Welcome back to the deep dive. Glad to be back.
So I want to start today with a picture. It's
an image that's been. Sort of burned into our
collective consciousness for, what, 70, 80 years
now? I think I know where you're going with this.
The American dream. The white picket fence. It's
always the white picket fence. It's always the
fence. The perfectly manicured lawn. Maybe there's
a dog, you know, chasing a ball. And behind it,
that two -story house with a garage. When we
think about homeownership, that's where our minds
go. To the physical thing. Exactly. We focus
on the asset. We obsess over. You know, the countertops,
the square footage, the neighborhood, the curb
appeal. We're looking at the house. Which makes
sense. That's the tangible thing. That's where
you're going to live. Of course. But today, I
want to do a pivot. We are going to look right
past all of that. Past the bricks, the mortar,
the shingles on the roof. Okay. We're going to
look at the invisible engine sitting right underneath
that house. Ah, the machinery. The machinery.
We're going to talk about a specific, highly
engineered financial tool that sounds, and I
mean this. incredibly boring. It might be the
most boring sounding phrase in finance. It really
might be. But it's actually the invention that
made the modern middle class possible. We are
talking about the fixed rate mortgage. The FRM.
It really is the engine room of the whole U .S.
economy in a lot of ways. Right. And you're right.
It sounds so dry, fixed rate mortgage. It just
sounds like stacks of paperwork. But when you
actually start to peel back the layers, it is
an incredibly complex and frankly. A really weird
anomaly in the global system. And that's our
mission for this deep dive. We're going to unpack
exactly how this machine works. We're going to
look at the sort of counterintuitive financial
science that suggests you probably shouldn't
even have one, even though most of us do. The
academic view. We're also going to jump in a
time machine, go back to the 1930s and see why
it was invented in the first place. And spoiler
alert, it was basically to stop society from
collapsing. A slight exaggeration, but not by
much. And then we're going to take a tour around
the world to see why pretty much every other
country thinks the American system is completely
bonkers. And we can't forget the math. We have
to talk about the math. Oh, we have to. We're
going to break down the actual formula that spits
out your exact monthly payment down to the penny.
It's surprisingly elegant, that formula. It really
is. So let's just dive right in. Let's define
the beast. You're in an elevator. What's the,
you know, the quick pitch for a fixed rate mortgage?
Fundamental level, a fixed rate mortgage, or
FRM, is a loan where the interest rate on the
note remains exactly the same for the entire
life of that loan. It sounds so simple when you
say it like that. It sounds simple, but the implications
of that one rule are just massive. How so? Because
that rate is locked. It means two other really
important things also become completely rigid.
Okay. First, your monthly payment amount is fixed.
Your first payment and your 360th payment, if
it's a 30 -year loan, are identical. Down to
the cent. Down to the cent. And second, the duration
is fixed. You know the exact month and year 30
years from now. when that final payment is made,
and you are free. I was trying to think of an
analogy for this, and the best I came up with
was, it's like a subscription service. A subscription
to a house. I like that. It's like a very, very
expensive Netflix subscription, but with two
huge differences. One, it definitely cancels
itself after a set number of years. And two,
and this is the really crucial part, the price
never, ever goes up. That's the price lock. Yeah.
And that is a perfect way to put it. No matter
what's happening in the world, you know, wars,
pandemics, economic booms, busts, whatever, your
price is your price. It's set in stone. And that
stability feels amazing for us, the borrowers.
But my assumption is always, you know, when I
deal with a bank, the bank is the one who's winning.
You usually have the edge, yeah. They've got
the marble floors. I've got the debt. But the
research suggests that with a fixed rate structure,
there's actually a scenario where the borrower
can come out way ahead of the bank. Absolutely.
The fixed rate mortgage is, at its heart, a bet.
And it's one of the few financial products where
the little guy has this huge structural advantage
if, and it's a big if, certain economic conditions
play out. OK, so that brings us to this idea
of the inflation hedge. Exactly. Let's unpack
that, because usually we hear the word inflation
and we get nervous. We think of groceries getting
more expensive, gas prices going through the
roof. Right. It feels like a tax on everything.
So how does that possibly help me when I'm carrying
hundreds of thousands of dollars of mortgage
debt? Well, you have to separate your day to
day expenses from the nature of your debt. When
you sign that mortgage, you are locking in. A
nominal payment. Nominal meaning just the dollar
amount? The number on the paper. Let's use a
round number. Say you buy a house today. Your
payment is $2 ,000 a month. Okay. A big chunk
of change. Right. And right now, today, that
$2 ,000 represents a certain amount of your purchasing
power. Maybe it's, I don't know, 30 or 40 % of
your monthly income. It hurts to write that check.
Definitely hurts. Okay. Now let's imagine a scenario
where inflation runs really hot. for, say, a
decade, the price of everything doubles. So a
loaf of bread is eight bucks, gallon of gas is
seven. Right. But, and this is key, in an inflationary
world, wages generally rise to eventually match
those prices. So let's just assume your salary
has also doubled over those 10 years. So I'm
making twice as much money, but everything costs
twice as much. So at the grocery store, I don't
feel any richer. Exactly. You feel like you're
just treading water when you're buying eggs.
But now look at your mortgage payment. Oh, it's
still $2 ,000. It's still $2 ,000. So if my income
doubled, that $2 ,000 check is now only half
as painful to write as it used to be. Precisely.
In real terms, which means adjusted for that
inflation, your debt has effectively been cut
in half. Wow. You are paying the bank back with
dollars that are worth significantly less than
the dollars that they lent you. They give you
valuable twenty twenty four dollars and you're
paying them back with cheap twenty thirty four
dollars. So from a purely financial standpoint,
if I have a fixed rate mortgage, I should be
quietly rooting for a little bit of inflation.
From a pure debt management perspective. Yes.
Yes. Inflation is the borrower's absolute best
friend. It erodes the real value of what you
owe. But there has to be a catch here. I mean,
the bank isn't dumb. They have entire floors
of economists. They have to know this is a possibility.
Oh, of course they do. And that's why there's
a flip side to this bet. The bank is shouldering
a massive risk. The interest rate risk. That's
the one. Think about it. If inflation goes up,
the central bank usually raises interest rates
to fight it. So imagine a world in 10 years where
the going rate for a new mortgage is, say, 10
% or 15%. Like in the early 1980s, that really
happened. It really did. So if the market rate
is 15%, the bank could be lending out its money
and making an absolute killing. But they can't.
They can't because a chunk of their capital is
tied up with you and they are stuck taking your
measly three or four percent. They are losing
money every single month on your loan compared
to what they could be doing with that capital.
So the bank is essentially taking the gamble
on the future of the economy for me. They're
shielding me from that volatility. They are.
But, and this is the part I think most borrowers
don't fully grasp, banks are not charities. They
do not take on that kind of risk. for free, you
are paying for that safety. It's like an insurance
premium. That's exactly what it is. If you go
and look at mortgage rates on any given day,
you almost always see a pattern. Okay. A 30 -year
fixed mortgage will have a noticeably higher
interest rate than, say, a five -year adjustable
rate mortgage, an ARM. And that gap, that difference
in the rate? That's the price of the insurance.
That is the premium. You're paying, let's say,
an extra 1 % or 1 .5 % in interest every single
year for the privilege of knowing that your rate
will never, ever change. Yeah. You're buying
insurance against a future economic disaster
that might never actually happen. Okay. This
leads me directly to one of the most, I have
to say, surprising things I read in the source
material. Oh, yeah. It was a paper that basically,
and I'm simplifying, said that most of us are
suckers for taking the fixed rate. It suggested
that from a pure numbers perspective, borrowers
should generally prefer adjustable rate mortgages.
Ah, yes. The classic battle between economic
theory and human psychology. It felt like a personal
attack. I love my fixed rate. I sleep well at
night knowing my payment isn't going to change.
Why would a smart person choose a loan where
the payment could suddenly double? That sounds
like financial suicide. Well, the economists
aren't looking at your sleep quality. They're
looking at the long -term data. They're looking
at something called the yield curve. Okay, you've
got to define that, the yield curve. The easiest
way to think of the yield curve is as the price
of time. The price of time. Yeah. Generally speaking,
if you want to borrow money for a very short
period of time, say one year, it's cheap. The
lender isn't taking on much risk. Not much can
go wrong in a year. Right. But if you want to
borrow that same money for 30 years, that's going
to be much more expensive. Because anything could
happen in 30 years. Exactly. 30 years is an eternity
in finance. You could have wars, recessions,
technological revolutions, pandemics. The future
is a dark room. And the further a lender has
to walk into that dark room, the more they demand
to be compensated for the risk. So the curve
of the graph showing the interest rate versus
time slopes upward. It almost always slopes upward.
So because the 30 -year fixed loan is the longest,
safest, most ironclad lock -in you can possibly
get, it is, by its very nature, the most expensive
product on the shelf on day one. It's the luxury,
fully loaded model, the tank. It is the tank.
Now, the argument from The Economist is this.
Because you are paying such a high premium for
that tank, you usually end up paying more in
total interest over the life of the loan than
if you had just taken the risky adjustable rate.
So even if the adjustable rate does go up sometimes,
it usually averages out to be lower than the
fixed rate over the long haul. Statistically,
for most households in most historical periods,
the ARM is the mathematically superior choice.
You save a ton of money on that lower rate in
the beginning. And even if rates do rise later,
they rarely stay high enough for long enough
to completely erase all those early savings.
So we are essentially paying a huge amount of
money just for peace of mind. We are paying to
avoid what they call tail risk, the worst case
scenario. The economists would say we are massively
overinsuring ourselves against a low probability
event. But there's a human element here they're
missing, isn't there? I think so. And this is
where I tend to part ways with the pure math.
Go on. The math assumes that you can handle the
volatility. It assumes that if your payment suddenly
jumps from $2 ,000 to $3 ,000 a month for a couple
of years, you can just absorb that shock. Because
you were supposed to be saving all that money
you weren't paying in the first few years. Right.
But in the real world, what do people do with
that extra money? They spend it. Life happens.
You don't just bank the difference in a special
account. And if you can't make that higher payment
when it comes due, you don't just lose some economic
efficiency. You lose your house. The cost of
failure is catastrophic and absolute. So, while
the ARM might be cheaper on average, The fixed
rate prevents ruin. It prevents the worst case
scenario. And speaking of worst case scenarios,
this is a perfect transition into the history
of this thing. Because we didn't always have
this safety net, did we? Not at all. And this
is what I think people completely forget. Yeah.
The 30 -year fixed mortgage is not some law of
nature. It's an invention. Right. And it was
invented because the system that came before
it failed so spectacularly that it almost took
the entire country down with it. So take us back.
Let's go to the before times. It's, say, in 1925.
I've saved up a down payment. I want to buy a
little bungalow. What kind of loan am I getting?
You are getting something called a balloon payment
mortgage. And if you think the mortgage process
today is stressful, this was a waking nightmare.
Okay. How'd it work? So you'd borrow the money.
but for a very short term, maybe three years,
five years at the absolute most. That's a really
short time. It is. And during those five years,
you would make monthly payments. But here's the
kicker. Usually, those payments were interest
only. Wait, so I'm not actually paying off the
house at all? I'm just renting the money from
the bank? That's a great way to put it. You're
just trading water. You're covering the bank's
cost of lending you the money. Okay. Then, at
the end of the five -year term, the balloon comes
due. And that means you owe the entire original
principal amount in one single massive lump sum
payment. So I borrow, I don't know, $5 ,000,
which was a fortune back then. I pay interest
on it for five years. And then on Tuesday, the
bank manager knocks on my door and says, OK,
give us the $5 ,000 back. Yes. But who has that
kind of cash just sitting around? Yeah. If I
had $5 ,000 in cash, I wouldn't have needed the
loan in the first place. Exactly. Nobody had
the cash. The entire system was built on one
crucial assumption. Refinancing. The idea was
you'd get to the end of your five years, the
bank would see you've been a good borrower, making
your interest payments on time, and they would
just roll the loan over into a new five -year
balloon mortgage. It's basically a confidence
game. It only works as long as the economy is
good and the bank is feeling generous. Right.
It works until the music stops. And in October
1929, the music didn't just stop. The entire
orchestra pit caught on fire. The Great Depression.
The Great Depression hits. So what happens to
all those homeowners with their balloon payments
coming due? It was an absolute catastrophe. First,
property values crashed. So suddenly the houses
were worth less than the loans on them. You're
underwater. Deeply underwater. And at the same
time, thousands of banks were going bankrupt.
So they literally didn't have any money to lend
out for a refinance, even if they wanted to.
So the balloon payment comes due. And the homeowner
says, I can't possibly pay this. And the bank
says, we can't refinance you. And the only possible
outcome is immediate foreclosure. And because
this was happening to millions of people all
at once, it just drove housing prices down even
further. It was a death spiral. It wasn't just
a housing crisis. It was a systemic collapse
of the very idea of private home ownership. Yeah.
By 1933, it's estimated that roughly half of
all home mortgages in the entire United States
were in default. Half. Half. Yeah. Just try to
imagine that today. Every other house on your
street with a for sale by sheriff sign out front.
It's unthinkable. So this is when the government
has to step in. The New Deal era. Exactly. You
get the creation of the Federal Housing Administration,
the FHA, and a bit later, Fannie Mae. And what
did they do? They looked at all this wreckage
and they identified that this refinancing risk
was the poison pill. The dependency on having
to get a new loan every few years was the fatal
flaw. They needed a new kind of loan, a loan
that killed itself off automatically. And this
brings us to that fantastic word, amortization.
Yes. It's from the Latin, et mortere, which means
to bring to death. The root is mort. Like mortal
death. So a mortgage is literally a death pledge.
It's a death pledge. But, you know, in a good
way. The innovation here was full amortization.
So what does that mean in practice? It means
they designed the math so that every single monthly
payment you make is composed of two parts. Yeah.
Some of it is interest and a little piece of
it is principal. So you're always paying down
the original debt, even if it's just by a tiny
amount at first. Slowly but surely. And at the
end of the term, whether it's 15 years or 30
years, the balance is guaranteed to be zero.
No balloon. No giant surprise bill at the end.
No more dependency on the bank's mood or the
state of the economy. Once you sign those papers,
you are, in a way, independent of the financial
markets. You just have to make your payment.
It brought stability to the entire housing sector.
It's actually amazing when you think about it.
This thing we see as just a boring financial
product was really a radical piece of social
engineering, a government -backed safety net.
It absolutely was. It was a policy tool designed
to create a nation of stable homeowners who couldn't
be kicked out of their houses just because Wall
Street had a bad year. And we're seeing that
tool evolve now. We're so used to the 15 and
30 year terms. But I saw in the notes that now
we're starting to see 40 year and even 50 year
mortgages pop up in really high cost areas. We
are. Yeah. And that's usually a sign of stress
in the system. A 50 year mortgage. I mean, just
do the math on that. If you buy a house at age
30, you pay it off when you're 80. Your mortgage
might outlive you. That's a lifetime commitment
and then some. Why is this happening? It's a
direct response to the affordability crisis.
Yeah. When home prices get so astronomical that
an average family can't afford the monthly payment
on a standard 30 -year loan. Right. The only
lever the bank has left to pull to make the numbers
work is to stretch the time, to spread the pain
out over a longer period. So it lowers the monthly
payment, which is what people focus on. It does,
but it... Absolutely. Explodes the total cost
of the loan. You end up paying just a staggering
amount of interest over those 50 years. It's
that expensive boots theory of economics. Say
more about that. You know, because you're poor,
you can only afford the cheap $10 boots that
fall apart after one winter. So over your lifetime,
you buy 10 pairs and spend $100. The rich person
buys the one good $50 pair that lasts forever.
I see, because you can't afford the higher monthly
payment of the 30 -year loan. You're forced into
the 50 -year loan, and you end up paying triple
the interest in the long run. It's a poverty
trap. It can be, yes. And it just highlights
how critically important that term, the length
of the loan. Really is. Okay, so we firmly establish
that the 30 -year fixed is the American standard.
We invented it. We love it. It saved us from
the Depression. The bedrock of the system. But
here's the part of the research that really floored
me. The rest of the world thinks we are absolutely
crazy for doing it this way. We are the weird
ones. The outlier. Let's do a little global tour.
If I pack my bags and move to Europe or Asia
or pretty much anywhere else, can I walk into
a bank and get a 30 -year fixed -rate mortgage?
In almost every single case, the answer is a
hard no. There is one country that's a twin to
the U .S. system, and that's Denmark, believe
it or not. Denmark? Denmark. They have a very
old, very sophisticated covered bond market that
allows them to do it, but pretty much everywhere
else. It's a completely different world. Okay,
let's start close to home. Our neighbors to the
north, Canada, they seem so similar to us. Their
mortgage market must be the same, right? Not
even close. If you walk into a Canadian bank
and ask for a fixed rate, you are speaking a
fundamentally different language. How is it different?
In Canada, the amortization period might be 25
years. So the payment is calculated as if it's
going to be paid off in 25 years. Okay. Sounds
similar so far. But the term... The actual period
of time that your interest rate is locked in
for is usually only five years. Sometimes you
can get seven, maybe 10 if you're lucky. Wait,
wait. So the rate is only fixed for five years?
Correct. After five years, your loan matures
and you have to go back to the bank and renew
it at whatever the current market interest rate
is. That sounds suspiciously like the old balloon
payment problem. You're at the mercy of the market
every five years. It doesn't have the lump sum
principle problem, but it absolutely has the
payment shock problem. Right. Just imagine you
were a Canadian who got a mortgage five years
ago at, say, a 2 % interest rate. Your five years
are up today. You go into the bank to renew,
and the new rate is 6%. My monthly payment would
just skyrocket overnight. By hundreds, maybe
thousands of dollars. The Canadian borrower carries
all of that future interest rate risk themselves.
The bank protects itself by just resetting the
rate every few years. I also saw a weird little
math quirk in the notes about Canada. Something
to do with compounding. Ah, yes. This is for
the real nerds out there. In the U .S., our mortgage
interest is compounded monthly. By law in Canada,
it has to be compounded semi -annually, so every
six months. And what's the practical effect of
that? It results in a slightly lower effective
interest rate for the borrower, all else being
equal. But frankly, the risk of your rate tripling
every five years is a much, much bigger deal.
No kidding. OK, let's hop across the Atlantic,
the United Kingdom. What does fixed mean in London?
It's even more short term. In the UK, if you
get a fixed -rate mortgage, that typically means
the rate is locked for two years. Two years!
That's nothing! That's barely enough time to
unpack all your boxes. I know. You can sometimes
pay a hefty premium to get a five -year fix.
But after that initial teaser period is over,
your loan automatically converts to a much higher
variable rate, the bank's standard variable rate.
So what do people do? It creates a culture of
constant refinancing. In Britain, homeowners
are perpetually shopping around for a new deal
every couple of years to avoid being rolled onto
that expensive floating rate. It's a constant
source of stress. But why? Why are British banks
so stingy with the long -term fixed rates? Is
it just tradition? No, it's structural. It goes
right down to the plumbing of their banking system.
It's all about where the money comes from. It's
a problem called asset liability mismatch. Okay,
break that down for me. In the UK, a lot of the
mortgage lenders are what they call building
societies, which are kind of like our old savings
and loans or modern credit unions. Right. They
get the money that they lend out primarily from
customer deposits. Just regular people putting
their cash in savings accounts. So they're lending
out grandma's savings to me to buy a house. Exactly.
Now think about grandma's savings account. That's
a short -term liability for the bank. Grandma
can demand her money back at any time. Right.
And grandma expects the interest rate on her
savings to go up if market rates are rising.
She won't accept 1 % if other banks are offering
5%. I think I see the problem. If the bank has
lent me money for 30 years at a fixed rate of,
say, 3%, but now they have to pay Grandma 5 %
on our savings account just to keep her from
taking her money elsewhere. The bank bleeds to
death. They become insolvent. You cannot fund
long -term fixed -rate assets, your mortgage,
with short -term variable -rate liabilities,
Grandma's savings account. The math simply breaks.
So how on earth does the U .S. do it? Where do
our banks get their money, if not from depositors?
We have a financial superpower. It's called securitization.
Okay. In the U .S. system, your local bank generally
doesn't keep your loan. They're just the originator.
They sell your 30 -year mortgage almost immediately
to giant government -sponsored entities like
Fannie Mae or Freddie Mac. And what do they do
with it? They bundle it together with thousands
of other similar mortgages. into a big pool,
and they issue a bond that is backed by the payments
from that pool of mortgages. A mortgage -backed
security. Exactly. And they sell that bond to
big, long -term investors, pension funds, life
insurance companies, sovereign wealth funds.
So investors who specifically want to hold a
safe asset for 30 years. Precisely. A pension
fund in California needs to find a safe way to
generate income to pay its retirees in 20 or
30 years. They love a 30 -year fixed -rate asset.
We've created a system that perfectly matches
the long -term borrower with the long -term investor.
While the UK and Canada are stuck trying to make
it work on the bank's balance sheet. So they
have to keep the terms short to manage their
risk. It's all about the plumbing. That is absolutely
fascinating. Okay, one last stop on our global
tour. Australia. The notes mention the Australian
mortgage, almost as if it's a specific, unique
product. It is, and I have to be honest, I'm
a little bit jealous of it. It's usually called
an offset account or an all -in -one loan. How
does that work? Okay, imagine you combine your
mortgage account and your main checking account
into one single bucket. Right. You get your paycheck.
Let's say it's $5 ,000. It gets deposited directly
into your mortgage account. So my mortgage balance
immediately drops by $5 ,000. Instantly. And
because mortgage interest in their system is
often calculated daily on the outstanding balance,
you are paying less interest from the very second
that money hits your account. And then what?
Then, as you go through your month paying your
bills, your groceries, your electric bill, your
car payment, you're just redrawing that money
back out of the mortgage account. That's incredibly
clever. It means every single dollar you have
is working to reduce your interest burden for
every single hour it's just sitting there waiting
to be spent. It forces your money to be as efficient
as possible. And it also provides incredible
flexibility. How so? In the U .S., if you make
an extra payment on your mortgage, that money
is basically gone. You can't get it back without
a costly refinancing. In Australia, if you've
overpaid, you can pull that extra money right
back out if you have an emergency or want to
buy a car. It basically turns your house into
a giant line of credit, a piggy bank. A piggy
bank that saves you 6 % or 7 % interest instead
of earning you zero in a checking account. It's
a very powerful, flexible tool. So it's really
true. The 30 -year fixed rate mortgage is a unicorn.
It's a product of very specific U .S. government
policies and this massive, complex bond market
structure that just doesn't exist in the same
way elsewhere. We are the anomaly. There's no
question about it. Okay. We have covered the
what, the why, and the where. Now we have to
roll up our sleeves and do the heavy lifting.
The math. The engine room. I know, I know. When
you hear the word math, you might want to tune
out. But please, stay with us on this. Because
this explains everything. It explains why, when
you look at your mortgage statement after making
payments for five years, it feels like the balance
has barely gone down. It's the most common complaint
from homeowners. And we promised we'd explain
how they calculate that very specific number.
Why is your payment... $1 ,264 and not $1 ,265.
It all comes from a formula. It's called the
present value of an ordinary annuity formula.
But let's not just recite algebra. Let's try
to visualize it. I want you to imagine a bucket.
Okay, a bucket. I can do that. This bucket represents
your principal. It's the total amount of money
you owe the bank. On day one, month zero of your
loan, that bucket is filled right to the very
brim with water. Let's say it's $300 ,000 worth
of water. Got it. A full bucket, $300 ,000 of
debt water. Every single month, two things happen
to the water in this bucket. First, the bank
comes along with a hose and they pour a little
more water in. That water is the interest that
is accrued for the month. And this is the critical
part, isn't it? How much water do they pour in?
The amount of water they pour in is directly
proportional to how much water is currently in
the bucket. It's a percentage of the current
balance. So at the very beginning, when the bucket
is completely full, the bank is pouring in a
massive amount of water every month. So the water
level is actively trying to rise. My debt is
trying to grow. It is. But then, right after
they pour their water in, you come along with
a ladle. That ladle is your fixed monthly payment.
And you scoop out a fixed amount of water. And
because it's a fixed rate mortgage, my ladle
is the exact same size every single month for
30 years. Your ladle never, ever changes size.
Now, here's the problem and the source of all
that frustration. Okay. At the beginning of the
loan, in those first few years, the bank is pouring
in a lot of water. So when you come along with
your big ladle and scoop out, say, $1 ,500 of
water, almost all of your scoop is just removing
the new interest water the bank just put in.
I'm basically just cleaning up the fresh mess
they just made. You're cleaning up their mess.
You scoop out your $1 ,500 payment. But $1 ,400
of it was just new interest. Only a tiny little
bit, maybe $100 of your scoop, actually goes
toward lowering the original water level in the
bucket. That's why the balance barely moves.
It's so depressing. It is. But, and this is the
mathematical magic of the geometric progression,
because you scooped out that tiny $100 of principal,
the water level is now slightly lower for next
month. Which means next month, the bank's hose
pours in slightly less water. Yes. Maybe next
month they only pour in $1 ,399 of interest,
which means your ladle, which is still the same
$1 ,500 size, is now able to remove 101 waters
of principal. It's an accelerating process. It
compounds in your favor very, very slowly at
first and then faster and faster. By the time
you get to year 20 or 25 of the loan. the water
level in the bucket is much lower. So the bank
is only pouring in a tiny trickle of interest
each month. Exactly. And now your big $1 ,500
ladle is almost entirely removing principal.
You start emptying that bucket in huge, satisfying
chunks toward the end. So that crazy -looking
formula with all the exponents, its only job
is to calculate the exact size your ladle needs
to be so that the bucket runs completely dry
on the very last scoop of the 30th year. That
is its only job. It solves for zero. If your
ladle were one penny too small, the water level
would slowly rise forever. That's negative amortization.
If it were too big, you'd pay the loan off early.
The formula finds the perfect balance. smaller
ladle, even just a teaspoon, and scoop out a
little extra water, I'm lowering the principle
level permanently. Which reduces the amount of
water the bank can pour in next month, and every
single month after that, making your main ladle
more and more effective forever. You disrupt
the geometric progression in your favor. You
absolutely do. Okay, speaking of the math, there
was a little puzzle in the source material that
I found fascinating. The equivalence puzzle.
Oh, this is a great one. A real brain teaser.
Let's pose it to you, the listener. Imagine you
are offered two very different loans on the same
house. Okay. Loan A is a 30 -year mortgage with
a super low interest rate, let's say 2 .5%. A
great rate. Loan B is only a 15 -year mortgage,
but the rate is much higher. It's 5%, double
the rate. So on the surface, Loan B looks twice
as expensive from a rate perspective. Exactly.
But here is the mind -bending part. If you actually
run the numbers, the total amount of money you
pay to the bank over the life of the loan The
principal plus every single dollar of interest
can be almost identical in both scenarios. It
feels completely wrong, doesn't it? It feels
impossible. How can a 5 % loan end up costing
the same as a 2 .5 % loan? It all comes back
to that other crucial variable, time. Time is
a multiplier for cost. Explain that. In the 30
-year loan, yes, you're paying a very low interest
rate, but you're paying it on a large, slowly
declining balance for 360 months. The interest
has three full decades to pile up and accumulate.
And in the 15 -year loan? You're paying a much
higher rate, but you're killing off the principal
so aggressively, your ladle is so big, that the
interest never gets a chance to really compound
against you. You starve at a time. That really
drives home the point that the interest rate
isn't the only thing you should look at. The
term of the loan is just as important, if not
more so. There are two levers that control the
same outcome. which is total cost you can lower
your total cost by finding a lower rate or by
shortening the time you take to pay it back and
this brings us right back around to the psychological
benefit of the fixed loan budgeting yes the fixed
rate mortgage is more than anything else a budgeting
tool it allows you to plan your entire financial
life You know that, come hell or high water,
that $1 ,264 .14 is leaving your account on the
first of the month. You can build everything
else around that one solid pillar of certainty.
Compare that to some of the horror stories we
saw with those other loan types leading up to
the 2008 crisis. The negative amortization loans.
Right, the pick -a -pay loans, where the bank
literally allowed you to use a ladle that was
too small for the bucket. You were paying less
than the interest that was accruing each month.
So the bucket was overflowing. The debt was actually
growing every single month, even though you were
making payments. Can you imagine? Yeah. You make
payments for five years and you owe more than
you originally borrowed. It was a toxic product
by design. The 30 -year fix makes that an impossibility.
So we've covered a lot of ground here. We certainly
have. We've established that the fixed rate mortgage
is this very specific U .S. centric innovation
that was born out of the ashes of the Great Depression
specifically to create housing stability. It
was a deliberate policy choice, a government
designed safety net made out of financial paper.
And its core function is to transfer the risk
of an uncertain future from your kitchen table
to the bank or more accurately to the global
investors backing the bank. For a price. And
that price is that little bit of extra interest
you pay. that insurance premium. And we've seen
how the rest of the world, the UK, Canada, Australia,
handles this risk in a completely different way,
usually by keeping the fixed period very short
to protect their banks. Which puts all that volatility
right back onto the homeowner. I want to leave
our listeners with one final and I think slightly
provocative thought. We've talked about how the
bank takes on all this risk for us. But do they
really keep that risk on their own books? Now
that is the billion dollar question, isn't it?
The source material mentioned terms like derivatives
and the black skulls model. That's some pretty
heavy Wall Street jargon. It is. But here's the
simple reality. When you sign that mortgage,
the bank doesn't just put your loan documents
in a dusty vault and wait for your checks to
come in for 30 years. They don't? No. Your mortgage
is instantly transformed into a data point in
a global system. They might sell the whole loan
off, as we discussed, or they might keep the
loan but then immediately buy a separate financial
instrument, a derivative, that's essentially
a side bet. A side bet that pays them off if
interest rates rise, so they're hedging their
hedge. It's even more complex than that. Your
individual mortgage is bundled with thousands
of others. Then it's sliced up into different
tranches based on risk level. And those slices
are turned into a mortgage backed security that
is bought and sold on markets all over the world.
So a pension fund in Norway could own the rights
to the. principal portion of my monthly payment.
And a hedge fund in New York could be trading
options based on the statistical probability
that I'm going to refinance my loan next year
if rates drop. That is exactly what is happening.
You pay a premium for stability and simplicity
at your kitchen table. But in order to manufacture
that stability for you, the financial system
has to create a mind -boggling amount of complexity
on the back end, slicing, dicing, and trading
your personal risk across the entire planet.
So my household budget is actually a tiny cog
in a massive global hedge fund equation. It is
the very nature of modern finance. Stability
for the end user requires immense complexity
for the system that provides it. Well, on that
slightly terrifying and awe -inspiring note,
I think we'll close the book on the fixed rate
mortgage for today. It's been a fascinating discussion.
Thank you for taking this deep dive with us.
Hopefully the next time you look at that monthly
mortgage statement, you won't just see a bill.
You'll see a history of the Great Depression,
a bucket and a ladle, and your own little piece
of a global financial engineering marvel. Indeed,
a death pledge that gives you life. Keep asking
questions. We'll see you next time.