:27.289 of interest you owe each month also decreases. 00:29:27.670 --> 00:29:30.349 So a steadily larger proportion of that constant 00:29:30.349 --> 00:29:32.769 monthly payment sortie shifts over to paying 00:29:32.769 --> 00:29:35.769 down the principal. That is the beautiful linear 00:29:35.769 --> 00:29:38.450 reduction of debt that characterizes full amortization. 00:29:39.120 --> 00:29:42.819 By year 25 of a 30 -year loan, the majority of 00:29:42.819 --> 00:29:46.960 your $12 ,264 .44 payment is going toward buying 00:29:46.960 --> 00:29:49.339 your equity, and only a small portion is paying 00:29:49.339 --> 00:29:51.559 for interest. And the third key component illustrated 00:29:51.559 --> 00:29:53.460 by the derivation is the endpoint condition. 00:29:53.700 --> 00:29:56.660 The fixed payment is meticulously chosen to guarantee 00:29:56.660 --> 00:29:58.920 that the final remaining principal after the 00:29:58.920 --> 00:30:02.720 final payment, P .N. DeFi, is exactly zero. This 00:30:02.720 --> 00:30:04.779 is the mathematical guarantee that the FRM provides. 00:30:05.039 --> 00:30:07.000 It means the amortization formula is the financial 00:30:07.000 --> 00:30:09.140 engine that calculates the precise constant required 00:30:09.140 --> 00:30:11.680 to ensure total debt retirement at the agreed 00:30:11.680 --> 00:30:13.900 upon deadline. It provides that security that 00:30:13.900 --> 00:30:15.500 was just missing from the financial landscape 00:30:15.500 --> 00:30:18.220 before the FHA standardized this structure. It's 00:30:18.220 --> 00:30:20.839 truly the culmination of time, interest, and 00:30:20.839 --> 00:30:24.519 principle, all managed by one precise constant 00:30:24.519 --> 00:30:28.579 number for... 30 long years. So as we conclude 00:30:28.579 --> 00:30:31.019 this deep dive, we've really tracked the fixed 00:30:31.019 --> 00:30:33.940 rate mortgage from its origins as this revolutionary 00:30:33.940 --> 00:30:37.099 safety product in the 1930s. All the way through 00:30:37.099 --> 00:30:40.039 the complexities of its math. To its wildly varied 00:30:40.039 --> 00:30:42.059 application across all these different countries. 00:30:42.240 --> 00:30:44.619 And that stability of the U .S. and Danish long 00:30:44.619 --> 00:30:47.420 term fixed rate is just such a sharp contrast 00:30:47.420 --> 00:30:50.700 to the short term refinancing heavy models of 00:30:50.700 --> 00:30:53.680 Canada and the U .K. It really is. But in every 00:30:53.680 --> 00:30:56.420 single market. The core tradeoff remains the 00:30:56.420 --> 00:30:59.940 same. The FRM buys you stability at a premium. 00:31:00.119 --> 00:31:02.720 It guards you against future interest rate shocks. 00:31:02.940 --> 00:31:04.599 But it makes you vulnerable to that inflation 00:31:04.599 --> 00:31:06.900 paradox if rates happen to drop dramatically. 00:31:07.160 --> 00:31:09.460 You are paying for certainty. And that premium 00:31:09.460 --> 00:31:11.480 protects you from the long -term risk of time. 00:31:12.009 --> 00:31:14.549 But let's end with how the lender manages the 00:31:14.549 --> 00:31:16.430 risk they take on. Right, because they don't 00:31:16.430 --> 00:31:18.890 just sit there and pray that rates stay stable 00:31:18.890 --> 00:31:21.509 for 30 years. Not at all. They use high finance 00:31:21.509 --> 00:31:23.930 to neutralize the risk completely. And this is 00:31:23.930 --> 00:31:25.890 the connection point that ties your home loan 00:31:25.890 --> 00:31:29.190 directly to the global capital markets. When 00:31:29.190 --> 00:31:32.150 a lender issues a massive portfolio of 30 -year 00:31:32.150 --> 00:31:35.109 fixed -rate mortgages, they have a massive liability 00:31:35.109 --> 00:31:37.990 on their books, a fixed rate in a potentially 00:31:37.990 --> 00:31:41.380 volatile market. So how do they hedge that? They 00:31:41.380 --> 00:31:43.900 sell off that fixed risk using financial engineering. 00:31:44.240 --> 00:31:46.839 They engage in what is called a fixed -to -floating 00:31:46.839 --> 00:31:49.880 swap, which is a type of derivative. Okay. What 00:31:49.880 --> 00:31:51.700 does that mean in simple terms? Essentially, 00:31:51.779 --> 00:31:54.279 the bank agrees to exchange the fixed stream 00:31:54.279 --> 00:31:56.240 of interest payments they're receiving from you 00:31:56.240 --> 00:31:59.579 for a variable or floating stream of payments 00:31:59.579 --> 00:32:02.319 from a counterparty like a major investment firm. 00:32:02.460 --> 00:32:04.759 So the lender keeps the stable payment stream 00:32:04.759 --> 00:32:06.759 from the borrower, but then they use the derivative 00:32:06.759 --> 00:32:09.359 market to trade that stability for a floating 00:32:09.359 --> 00:32:11.769 rate. Why on earth would they want a floating 00:32:11.769 --> 00:32:13.690 rate? Because if the central bank raises short 00:32:13.690 --> 00:32:16.490 -term rates, the bank's own funding costs, what 00:32:16.490 --> 00:32:20.109 they pay their depositors, also rise. By holding 00:32:20.109 --> 00:32:22.009 a derivative that pays them a floating rate, 00:32:22.130 --> 00:32:24.910 they receive more money when rates rise, which 00:32:24.910 --> 00:32:27.069 perfectly offsets the higher cost of their funding 00:32:27.069 --> 00:32:29.789 liabilities. So they transfer the fixed rate 00:32:29.789 --> 00:32:32.930 risk to a specialist counterparty who is better 00:32:32.930 --> 00:32:35.230 positioned to handle floating rates. They do. 00:32:35.769 --> 00:32:38.210 It transforms the fixed -rate mortgage from a 00:32:38.210 --> 00:32:41.509 simple loan contract into a piece of a much larger 00:32:41.509 --> 00:32:43.890 global market designed to manage and distribute 00:32:43.890 --> 00:32:46.630 risk. And I assume this requires some extremely 00:32:46.630 --> 00:32:49.329 complex mathematics to price correctly. You have 00:32:49.329 --> 00:32:51.650 to determine the value and risk of that rate 00:32:51.650 --> 00:32:54.470 optionality? Oh, absolutely. This is where models 00:32:54.470 --> 00:32:56.890 like the famous Black -Skulls equation, which 00:32:56.890 --> 00:32:58.990 was originally designed for pricing stock options, 00:32:59.250 --> 00:33:02.150 come into play in valuing and managing these 00:33:02.150 --> 00:33:04.670 interest rate derivatives. They help the lender 00:33:04.670 --> 00:33:07.569 assign a precise numerical value to the uncertainty 00:33:07.569 --> 00:33:10.049 of future rate movements. So the next time you 00:33:10.049 --> 00:33:12.150 look at your fixed monthly payment, remember 00:33:12.150 --> 00:33:14.869 that it is the stable anchor of the... this massive, 00:33:14.869 --> 00:33:17.710 sophisticated financial operation designed to 00:33:17.710 --> 00:33:20.769 manage risk across decades, connecting your kitchen 00:33:20.769 --> 00:33:23.390 table commitment to the deepest concepts of financial 00:33:23.390 --> 00:33:26.190 mathematics and global markets. It's a number 00:33:26.190 --> 00:33:29.369 engineered for certainty, but managed by speculation. 00:33:30.009 --> 00:33:32.609 And that complexity is definitely worth exploring 00:33:32.609 --> 00:33:34.470 further. We'll see you next time for the next 00:33:34.470 --> 00:33:35.009 Deep Dive.