WEBVTT 00:00:00.000 --> 00:00:02.299 Welcome back to the deep dive. Glad to be back. 00:00:02.660 --> 00:00:06.559 So I want to start today with a picture. It's 00:00:06.559 --> 00:00:10.240 an image that's been. Sort of burned into our 00:00:10.240 --> 00:00:13.660 collective consciousness for, what, 70, 80 years 00:00:13.660 --> 00:00:15.259 now? I think I know where you're going with this. 00:00:15.380 --> 00:00:17.920 The American dream. The white picket fence. It's 00:00:17.920 --> 00:00:19.300 always the white picket fence. It's always the 00:00:19.300 --> 00:00:23.379 fence. The perfectly manicured lawn. Maybe there's 00:00:23.379 --> 00:00:27.160 a dog, you know, chasing a ball. And behind it, 00:00:27.199 --> 00:00:30.920 that two -story house with a garage. When we 00:00:30.920 --> 00:00:32.939 think about homeownership, that's where our minds 00:00:32.939 --> 00:00:35.820 go. To the physical thing. Exactly. We focus 00:00:35.820 --> 00:00:39.340 on the asset. We obsess over. You know, the countertops, 00:00:39.340 --> 00:00:40.920 the square footage, the neighborhood, the curb 00:00:40.920 --> 00:00:43.079 appeal. We're looking at the house. Which makes 00:00:43.079 --> 00:00:44.840 sense. That's the tangible thing. That's where 00:00:44.840 --> 00:00:48.740 you're going to live. Of course. But today, I 00:00:48.740 --> 00:00:51.299 want to do a pivot. We are going to look right 00:00:51.299 --> 00:00:53.799 past all of that. Past the bricks, the mortar, 00:00:53.979 --> 00:00:56.240 the shingles on the roof. Okay. We're going to 00:00:56.240 --> 00:00:58.600 look at the invisible engine sitting right underneath 00:00:58.600 --> 00:01:01.280 that house. Ah, the machinery. The machinery. 00:01:01.659 --> 00:01:03.920 We're going to talk about a specific, highly 00:01:03.920 --> 00:01:07.019 engineered financial tool that sounds, and I 00:01:07.019 --> 00:01:09.769 mean this. incredibly boring. It might be the 00:01:09.769 --> 00:01:12.010 most boring sounding phrase in finance. It really 00:01:12.010 --> 00:01:15.510 might be. But it's actually the invention that 00:01:15.510 --> 00:01:18.310 made the modern middle class possible. We are 00:01:18.310 --> 00:01:21.069 talking about the fixed rate mortgage. The FRM. 00:01:21.069 --> 00:01:24.030 It really is the engine room of the whole U .S. 00:01:24.109 --> 00:01:26.170 economy in a lot of ways. Right. And you're right. 00:01:26.209 --> 00:01:28.689 It sounds so dry, fixed rate mortgage. It just 00:01:28.689 --> 00:01:30.909 sounds like stacks of paperwork. But when you 00:01:30.909 --> 00:01:33.790 actually start to peel back the layers, it is 00:01:33.790 --> 00:01:37.959 an incredibly complex and frankly. A really weird 00:01:37.959 --> 00:01:40.280 anomaly in the global system. And that's our 00:01:40.280 --> 00:01:41.719 mission for this deep dive. We're going to unpack 00:01:41.719 --> 00:01:44.420 exactly how this machine works. We're going to 00:01:44.420 --> 00:01:46.840 look at the sort of counterintuitive financial 00:01:46.840 --> 00:01:48.840 science that suggests you probably shouldn't 00:01:48.840 --> 00:01:50.920 even have one, even though most of us do. The 00:01:50.920 --> 00:01:53.000 academic view. We're also going to jump in a 00:01:53.000 --> 00:01:55.700 time machine, go back to the 1930s and see why 00:01:55.700 --> 00:01:57.700 it was invented in the first place. And spoiler 00:01:57.700 --> 00:02:00.239 alert, it was basically to stop society from 00:02:00.239 --> 00:02:03.280 collapsing. A slight exaggeration, but not by 00:02:03.280 --> 00:02:05.790 much. And then we're going to take a tour around 00:02:05.790 --> 00:02:08.009 the world to see why pretty much every other 00:02:08.009 --> 00:02:10.150 country thinks the American system is completely 00:02:10.150 --> 00:02:12.870 bonkers. And we can't forget the math. We have 00:02:12.870 --> 00:02:14.889 to talk about the math. Oh, we have to. We're 00:02:14.889 --> 00:02:17.409 going to break down the actual formula that spits 00:02:17.409 --> 00:02:20.449 out your exact monthly payment down to the penny. 00:02:20.629 --> 00:02:23.449 It's surprisingly elegant, that formula. It really 00:02:23.449 --> 00:02:25.710 is. So let's just dive right in. Let's define 00:02:25.710 --> 00:02:28.310 the beast. You're in an elevator. What's the, 00:02:28.310 --> 00:02:31.050 you know, the quick pitch for a fixed rate mortgage? 00:02:33.259 --> 00:02:36.479 Fundamental level, a fixed rate mortgage, or 00:02:36.479 --> 00:02:40.060 FRM, is a loan where the interest rate on the 00:02:40.060 --> 00:02:43.340 note remains exactly the same for the entire 00:02:43.340 --> 00:02:45.539 life of that loan. It sounds so simple when you 00:02:45.539 --> 00:02:47.819 say it like that. It sounds simple, but the implications 00:02:47.819 --> 00:02:51.180 of that one rule are just massive. How so? Because 00:02:51.180 --> 00:02:54.360 that rate is locked. It means two other really 00:02:54.360 --> 00:02:57.340 important things also become completely rigid. 00:02:57.520 --> 00:03:00.099 Okay. First, your monthly payment amount is fixed. 00:03:00.280 --> 00:03:02.960 Your first payment and your 360th payment, if 00:03:02.960 --> 00:03:05.240 it's a 30 -year loan, are identical. Down to 00:03:05.240 --> 00:03:08.139 the cent. Down to the cent. And second, the duration 00:03:08.139 --> 00:03:12.360 is fixed. You know the exact month and year 30 00:03:12.360 --> 00:03:14.819 years from now. when that final payment is made, 00:03:14.960 --> 00:03:17.280 and you are free. I was trying to think of an 00:03:17.280 --> 00:03:19.439 analogy for this, and the best I came up with 00:03:19.439 --> 00:03:22.139 was, it's like a subscription service. A subscription 00:03:22.139 --> 00:03:24.479 to a house. I like that. It's like a very, very 00:03:24.479 --> 00:03:27.219 expensive Netflix subscription, but with two 00:03:27.219 --> 00:03:30.479 huge differences. One, it definitely cancels 00:03:30.479 --> 00:03:33.280 itself after a set number of years. And two, 00:03:33.500 --> 00:03:35.680 and this is the really crucial part, the price 00:03:35.680 --> 00:03:39.139 never, ever goes up. That's the price lock. Yeah. 00:03:39.580 --> 00:03:41.860 And that is a perfect way to put it. No matter 00:03:41.860 --> 00:03:43.979 what's happening in the world, you know, wars, 00:03:44.139 --> 00:03:47.360 pandemics, economic booms, busts, whatever, your 00:03:47.360 --> 00:03:49.699 price is your price. It's set in stone. And that 00:03:49.699 --> 00:03:52.400 stability feels amazing for us, the borrowers. 00:03:52.460 --> 00:03:54.840 But my assumption is always, you know, when I 00:03:54.840 --> 00:03:57.120 deal with a bank, the bank is the one who's winning. 00:03:57.240 --> 00:03:58.539 You usually have the edge, yeah. They've got 00:03:58.539 --> 00:04:01.060 the marble floors. I've got the debt. But the 00:04:01.060 --> 00:04:03.520 research suggests that with a fixed rate structure, 00:04:03.819 --> 00:04:05.759 there's actually a scenario where the borrower 00:04:05.759 --> 00:04:08.539 can come out way ahead of the bank. Absolutely. 00:04:09.240 --> 00:04:12.900 The fixed rate mortgage is, at its heart, a bet. 00:04:13.520 --> 00:04:15.879 And it's one of the few financial products where 00:04:15.879 --> 00:04:18.519 the little guy has this huge structural advantage 00:04:18.519 --> 00:04:22.279 if, and it's a big if, certain economic conditions 00:04:22.279 --> 00:04:25.009 play out. OK, so that brings us to this idea 00:04:25.009 --> 00:04:27.829 of the inflation hedge. Exactly. Let's unpack 00:04:27.829 --> 00:04:30.470 that, because usually we hear the word inflation 00:04:30.470 --> 00:04:33.189 and we get nervous. We think of groceries getting 00:04:33.189 --> 00:04:35.329 more expensive, gas prices going through the 00:04:35.329 --> 00:04:37.569 roof. Right. It feels like a tax on everything. 00:04:37.870 --> 00:04:40.029 So how does that possibly help me when I'm carrying 00:04:40.029 --> 00:04:41.990 hundreds of thousands of dollars of mortgage 00:04:41.990 --> 00:04:44.050 debt? Well, you have to separate your day to 00:04:44.050 --> 00:04:47.110 day expenses from the nature of your debt. When 00:04:47.110 --> 00:04:50.040 you sign that mortgage, you are locking in. A 00:04:50.040 --> 00:04:53.399 nominal payment. Nominal meaning just the dollar 00:04:53.399 --> 00:04:55.620 amount? The number on the paper. Let's use a 00:04:55.620 --> 00:04:58.259 round number. Say you buy a house today. Your 00:04:58.259 --> 00:05:01.480 payment is $2 ,000 a month. Okay. A big chunk 00:05:01.480 --> 00:05:04.439 of change. Right. And right now, today, that 00:05:04.439 --> 00:05:06.939 $2 ,000 represents a certain amount of your purchasing 00:05:06.939 --> 00:05:10.579 power. Maybe it's, I don't know, 30 or 40 % of 00:05:10.579 --> 00:05:13.240 your monthly income. It hurts to write that check. 00:05:13.399 --> 00:05:15.699 Definitely hurts. Okay. Now let's imagine a scenario 00:05:15.699 --> 00:05:19.620 where inflation runs really hot. for, say, a 00:05:19.620 --> 00:05:22.220 decade, the price of everything doubles. So a 00:05:22.220 --> 00:05:24.439 loaf of bread is eight bucks, gallon of gas is 00:05:24.439 --> 00:05:28.220 seven. Right. But, and this is key, in an inflationary 00:05:28.220 --> 00:05:31.399 world, wages generally rise to eventually match 00:05:31.399 --> 00:05:34.019 those prices. So let's just assume your salary 00:05:34.019 --> 00:05:36.740 has also doubled over those 10 years. So I'm 00:05:36.740 --> 00:05:39.000 making twice as much money, but everything costs 00:05:39.000 --> 00:05:41.139 twice as much. So at the grocery store, I don't 00:05:41.139 --> 00:05:43.480 feel any richer. Exactly. You feel like you're 00:05:43.480 --> 00:05:45.139 just treading water when you're buying eggs. 00:05:45.379 --> 00:05:49.100 But now look at your mortgage payment. Oh, it's 00:05:49.100 --> 00:05:52.279 still $2 ,000. It's still $2 ,000. So if my income 00:05:52.279 --> 00:05:55.120 doubled, that $2 ,000 check is now only half 00:05:55.120 --> 00:05:57.439 as painful to write as it used to be. Precisely. 00:05:57.439 --> 00:06:01.000 In real terms, which means adjusted for that 00:06:01.000 --> 00:06:04.160 inflation, your debt has effectively been cut 00:06:04.160 --> 00:06:07.699 in half. Wow. You are paying the bank back with 00:06:07.699 --> 00:06:09.959 dollars that are worth significantly less than 00:06:09.959 --> 00:06:12.040 the dollars that they lent you. They give you 00:06:12.040 --> 00:06:14.199 valuable twenty twenty four dollars and you're 00:06:14.199 --> 00:06:16.300 paying them back with cheap twenty thirty four 00:06:16.300 --> 00:06:19.319 dollars. So from a purely financial standpoint, 00:06:19.399 --> 00:06:22.000 if I have a fixed rate mortgage, I should be 00:06:22.000 --> 00:06:24.680 quietly rooting for a little bit of inflation. 00:06:24.819 --> 00:06:27.379 From a pure debt management perspective. Yes. 00:06:27.420 --> 00:06:31.259 Yes. Inflation is the borrower's absolute best 00:06:31.259 --> 00:06:34.579 friend. It erodes the real value of what you 00:06:34.579 --> 00:06:36.920 owe. But there has to be a catch here. I mean, 00:06:36.920 --> 00:06:40.199 the bank isn't dumb. They have entire floors 00:06:40.199 --> 00:06:42.420 of economists. They have to know this is a possibility. 00:06:42.779 --> 00:06:44.740 Oh, of course they do. And that's why there's 00:06:44.740 --> 00:06:47.279 a flip side to this bet. The bank is shouldering 00:06:47.279 --> 00:06:50.420 a massive risk. The interest rate risk. That's 00:06:50.420 --> 00:06:53.180 the one. Think about it. If inflation goes up, 00:06:53.220 --> 00:06:55.620 the central bank usually raises interest rates 00:06:55.620 --> 00:06:59.120 to fight it. So imagine a world in 10 years where 00:06:59.120 --> 00:07:01.779 the going rate for a new mortgage is, say, 10 00:07:01.779 --> 00:07:05.500 % or 15%. Like in the early 1980s, that really 00:07:05.500 --> 00:07:07.939 happened. It really did. So if the market rate 00:07:07.939 --> 00:07:10.699 is 15%, the bank could be lending out its money 00:07:10.699 --> 00:07:13.290 and making an absolute killing. But they can't. 00:07:13.310 --> 00:07:15.610 They can't because a chunk of their capital is 00:07:15.610 --> 00:07:18.189 tied up with you and they are stuck taking your 00:07:18.189 --> 00:07:20.529 measly three or four percent. They are losing 00:07:20.529 --> 00:07:22.910 money every single month on your loan compared 00:07:22.910 --> 00:07:24.750 to what they could be doing with that capital. 00:07:24.889 --> 00:07:27.550 So the bank is essentially taking the gamble 00:07:27.550 --> 00:07:30.189 on the future of the economy for me. They're 00:07:30.189 --> 00:07:32.350 shielding me from that volatility. They are. 00:07:32.689 --> 00:07:35.449 But, and this is the part I think most borrowers 00:07:35.449 --> 00:07:38.769 don't fully grasp, banks are not charities. They 00:07:38.769 --> 00:07:43.069 do not take on that kind of risk. for free, you 00:07:43.069 --> 00:07:45.170 are paying for that safety. It's like an insurance 00:07:45.170 --> 00:07:47.490 premium. That's exactly what it is. If you go 00:07:47.490 --> 00:07:49.350 and look at mortgage rates on any given day, 00:07:49.490 --> 00:07:52.850 you almost always see a pattern. Okay. A 30 -year 00:07:52.850 --> 00:07:54.970 fixed mortgage will have a noticeably higher 00:07:54.970 --> 00:07:58.269 interest rate than, say, a five -year adjustable 00:07:58.269 --> 00:08:01.389 rate mortgage, an ARM. And that gap, that difference 00:08:01.389 --> 00:08:03.430 in the rate? That's the price of the insurance. 00:08:03.569 --> 00:08:05.550 That is the premium. You're paying, let's say, 00:08:05.550 --> 00:08:09.089 an extra 1 % or 1 .5 % in interest every single 00:08:09.089 --> 00:08:11.269 year for the privilege of knowing that your rate 00:08:11.269 --> 00:08:13.629 will never, ever change. Yeah. You're buying 00:08:13.629 --> 00:08:16.170 insurance against a future economic disaster 00:08:16.170 --> 00:08:18.930 that might never actually happen. Okay. This 00:08:18.930 --> 00:08:21.209 leads me directly to one of the most, I have 00:08:21.209 --> 00:08:23.290 to say, surprising things I read in the source 00:08:23.290 --> 00:08:25.529 material. Oh, yeah. It was a paper that basically, 00:08:25.829 --> 00:08:28.529 and I'm simplifying, said that most of us are 00:08:28.529 --> 00:08:31.529 suckers for taking the fixed rate. It suggested 00:08:31.529 --> 00:08:35.450 that from a pure numbers perspective, borrowers 00:08:35.450 --> 00:08:38.009 should generally prefer adjustable rate mortgages. 00:08:38.190 --> 00:08:41.149 Ah, yes. The classic battle between economic 00:08:41.149 --> 00:08:44.210 theory and human psychology. It felt like a personal 00:08:44.210 --> 00:08:47.580 attack. I love my fixed rate. I sleep well at 00:08:47.580 --> 00:08:49.460 night knowing my payment isn't going to change. 00:08:50.000 --> 00:08:53.519 Why would a smart person choose a loan where 00:08:53.519 --> 00:08:55.700 the payment could suddenly double? That sounds 00:08:55.700 --> 00:08:58.100 like financial suicide. Well, the economists 00:08:58.100 --> 00:09:00.039 aren't looking at your sleep quality. They're 00:09:00.039 --> 00:09:02.000 looking at the long -term data. They're looking 00:09:02.000 --> 00:09:04.620 at something called the yield curve. Okay, you've 00:09:04.620 --> 00:09:06.679 got to define that, the yield curve. The easiest 00:09:06.679 --> 00:09:09.679 way to think of the yield curve is as the price 00:09:09.679 --> 00:09:13.009 of time. The price of time. Yeah. Generally speaking, 00:09:13.149 --> 00:09:14.769 if you want to borrow money for a very short 00:09:14.769 --> 00:09:18.710 period of time, say one year, it's cheap. The 00:09:18.710 --> 00:09:20.909 lender isn't taking on much risk. Not much can 00:09:20.909 --> 00:09:22.870 go wrong in a year. Right. But if you want to 00:09:22.870 --> 00:09:25.629 borrow that same money for 30 years, that's going 00:09:25.629 --> 00:09:27.289 to be much more expensive. Because anything could 00:09:27.289 --> 00:09:30.409 happen in 30 years. Exactly. 30 years is an eternity 00:09:30.409 --> 00:09:33.049 in finance. You could have wars, recessions, 00:09:33.090 --> 00:09:36.009 technological revolutions, pandemics. The future 00:09:36.009 --> 00:09:38.960 is a dark room. And the further a lender has 00:09:38.960 --> 00:09:41.559 to walk into that dark room, the more they demand 00:09:41.559 --> 00:09:43.799 to be compensated for the risk. So the curve 00:09:43.799 --> 00:09:45.879 of the graph showing the interest rate versus 00:09:45.879 --> 00:09:49.220 time slopes upward. It almost always slopes upward. 00:09:49.299 --> 00:09:52.720 So because the 30 -year fixed loan is the longest, 00:09:52.840 --> 00:09:55.559 safest, most ironclad lock -in you can possibly 00:09:55.559 --> 00:09:59.639 get, it is, by its very nature, the most expensive 00:09:59.639 --> 00:10:02.690 product on the shelf on day one. It's the luxury, 00:10:02.870 --> 00:10:05.389 fully loaded model, the tank. It is the tank. 00:10:05.529 --> 00:10:07.610 Now, the argument from The Economist is this. 00:10:08.509 --> 00:10:10.549 Because you are paying such a high premium for 00:10:10.549 --> 00:10:12.809 that tank, you usually end up paying more in 00:10:12.809 --> 00:10:15.029 total interest over the life of the loan than 00:10:15.029 --> 00:10:16.889 if you had just taken the risky adjustable rate. 00:10:17.070 --> 00:10:19.190 So even if the adjustable rate does go up sometimes, 00:10:19.529 --> 00:10:22.210 it usually averages out to be lower than the 00:10:22.210 --> 00:10:24.350 fixed rate over the long haul. Statistically, 00:10:24.409 --> 00:10:26.549 for most households in most historical periods, 00:10:26.889 --> 00:10:29.649 the ARM is the mathematically superior choice. 00:10:30.299 --> 00:10:32.840 You save a ton of money on that lower rate in 00:10:32.840 --> 00:10:35.419 the beginning. And even if rates do rise later, 00:10:35.639 --> 00:10:37.960 they rarely stay high enough for long enough 00:10:37.960 --> 00:10:40.220 to completely erase all those early savings. 00:10:40.519 --> 00:10:43.299 So we are essentially paying a huge amount of 00:10:43.299 --> 00:10:45.519 money just for peace of mind. We are paying to 00:10:45.519 --> 00:10:48.379 avoid what they call tail risk, the worst case 00:10:48.379 --> 00:10:51.360 scenario. The economists would say we are massively 00:10:51.360 --> 00:10:53.759 overinsuring ourselves against a low probability 00:10:53.759 --> 00:10:56.120 event. But there's a human element here they're 00:10:56.120 --> 00:10:58.360 missing, isn't there? I think so. And this is 00:10:58.360 --> 00:11:00.399 where I tend to part ways with the pure math. 00:11:00.639 --> 00:11:03.720 Go on. The math assumes that you can handle the 00:11:03.720 --> 00:11:06.899 volatility. It assumes that if your payment suddenly 00:11:06.899 --> 00:11:10.460 jumps from $2 ,000 to $3 ,000 a month for a couple 00:11:10.460 --> 00:11:13.399 of years, you can just absorb that shock. Because 00:11:13.399 --> 00:11:14.740 you were supposed to be saving all that money 00:11:14.740 --> 00:11:16.840 you weren't paying in the first few years. Right. 00:11:17.139 --> 00:11:19.360 But in the real world, what do people do with 00:11:19.360 --> 00:11:21.860 that extra money? They spend it. Life happens. 00:11:22.039 --> 00:11:24.080 You don't just bank the difference in a special 00:11:24.080 --> 00:11:27.929 account. And if you can't make that higher payment 00:11:27.929 --> 00:11:31.070 when it comes due, you don't just lose some economic 00:11:31.070 --> 00:11:34.850 efficiency. You lose your house. The cost of 00:11:34.850 --> 00:11:39.789 failure is catastrophic and absolute. So, while 00:11:39.789 --> 00:11:43.000 the ARM might be cheaper on average, The fixed 00:11:43.000 --> 00:11:45.559 rate prevents ruin. It prevents the worst case 00:11:45.559 --> 00:11:47.720 scenario. And speaking of worst case scenarios, 00:11:47.799 --> 00:11:49.639 this is a perfect transition into the history 00:11:49.639 --> 00:11:51.860 of this thing. Because we didn't always have 00:11:51.860 --> 00:11:54.299 this safety net, did we? Not at all. And this 00:11:54.299 --> 00:11:56.240 is what I think people completely forget. Yeah. 00:11:56.340 --> 00:11:59.139 The 30 -year fixed mortgage is not some law of 00:11:59.139 --> 00:12:02.159 nature. It's an invention. Right. And it was 00:12:02.159 --> 00:12:04.259 invented because the system that came before 00:12:04.259 --> 00:12:07.899 it failed so spectacularly that it almost took 00:12:07.899 --> 00:12:10.480 the entire country down with it. So take us back. 00:12:10.519 --> 00:12:13.519 Let's go to the before times. It's, say, in 1925. 00:12:13.679 --> 00:12:15.580 I've saved up a down payment. I want to buy a 00:12:15.580 --> 00:12:17.980 little bungalow. What kind of loan am I getting? 00:12:18.139 --> 00:12:19.960 You are getting something called a balloon payment 00:12:19.960 --> 00:12:22.440 mortgage. And if you think the mortgage process 00:12:22.440 --> 00:12:25.059 today is stressful, this was a waking nightmare. 00:12:25.360 --> 00:12:27.620 Okay. How'd it work? So you'd borrow the money. 00:12:27.980 --> 00:12:30.000 but for a very short term, maybe three years, 00:12:30.039 --> 00:12:32.080 five years at the absolute most. That's a really 00:12:32.080 --> 00:12:35.000 short time. It is. And during those five years, 00:12:35.100 --> 00:12:37.340 you would make monthly payments. But here's the 00:12:37.340 --> 00:12:41.360 kicker. Usually, those payments were interest 00:12:41.360 --> 00:12:44.159 only. Wait, so I'm not actually paying off the 00:12:44.159 --> 00:12:46.279 house at all? I'm just renting the money from 00:12:46.279 --> 00:12:48.080 the bank? That's a great way to put it. You're 00:12:48.080 --> 00:12:49.879 just trading water. You're covering the bank's 00:12:49.879 --> 00:12:53.299 cost of lending you the money. Okay. Then, at 00:12:53.299 --> 00:12:55.740 the end of the five -year term, the balloon comes 00:12:55.740 --> 00:12:59.289 due. And that means you owe the entire original 00:12:59.289 --> 00:13:04.230 principal amount in one single massive lump sum 00:13:04.230 --> 00:13:06.629 payment. So I borrow, I don't know, $5 ,000, 00:13:06.870 --> 00:13:08.929 which was a fortune back then. I pay interest 00:13:08.929 --> 00:13:11.529 on it for five years. And then on Tuesday, the 00:13:11.529 --> 00:13:13.269 bank manager knocks on my door and says, OK, 00:13:13.350 --> 00:13:17.230 give us the $5 ,000 back. Yes. But who has that 00:13:17.230 --> 00:13:19.610 kind of cash just sitting around? Yeah. If I 00:13:19.610 --> 00:13:21.549 had $5 ,000 in cash, I wouldn't have needed the 00:13:21.549 --> 00:13:23.289 loan in the first place. Exactly. Nobody had 00:13:23.289 --> 00:13:25.610 the cash. The entire system was built on one 00:13:25.610 --> 00:13:28.769 crucial assumption. Refinancing. The idea was 00:13:28.769 --> 00:13:30.990 you'd get to the end of your five years, the 00:13:30.990 --> 00:13:33.370 bank would see you've been a good borrower, making 00:13:33.370 --> 00:13:35.590 your interest payments on time, and they would 00:13:35.590 --> 00:13:38.730 just roll the loan over into a new five -year 00:13:38.730 --> 00:13:40.850 balloon mortgage. It's basically a confidence 00:13:40.850 --> 00:13:43.690 game. It only works as long as the economy is 00:13:43.690 --> 00:13:45.629 good and the bank is feeling generous. Right. 00:13:45.850 --> 00:13:48.750 It works until the music stops. And in October 00:13:48.750 --> 00:13:52.250 1929, the music didn't just stop. The entire 00:13:52.250 --> 00:13:54.929 orchestra pit caught on fire. The Great Depression. 00:13:55.190 --> 00:13:57.230 The Great Depression hits. So what happens to 00:13:57.230 --> 00:13:59.129 all those homeowners with their balloon payments 00:13:59.129 --> 00:14:01.850 coming due? It was an absolute catastrophe. First, 00:14:02.009 --> 00:14:04.889 property values crashed. So suddenly the houses 00:14:04.889 --> 00:14:06.860 were worth less than the loans on them. You're 00:14:06.860 --> 00:14:09.580 underwater. Deeply underwater. And at the same 00:14:09.580 --> 00:14:12.220 time, thousands of banks were going bankrupt. 00:14:12.379 --> 00:14:14.659 So they literally didn't have any money to lend 00:14:14.659 --> 00:14:17.139 out for a refinance, even if they wanted to. 00:14:17.240 --> 00:14:19.480 So the balloon payment comes due. And the homeowner 00:14:19.480 --> 00:14:21.779 says, I can't possibly pay this. And the bank 00:14:21.779 --> 00:14:24.539 says, we can't refinance you. And the only possible 00:14:24.539 --> 00:14:27.720 outcome is immediate foreclosure. And because 00:14:27.720 --> 00:14:29.639 this was happening to millions of people all 00:14:29.639 --> 00:14:32.399 at once, it just drove housing prices down even 00:14:32.399 --> 00:14:34.750 further. It was a death spiral. It wasn't just 00:14:34.750 --> 00:14:37.090 a housing crisis. It was a systemic collapse 00:14:37.090 --> 00:14:40.649 of the very idea of private home ownership. Yeah. 00:14:40.690 --> 00:14:44.129 By 1933, it's estimated that roughly half of 00:14:44.129 --> 00:14:46.690 all home mortgages in the entire United States 00:14:46.690 --> 00:14:49.570 were in default. Half. Half. Yeah. Just try to 00:14:49.570 --> 00:14:51.710 imagine that today. Every other house on your 00:14:51.710 --> 00:14:54.570 street with a for sale by sheriff sign out front. 00:14:54.649 --> 00:14:56.789 It's unthinkable. So this is when the government 00:14:56.789 --> 00:15:00.049 has to step in. The New Deal era. Exactly. You 00:15:00.049 --> 00:15:01.850 get the creation of the Federal Housing Administration, 00:15:02.149 --> 00:15:05.590 the FHA, and a bit later, Fannie Mae. And what 00:15:05.590 --> 00:15:07.509 did they do? They looked at all this wreckage 00:15:07.509 --> 00:15:09.750 and they identified that this refinancing risk 00:15:09.750 --> 00:15:13.029 was the poison pill. The dependency on having 00:15:13.029 --> 00:15:15.350 to get a new loan every few years was the fatal 00:15:15.350 --> 00:15:18.190 flaw. They needed a new kind of loan, a loan 00:15:18.190 --> 00:15:20.090 that killed itself off automatically. And this 00:15:20.090 --> 00:15:22.330 brings us to that fantastic word, amortization. 00:15:22.590 --> 00:15:25.990 Yes. It's from the Latin, et mortere, which means 00:15:25.990 --> 00:15:29.529 to bring to death. The root is mort. Like mortal 00:15:29.529 --> 00:15:32.529 death. So a mortgage is literally a death pledge. 00:15:32.870 --> 00:15:34.970 It's a death pledge. But, you know, in a good 00:15:34.970 --> 00:15:38.049 way. The innovation here was full amortization. 00:15:38.470 --> 00:15:41.129 So what does that mean in practice? It means 00:15:41.129 --> 00:15:44.429 they designed the math so that every single monthly 00:15:44.429 --> 00:15:47.750 payment you make is composed of two parts. Yeah. 00:15:48.029 --> 00:15:50.669 Some of it is interest and a little piece of 00:15:50.669 --> 00:15:53.169 it is principal. So you're always paying down 00:15:53.169 --> 00:15:55.350 the original debt, even if it's just by a tiny 00:15:55.350 --> 00:15:57.590 amount at first. Slowly but surely. And at the 00:15:57.590 --> 00:15:59.509 end of the term, whether it's 15 years or 30 00:15:59.509 --> 00:16:02.090 years, the balance is guaranteed to be zero. 00:16:02.269 --> 00:16:05.450 No balloon. No giant surprise bill at the end. 00:16:05.570 --> 00:16:07.990 No more dependency on the bank's mood or the 00:16:07.990 --> 00:16:10.190 state of the economy. Once you sign those papers, 00:16:10.389 --> 00:16:13.029 you are, in a way, independent of the financial 00:16:13.029 --> 00:16:15.590 markets. You just have to make your payment. 00:16:16.120 --> 00:16:18.600 It brought stability to the entire housing sector. 00:16:18.720 --> 00:16:20.700 It's actually amazing when you think about it. 00:16:20.759 --> 00:16:22.980 This thing we see as just a boring financial 00:16:22.980 --> 00:16:25.519 product was really a radical piece of social 00:16:25.519 --> 00:16:28.100 engineering, a government -backed safety net. 00:16:28.279 --> 00:16:31.019 It absolutely was. It was a policy tool designed 00:16:31.019 --> 00:16:34.039 to create a nation of stable homeowners who couldn't 00:16:34.039 --> 00:16:36.019 be kicked out of their houses just because Wall 00:16:36.019 --> 00:16:38.240 Street had a bad year. And we're seeing that 00:16:38.240 --> 00:16:41.919 tool evolve now. We're so used to the 15 and 00:16:41.919 --> 00:16:44.399 30 year terms. But I saw in the notes that now 00:16:44.399 --> 00:16:47.399 we're starting to see 40 year and even 50 year 00:16:47.399 --> 00:16:50.379 mortgages pop up in really high cost areas. We 00:16:50.379 --> 00:16:52.340 are. Yeah. And that's usually a sign of stress 00:16:52.340 --> 00:16:54.779 in the system. A 50 year mortgage. I mean, just 00:16:54.779 --> 00:16:56.779 do the math on that. If you buy a house at age 00:16:56.779 --> 00:16:59.340 30, you pay it off when you're 80. Your mortgage 00:16:59.340 --> 00:17:02.370 might outlive you. That's a lifetime commitment 00:17:02.370 --> 00:17:04.450 and then some. Why is this happening? It's a 00:17:04.450 --> 00:17:06.869 direct response to the affordability crisis. 00:17:07.089 --> 00:17:10.089 Yeah. When home prices get so astronomical that 00:17:10.089 --> 00:17:12.369 an average family can't afford the monthly payment 00:17:12.369 --> 00:17:14.869 on a standard 30 -year loan. Right. The only 00:17:14.869 --> 00:17:17.150 lever the bank has left to pull to make the numbers 00:17:17.150 --> 00:17:20.509 work is to stretch the time, to spread the pain 00:17:20.509 --> 00:17:22.869 out over a longer period. So it lowers the monthly 00:17:22.869 --> 00:17:25.609 payment, which is what people focus on. It does, 00:17:25.789 --> 00:17:28.700 but it... Absolutely. Explodes the total cost 00:17:28.700 --> 00:17:31.460 of the loan. You end up paying just a staggering 00:17:31.460 --> 00:17:33.680 amount of interest over those 50 years. It's 00:17:33.680 --> 00:17:36.660 that expensive boots theory of economics. Say 00:17:36.660 --> 00:17:38.519 more about that. You know, because you're poor, 00:17:38.720 --> 00:17:41.519 you can only afford the cheap $10 boots that 00:17:41.519 --> 00:17:44.539 fall apart after one winter. So over your lifetime, 00:17:44.640 --> 00:17:48.200 you buy 10 pairs and spend $100. The rich person 00:17:48.200 --> 00:17:51.559 buys the one good $50 pair that lasts forever. 00:17:51.799 --> 00:17:54.160 I see, because you can't afford the higher monthly 00:17:54.160 --> 00:17:56.880 payment of the 30 -year loan. You're forced into 00:17:56.880 --> 00:17:59.539 the 50 -year loan, and you end up paying triple 00:17:59.539 --> 00:18:01.579 the interest in the long run. It's a poverty 00:18:01.579 --> 00:18:04.420 trap. It can be, yes. And it just highlights 00:18:04.420 --> 00:18:07.059 how critically important that term, the length 00:18:07.059 --> 00:18:10.190 of the loan. Really is. Okay, so we firmly establish 00:18:10.190 --> 00:18:13.089 that the 30 -year fixed is the American standard. 00:18:13.589 --> 00:18:16.549 We invented it. We love it. It saved us from 00:18:16.549 --> 00:18:18.769 the Depression. The bedrock of the system. But 00:18:18.769 --> 00:18:20.650 here's the part of the research that really floored 00:18:20.650 --> 00:18:23.190 me. The rest of the world thinks we are absolutely 00:18:23.190 --> 00:18:25.609 crazy for doing it this way. We are the weird 00:18:25.609 --> 00:18:28.349 ones. The outlier. Let's do a little global tour. 00:18:28.829 --> 00:18:31.349 If I pack my bags and move to Europe or Asia 00:18:31.349 --> 00:18:34.289 or pretty much anywhere else, can I walk into 00:18:34.289 --> 00:18:36.910 a bank and get a 30 -year fixed -rate mortgage? 00:18:37.250 --> 00:18:39.990 In almost every single case, the answer is a 00:18:39.990 --> 00:18:43.609 hard no. There is one country that's a twin to 00:18:43.609 --> 00:18:46.289 the U .S. system, and that's Denmark, believe 00:18:46.289 --> 00:18:48.410 it or not. Denmark? Denmark. They have a very 00:18:48.410 --> 00:18:51.410 old, very sophisticated covered bond market that 00:18:51.410 --> 00:18:53.589 allows them to do it, but pretty much everywhere 00:18:53.589 --> 00:18:55.549 else. It's a completely different world. Okay, 00:18:55.609 --> 00:18:57.920 let's start close to home. Our neighbors to the 00:18:57.920 --> 00:19:01.059 north, Canada, they seem so similar to us. Their 00:19:01.059 --> 00:19:03.259 mortgage market must be the same, right? Not 00:19:03.259 --> 00:19:05.200 even close. If you walk into a Canadian bank 00:19:05.200 --> 00:19:08.519 and ask for a fixed rate, you are speaking a 00:19:08.519 --> 00:19:10.339 fundamentally different language. How is it different? 00:19:10.539 --> 00:19:14.559 In Canada, the amortization period might be 25 00:19:14.559 --> 00:19:17.160 years. So the payment is calculated as if it's 00:19:17.160 --> 00:19:19.259 going to be paid off in 25 years. Okay. Sounds 00:19:19.259 --> 00:19:22.279 similar so far. But the term... The actual period 00:19:22.279 --> 00:19:23.880 of time that your interest rate is locked in 00:19:23.880 --> 00:19:26.299 for is usually only five years. Sometimes you 00:19:26.299 --> 00:19:29.000 can get seven, maybe 10 if you're lucky. Wait, 00:19:29.019 --> 00:19:30.740 wait. So the rate is only fixed for five years? 00:19:30.859 --> 00:19:33.359 Correct. After five years, your loan matures 00:19:33.359 --> 00:19:35.920 and you have to go back to the bank and renew 00:19:35.920 --> 00:19:37.759 it at whatever the current market interest rate 00:19:37.759 --> 00:19:40.480 is. That sounds suspiciously like the old balloon 00:19:40.480 --> 00:19:42.920 payment problem. You're at the mercy of the market 00:19:42.920 --> 00:19:44.900 every five years. It doesn't have the lump sum 00:19:44.900 --> 00:19:47.279 principle problem, but it absolutely has the 00:19:47.279 --> 00:19:49.819 payment shock problem. Right. Just imagine you 00:19:49.819 --> 00:19:52.059 were a Canadian who got a mortgage five years 00:19:52.059 --> 00:19:55.599 ago at, say, a 2 % interest rate. Your five years 00:19:55.599 --> 00:19:58.059 are up today. You go into the bank to renew, 00:19:58.240 --> 00:20:01.880 and the new rate is 6%. My monthly payment would 00:20:01.880 --> 00:20:04.559 just skyrocket overnight. By hundreds, maybe 00:20:04.559 --> 00:20:07.460 thousands of dollars. The Canadian borrower carries 00:20:07.460 --> 00:20:09.539 all of that future interest rate risk themselves. 00:20:10.039 --> 00:20:12.819 The bank protects itself by just resetting the 00:20:12.819 --> 00:20:15.579 rate every few years. I also saw a weird little 00:20:15.579 --> 00:20:17.940 math quirk in the notes about Canada. Something 00:20:17.940 --> 00:20:20.859 to do with compounding. Ah, yes. This is for 00:20:20.859 --> 00:20:23.680 the real nerds out there. In the U .S., our mortgage 00:20:23.680 --> 00:20:26.980 interest is compounded monthly. By law in Canada, 00:20:27.160 --> 00:20:29.819 it has to be compounded semi -annually, so every 00:20:29.819 --> 00:20:31.920 six months. And what's the practical effect of 00:20:31.920 --> 00:20:34.220 that? It results in a slightly lower effective 00:20:34.220 --> 00:20:36.240 interest rate for the borrower, all else being 00:20:36.240 --> 00:20:39.019 equal. But frankly, the risk of your rate tripling 00:20:39.019 --> 00:20:41.640 every five years is a much, much bigger deal. 00:20:41.940 --> 00:20:44.500 No kidding. OK, let's hop across the Atlantic, 00:20:44.680 --> 00:20:48.039 the United Kingdom. What does fixed mean in London? 00:20:48.400 --> 00:20:51.299 It's even more short term. In the UK, if you 00:20:51.299 --> 00:20:53.720 get a fixed -rate mortgage, that typically means 00:20:53.720 --> 00:20:56.279 the rate is locked for two years. Two years! 00:20:56.640 --> 00:20:59.279 That's nothing! That's barely enough time to 00:20:59.279 --> 00:21:01.380 unpack all your boxes. I know. You can sometimes 00:21:01.380 --> 00:21:04.299 pay a hefty premium to get a five -year fix. 00:21:04.750 --> 00:21:07.089 But after that initial teaser period is over, 00:21:07.289 --> 00:21:10.569 your loan automatically converts to a much higher 00:21:10.569 --> 00:21:13.769 variable rate, the bank's standard variable rate. 00:21:13.950 --> 00:21:16.750 So what do people do? It creates a culture of 00:21:16.750 --> 00:21:19.609 constant refinancing. In Britain, homeowners 00:21:19.609 --> 00:21:22.130 are perpetually shopping around for a new deal 00:21:22.130 --> 00:21:24.630 every couple of years to avoid being rolled onto 00:21:24.630 --> 00:21:26.910 that expensive floating rate. It's a constant 00:21:26.910 --> 00:21:29.769 source of stress. But why? Why are British banks 00:21:29.769 --> 00:21:32.849 so stingy with the long -term fixed rates? Is 00:21:32.849 --> 00:21:34.970 it just tradition? No, it's structural. It goes 00:21:34.970 --> 00:21:36.690 right down to the plumbing of their banking system. 00:21:36.750 --> 00:21:38.450 It's all about where the money comes from. It's 00:21:38.450 --> 00:21:40.730 a problem called asset liability mismatch. Okay, 00:21:40.769 --> 00:21:43.269 break that down for me. In the UK, a lot of the 00:21:43.269 --> 00:21:45.269 mortgage lenders are what they call building 00:21:45.269 --> 00:21:47.269 societies, which are kind of like our old savings 00:21:47.269 --> 00:21:50.210 and loans or modern credit unions. Right. They 00:21:50.210 --> 00:21:52.369 get the money that they lend out primarily from 00:21:52.369 --> 00:21:55.049 customer deposits. Just regular people putting 00:21:55.049 --> 00:21:57.349 their cash in savings accounts. So they're lending 00:21:57.349 --> 00:22:00.289 out grandma's savings to me to buy a house. Exactly. 00:22:00.289 --> 00:22:02.869 Now think about grandma's savings account. That's 00:22:02.869 --> 00:22:05.250 a short -term liability for the bank. Grandma 00:22:05.250 --> 00:22:07.789 can demand her money back at any time. Right. 00:22:07.869 --> 00:22:10.529 And grandma expects the interest rate on her 00:22:10.529 --> 00:22:13.150 savings to go up if market rates are rising. 00:22:13.430 --> 00:22:16.930 She won't accept 1 % if other banks are offering 00:22:16.930 --> 00:22:20.500 5%. I think I see the problem. If the bank has 00:22:20.500 --> 00:22:23.059 lent me money for 30 years at a fixed rate of, 00:22:23.079 --> 00:22:26.839 say, 3%, but now they have to pay Grandma 5 % 00:22:26.839 --> 00:22:28.740 on our savings account just to keep her from 00:22:28.740 --> 00:22:31.279 taking her money elsewhere. The bank bleeds to 00:22:31.279 --> 00:22:33.740 death. They become insolvent. You cannot fund 00:22:33.740 --> 00:22:36.859 long -term fixed -rate assets, your mortgage, 00:22:37.099 --> 00:22:39.500 with short -term variable -rate liabilities, 00:22:39.700 --> 00:22:42.839 Grandma's savings account. The math simply breaks. 00:22:43.220 --> 00:22:45.839 So how on earth does the U .S. do it? Where do 00:22:45.839 --> 00:22:48.680 our banks get their money, if not from depositors? 00:22:48.880 --> 00:22:51.980 We have a financial superpower. It's called securitization. 00:22:52.200 --> 00:22:55.720 Okay. In the U .S. system, your local bank generally 00:22:55.720 --> 00:22:57.799 doesn't keep your loan. They're just the originator. 00:22:58.099 --> 00:23:01.099 They sell your 30 -year mortgage almost immediately 00:23:01.099 --> 00:23:04.220 to giant government -sponsored entities like 00:23:04.220 --> 00:23:06.460 Fannie Mae or Freddie Mac. And what do they do 00:23:06.460 --> 00:23:09.240 with it? They bundle it together with thousands 00:23:09.240 --> 00:23:11.900 of other similar mortgages. into a big pool, 00:23:12.119 --> 00:23:15.880 and they issue a bond that is backed by the payments 00:23:15.880 --> 00:23:18.519 from that pool of mortgages. A mortgage -backed 00:23:18.519 --> 00:23:21.420 security. Exactly. And they sell that bond to 00:23:21.420 --> 00:23:24.339 big, long -term investors, pension funds, life 00:23:24.339 --> 00:23:26.400 insurance companies, sovereign wealth funds. 00:23:26.599 --> 00:23:28.880 So investors who specifically want to hold a 00:23:28.880 --> 00:23:32.079 safe asset for 30 years. Precisely. A pension 00:23:32.079 --> 00:23:34.819 fund in California needs to find a safe way to 00:23:34.819 --> 00:23:37.240 generate income to pay its retirees in 20 or 00:23:37.240 --> 00:23:40.180 30 years. They love a 30 -year fixed -rate asset. 00:23:40.880 --> 00:23:42.920 We've created a system that perfectly matches 00:23:42.920 --> 00:23:45.440 the long -term borrower with the long -term investor. 00:23:45.640 --> 00:23:47.960 While the UK and Canada are stuck trying to make 00:23:47.960 --> 00:23:49.859 it work on the bank's balance sheet. So they 00:23:49.859 --> 00:23:51.759 have to keep the terms short to manage their 00:23:51.759 --> 00:23:54.240 risk. It's all about the plumbing. That is absolutely 00:23:54.240 --> 00:23:56.519 fascinating. Okay, one last stop on our global 00:23:56.519 --> 00:24:00.579 tour. Australia. The notes mention the Australian 00:24:00.579 --> 00:24:03.599 mortgage, almost as if it's a specific, unique 00:24:03.599 --> 00:24:06.279 product. It is, and I have to be honest, I'm 00:24:06.279 --> 00:24:08.059 a little bit jealous of it. It's usually called 00:24:08.059 --> 00:24:10.740 an offset account or an all -in -one loan. How 00:24:10.740 --> 00:24:12.819 does that work? Okay, imagine you combine your 00:24:12.819 --> 00:24:14.900 mortgage account and your main checking account 00:24:14.900 --> 00:24:18.000 into one single bucket. Right. You get your paycheck. 00:24:18.579 --> 00:24:21.759 Let's say it's $5 ,000. It gets deposited directly 00:24:21.759 --> 00:24:24.160 into your mortgage account. So my mortgage balance 00:24:24.160 --> 00:24:28.039 immediately drops by $5 ,000. Instantly. And 00:24:28.039 --> 00:24:30.220 because mortgage interest in their system is 00:24:30.220 --> 00:24:32.839 often calculated daily on the outstanding balance, 00:24:33.180 --> 00:24:35.960 you are paying less interest from the very second 00:24:35.960 --> 00:24:37.900 that money hits your account. And then what? 00:24:38.240 --> 00:24:40.339 Then, as you go through your month paying your 00:24:40.339 --> 00:24:42.940 bills, your groceries, your electric bill, your 00:24:42.940 --> 00:24:45.539 car payment, you're just redrawing that money 00:24:45.539 --> 00:24:47.859 back out of the mortgage account. That's incredibly 00:24:47.859 --> 00:24:50.960 clever. It means every single dollar you have 00:24:50.960 --> 00:24:53.539 is working to reduce your interest burden for 00:24:53.539 --> 00:24:55.599 every single hour it's just sitting there waiting 00:24:55.599 --> 00:24:58.059 to be spent. It forces your money to be as efficient 00:24:58.059 --> 00:25:00.799 as possible. And it also provides incredible 00:25:00.799 --> 00:25:03.940 flexibility. How so? In the U .S., if you make 00:25:03.940 --> 00:25:06.380 an extra payment on your mortgage, that money 00:25:06.380 --> 00:25:09.400 is basically gone. You can't get it back without 00:25:09.400 --> 00:25:12.279 a costly refinancing. In Australia, if you've 00:25:12.279 --> 00:25:14.980 overpaid, you can pull that extra money right 00:25:14.980 --> 00:25:16.740 back out if you have an emergency or want to 00:25:16.740 --> 00:25:18.980 buy a car. It basically turns your house into 00:25:18.980 --> 00:25:21.500 a giant line of credit, a piggy bank. A piggy 00:25:21.500 --> 00:25:23.920 bank that saves you 6 % or 7 % interest instead 00:25:23.920 --> 00:25:26.759 of earning you zero in a checking account. It's 00:25:26.759 --> 00:25:29.019 a very powerful, flexible tool. So it's really 00:25:29.019 --> 00:25:31.819 true. The 30 -year fixed rate mortgage is a unicorn. 00:25:32.160 --> 00:25:34.880 It's a product of very specific U .S. government 00:25:34.880 --> 00:25:38.900 policies and this massive, complex bond market 00:25:38.900 --> 00:25:41.359 structure that just doesn't exist in the same 00:25:41.359 --> 00:25:43.220 way elsewhere. We are the anomaly. There's no 00:25:43.220 --> 00:25:45.460 question about it. Okay. We have covered the 00:25:45.460 --> 00:25:47.700 what, the why, and the where. Now we have to 00:25:47.700 --> 00:25:49.339 roll up our sleeves and do the heavy lifting. 00:25:49.500 --> 00:25:52.519 The math. The engine room. I know, I know. When 00:25:52.519 --> 00:25:54.440 you hear the word math, you might want to tune 00:25:54.440 --> 00:25:56.960 out. But please, stay with us on this. Because 00:25:56.960 --> 00:26:00.019 this explains everything. It explains why, when 00:26:00.019 --> 00:26:01.880 you look at your mortgage statement after making 00:26:01.880 --> 00:26:04.839 payments for five years, it feels like the balance 00:26:04.839 --> 00:26:07.500 has barely gone down. It's the most common complaint 00:26:07.500 --> 00:26:09.500 from homeowners. And we promised we'd explain 00:26:09.500 --> 00:26:11.660 how they calculate that very specific number. 00:26:12.279 --> 00:26:18.059 Why is your payment... $1 ,264 and not $1 ,265. 00:26:18.279 --> 00:26:20.380 It all comes from a formula. It's called the 00:26:20.380 --> 00:26:22.460 present value of an ordinary annuity formula. 00:26:22.799 --> 00:26:25.240 But let's not just recite algebra. Let's try 00:26:25.240 --> 00:26:27.779 to visualize it. I want you to imagine a bucket. 00:26:28.119 --> 00:26:30.720 Okay, a bucket. I can do that. This bucket represents 00:26:30.720 --> 00:26:33.000 your principal. It's the total amount of money 00:26:33.000 --> 00:26:36.079 you owe the bank. On day one, month zero of your 00:26:36.079 --> 00:26:38.740 loan, that bucket is filled right to the very 00:26:38.740 --> 00:26:41.640 brim with water. Let's say it's $300 ,000 worth 00:26:41.640 --> 00:26:44.900 of water. Got it. A full bucket, $300 ,000 of 00:26:44.900 --> 00:26:47.160 debt water. Every single month, two things happen 00:26:47.160 --> 00:26:49.339 to the water in this bucket. First, the bank 00:26:49.339 --> 00:26:51.099 comes along with a hose and they pour a little 00:26:51.099 --> 00:26:53.779 more water in. That water is the interest that 00:26:53.779 --> 00:26:56.099 is accrued for the month. And this is the critical 00:26:56.099 --> 00:26:58.579 part, isn't it? How much water do they pour in? 00:26:58.700 --> 00:27:01.680 The amount of water they pour in is directly 00:27:01.680 --> 00:27:04.480 proportional to how much water is currently in 00:27:04.480 --> 00:27:06.619 the bucket. It's a percentage of the current 00:27:06.619 --> 00:27:09.839 balance. So at the very beginning, when the bucket 00:27:09.839 --> 00:27:13.000 is completely full, the bank is pouring in a 00:27:13.000 --> 00:27:15.579 massive amount of water every month. So the water 00:27:15.579 --> 00:27:18.180 level is actively trying to rise. My debt is 00:27:18.180 --> 00:27:21.240 trying to grow. It is. But then, right after 00:27:21.240 --> 00:27:23.640 they pour their water in, you come along with 00:27:23.640 --> 00:27:25.920 a ladle. That ladle is your fixed monthly payment. 00:27:26.579 --> 00:27:28.930 And you scoop out a fixed amount of water. And 00:27:28.930 --> 00:27:31.170 because it's a fixed rate mortgage, my ladle 00:27:31.170 --> 00:27:34.690 is the exact same size every single month for 00:27:34.690 --> 00:27:37.849 30 years. Your ladle never, ever changes size. 00:27:38.130 --> 00:27:40.829 Now, here's the problem and the source of all 00:27:40.829 --> 00:27:43.309 that frustration. Okay. At the beginning of the 00:27:43.309 --> 00:27:46.470 loan, in those first few years, the bank is pouring 00:27:46.470 --> 00:27:49.069 in a lot of water. So when you come along with 00:27:49.069 --> 00:27:51.670 your big ladle and scoop out, say, $1 ,500 of 00:27:51.670 --> 00:27:54.170 water, almost all of your scoop is just removing 00:27:54.170 --> 00:27:56.150 the new interest water the bank just put in. 00:27:56.170 --> 00:27:57.789 I'm basically just cleaning up the fresh mess 00:27:57.789 --> 00:27:59.589 they just made. You're cleaning up their mess. 00:27:59.809 --> 00:28:03.369 You scoop out your $1 ,500 payment. But $1 ,400 00:28:03.369 --> 00:28:06.230 of it was just new interest. Only a tiny little 00:28:06.230 --> 00:28:08.950 bit, maybe $100 of your scoop, actually goes 00:28:08.950 --> 00:28:11.430 toward lowering the original water level in the 00:28:11.430 --> 00:28:13.369 bucket. That's why the balance barely moves. 00:28:13.509 --> 00:28:16.710 It's so depressing. It is. But, and this is the 00:28:16.710 --> 00:28:18.690 mathematical magic of the geometric progression, 00:28:18.950 --> 00:28:21.509 because you scooped out that tiny $100 of principal, 00:28:21.789 --> 00:28:24.650 the water level is now slightly lower for next 00:28:24.650 --> 00:28:27.059 month. Which means next month, the bank's hose 00:28:27.059 --> 00:28:30.299 pours in slightly less water. Yes. Maybe next 00:28:30.299 --> 00:28:33.579 month they only pour in $1 ,399 of interest, 00:28:33.779 --> 00:28:36.759 which means your ladle, which is still the same 00:28:36.759 --> 00:28:40.799 $1 ,500 size, is now able to remove 101 waters 00:28:40.799 --> 00:28:43.220 of principal. It's an accelerating process. It 00:28:43.220 --> 00:28:45.960 compounds in your favor very, very slowly at 00:28:45.960 --> 00:28:48.319 first and then faster and faster. By the time 00:28:48.319 --> 00:28:50.890 you get to year 20 or 25 of the loan. the water 00:28:50.890 --> 00:28:52.970 level in the bucket is much lower. So the bank 00:28:52.970 --> 00:28:54.809 is only pouring in a tiny trickle of interest 00:28:54.809 --> 00:28:57.309 each month. Exactly. And now your big $1 ,500 00:28:57.309 --> 00:28:59.670 ladle is almost entirely removing principal. 00:28:59.869 --> 00:29:02.329 You start emptying that bucket in huge, satisfying 00:29:02.329 --> 00:29:04.670 chunks toward the end. So that crazy -looking 00:29:04.670 --> 00:29:07.910 formula with all the exponents, its only job 00:29:07.910 --> 00:29:10.450 is to calculate the exact size your ladle needs 00:29:10.450 --> 00:29:12.609 to be so that the bucket runs completely dry 00:29:12.609 --> 00:29:15.230 on the very last scoop of the 30th year. That 00:29:15.230 --> 00:29:18.410 is its only job. It solves for zero. If your 00:29:18.410 --> 00:29:21.220 ladle were one penny too small, the water level 00:29:21.220 --> 00:29:24.259 would slowly rise forever. That's negative amortization. 00:29:24.559 --> 00:29:26.859 If it were too big, you'd pay the loan off early. 00:29:27.119 --> 00:29:37.660 The formula finds the perfect balance. smaller 00:29:37.660 --> 00:29:40.119 ladle, even just a teaspoon, and scoop out a 00:29:40.119 --> 00:29:42.160 little extra water, I'm lowering the principle 00:29:42.160 --> 00:29:44.640 level permanently. Which reduces the amount of 00:29:44.640 --> 00:29:46.880 water the bank can pour in next month, and every 00:29:46.880 --> 00:29:49.160 single month after that, making your main ladle 00:29:49.160 --> 00:29:51.640 more and more effective forever. You disrupt 00:29:51.640 --> 00:29:53.619 the geometric progression in your favor. You 00:29:53.619 --> 00:29:55.960 absolutely do. Okay, speaking of the math, there 00:29:55.960 --> 00:29:57.920 was a little puzzle in the source material that 00:29:57.920 --> 00:30:00.599 I found fascinating. The equivalence puzzle. 00:30:00.859 --> 00:30:02.700 Oh, this is a great one. A real brain teaser. 00:30:03.039 --> 00:30:06.589 Let's pose it to you, the listener. Imagine you 00:30:06.589 --> 00:30:08.869 are offered two very different loans on the same 00:30:08.869 --> 00:30:12.430 house. Okay. Loan A is a 30 -year mortgage with 00:30:12.430 --> 00:30:15.869 a super low interest rate, let's say 2 .5%. A 00:30:15.869 --> 00:30:19.029 great rate. Loan B is only a 15 -year mortgage, 00:30:19.250 --> 00:30:21.910 but the rate is much higher. It's 5%, double 00:30:21.910 --> 00:30:25.049 the rate. So on the surface, Loan B looks twice 00:30:25.049 --> 00:30:27.410 as expensive from a rate perspective. Exactly. 00:30:27.549 --> 00:30:30.710 But here is the mind -bending part. If you actually 00:30:30.710 --> 00:30:33.250 run the numbers, the total amount of money you 00:30:33.250 --> 00:30:35.740 pay to the bank over the life of the loan The 00:30:35.740 --> 00:30:37.799 principal plus every single dollar of interest 00:30:37.799 --> 00:30:41.039 can be almost identical in both scenarios. It 00:30:41.039 --> 00:30:42.799 feels completely wrong, doesn't it? It feels 00:30:42.799 --> 00:30:45.660 impossible. How can a 5 % loan end up costing 00:30:45.660 --> 00:30:48.319 the same as a 2 .5 % loan? It all comes back 00:30:48.319 --> 00:30:51.359 to that other crucial variable, time. Time is 00:30:51.359 --> 00:30:54.279 a multiplier for cost. Explain that. In the 30 00:30:54.279 --> 00:30:56.740 -year loan, yes, you're paying a very low interest 00:30:56.740 --> 00:30:59.799 rate, but you're paying it on a large, slowly 00:30:59.799 --> 00:31:03.490 declining balance for 360 months. The interest 00:31:03.490 --> 00:31:05.910 has three full decades to pile up and accumulate. 00:31:06.170 --> 00:31:08.609 And in the 15 -year loan? You're paying a much 00:31:08.609 --> 00:31:11.029 higher rate, but you're killing off the principal 00:31:11.029 --> 00:31:14.890 so aggressively, your ladle is so big, that the 00:31:14.890 --> 00:31:16.769 interest never gets a chance to really compound 00:31:16.769 --> 00:31:19.309 against you. You starve at a time. That really 00:31:19.309 --> 00:31:21.410 drives home the point that the interest rate 00:31:21.410 --> 00:31:23.349 isn't the only thing you should look at. The 00:31:23.349 --> 00:31:26.210 term of the loan is just as important, if not 00:31:26.210 --> 00:31:28.589 more so. There are two levers that control the 00:31:28.589 --> 00:31:31.490 same outcome. which is total cost you can lower 00:31:31.490 --> 00:31:34.309 your total cost by finding a lower rate or by 00:31:34.309 --> 00:31:36.710 shortening the time you take to pay it back and 00:31:36.710 --> 00:31:38.950 this brings us right back around to the psychological 00:31:38.950 --> 00:31:42.789 benefit of the fixed loan budgeting yes the fixed 00:31:42.789 --> 00:31:45.470 rate mortgage is more than anything else a budgeting 00:31:45.470 --> 00:31:47.970 tool it allows you to plan your entire financial 00:31:47.970 --> 00:31:50.430 life You know that, come hell or high water, 00:31:50.609 --> 00:31:55.390 that $1 ,264 .14 is leaving your account on the 00:31:55.390 --> 00:31:57.490 first of the month. You can build everything 00:31:57.490 --> 00:32:00.390 else around that one solid pillar of certainty. 00:32:00.710 --> 00:32:02.529 Compare that to some of the horror stories we 00:32:02.529 --> 00:32:04.450 saw with those other loan types leading up to 00:32:04.450 --> 00:32:07.170 the 2008 crisis. The negative amortization loans. 00:32:07.490 --> 00:32:10.089 Right, the pick -a -pay loans, where the bank 00:32:10.089 --> 00:32:12.470 literally allowed you to use a ladle that was 00:32:12.470 --> 00:32:15.349 too small for the bucket. You were paying less 00:32:15.349 --> 00:32:17.250 than the interest that was accruing each month. 00:32:17.329 --> 00:32:19.569 So the bucket was overflowing. The debt was actually 00:32:19.569 --> 00:32:21.849 growing every single month, even though you were 00:32:21.849 --> 00:32:24.250 making payments. Can you imagine? Yeah. You make 00:32:24.250 --> 00:32:27.210 payments for five years and you owe more than 00:32:27.210 --> 00:32:30.049 you originally borrowed. It was a toxic product 00:32:30.049 --> 00:32:33.650 by design. The 30 -year fix makes that an impossibility. 00:32:33.890 --> 00:32:36.630 So we've covered a lot of ground here. We certainly 00:32:36.630 --> 00:32:39.099 have. We've established that the fixed rate mortgage 00:32:39.099 --> 00:32:42.519 is this very specific U .S. centric innovation 00:32:42.519 --> 00:32:45.240 that was born out of the ashes of the Great Depression 00:32:45.240 --> 00:32:48.279 specifically to create housing stability. It 00:32:48.279 --> 00:32:50.420 was a deliberate policy choice, a government 00:32:50.420 --> 00:32:53.000 designed safety net made out of financial paper. 00:32:53.160 --> 00:32:55.740 And its core function is to transfer the risk 00:32:55.740 --> 00:32:57.980 of an uncertain future from your kitchen table 00:32:57.980 --> 00:33:01.140 to the bank or more accurately to the global 00:33:01.140 --> 00:33:04.000 investors backing the bank. For a price. And 00:33:04.000 --> 00:33:06.039 that price is that little bit of extra interest 00:33:06.039 --> 00:33:09.250 you pay. that insurance premium. And we've seen 00:33:09.250 --> 00:33:11.890 how the rest of the world, the UK, Canada, Australia, 00:33:12.170 --> 00:33:14.829 handles this risk in a completely different way, 00:33:15.049 --> 00:33:18.690 usually by keeping the fixed period very short 00:33:18.690 --> 00:33:20.970 to protect their banks. Which puts all that volatility 00:33:20.970 --> 00:33:22.849 right back onto the homeowner. I want to leave 00:33:22.849 --> 00:33:25.569 our listeners with one final and I think slightly 00:33:25.569 --> 00:33:29.089 provocative thought. We've talked about how the 00:33:29.089 --> 00:33:33.420 bank takes on all this risk for us. But do they 00:33:33.420 --> 00:33:35.819 really keep that risk on their own books? Now 00:33:35.819 --> 00:33:37.740 that is the billion dollar question, isn't it? 00:33:37.759 --> 00:33:40.339 The source material mentioned terms like derivatives 00:33:40.339 --> 00:33:43.619 and the black skulls model. That's some pretty 00:33:43.619 --> 00:33:45.960 heavy Wall Street jargon. It is. But here's the 00:33:45.960 --> 00:33:48.700 simple reality. When you sign that mortgage, 00:33:48.940 --> 00:33:50.920 the bank doesn't just put your loan documents 00:33:50.920 --> 00:33:53.359 in a dusty vault and wait for your checks to 00:33:53.359 --> 00:33:56.480 come in for 30 years. They don't? No. Your mortgage 00:33:56.480 --> 00:33:59.059 is instantly transformed into a data point in 00:33:59.059 --> 00:34:01.480 a global system. They might sell the whole loan 00:34:01.480 --> 00:34:04.140 off, as we discussed, or they might keep the 00:34:04.140 --> 00:34:06.160 loan but then immediately buy a separate financial 00:34:06.160 --> 00:34:08.199 instrument, a derivative, that's essentially 00:34:08.199 --> 00:34:10.579 a side bet. A side bet that pays them off if 00:34:10.579 --> 00:34:12.519 interest rates rise, so they're hedging their 00:34:12.519 --> 00:34:15.590 hedge. It's even more complex than that. Your 00:34:15.590 --> 00:34:17.769 individual mortgage is bundled with thousands 00:34:17.769 --> 00:34:19.929 of others. Then it's sliced up into different 00:34:19.929 --> 00:34:22.550 tranches based on risk level. And those slices 00:34:22.550 --> 00:34:25.170 are turned into a mortgage backed security that 00:34:25.170 --> 00:34:27.230 is bought and sold on markets all over the world. 00:34:27.429 --> 00:34:30.690 So a pension fund in Norway could own the rights 00:34:30.690 --> 00:34:33.150 to the. principal portion of my monthly payment. 00:34:33.389 --> 00:34:36.630 And a hedge fund in New York could be trading 00:34:36.630 --> 00:34:39.449 options based on the statistical probability 00:34:39.449 --> 00:34:41.670 that I'm going to refinance my loan next year 00:34:41.670 --> 00:34:44.550 if rates drop. That is exactly what is happening. 00:34:44.570 --> 00:34:46.809 You pay a premium for stability and simplicity 00:34:46.809 --> 00:34:50.090 at your kitchen table. But in order to manufacture 00:34:50.090 --> 00:34:52.730 that stability for you, the financial system 00:34:52.730 --> 00:34:55.250 has to create a mind -boggling amount of complexity 00:34:55.250 --> 00:34:58.530 on the back end, slicing, dicing, and trading 00:34:58.530 --> 00:35:00.849 your personal risk across the entire planet. 00:35:01.079 --> 00:35:04.260 So my household budget is actually a tiny cog 00:35:04.260 --> 00:35:07.159 in a massive global hedge fund equation. It is 00:35:07.159 --> 00:35:09.719 the very nature of modern finance. Stability 00:35:09.719 --> 00:35:12.280 for the end user requires immense complexity 00:35:12.280 --> 00:35:14.519 for the system that provides it. Well, on that 00:35:14.519 --> 00:35:16.940 slightly terrifying and awe -inspiring note, 00:35:17.039 --> 00:35:18.719 I think we'll close the book on the fixed rate 00:35:18.719 --> 00:35:21.079 mortgage for today. It's been a fascinating discussion. 00:35:21.340 --> 00:35:23.260 Thank you for taking this deep dive with us. 00:35:23.320 --> 00:35:25.880 Hopefully the next time you look at that monthly 00:35:25.880 --> 00:35:28.380 mortgage statement, you won't just see a bill. 00:35:29.000 --> 00:35:31.159 You'll see a history of the Great Depression, 00:35:31.519 --> 00:35:34.699 a bucket and a ladle, and your own little piece 00:35:34.699 --> 00:35:37.860 of a global financial engineering marvel. Indeed, 00:35:38.079 --> 00:35:40.420 a death pledge that gives you life. Keep asking 00:35:40.420 --> 00:35:42.079 questions. We'll see you next time.