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After this week I don’t think there is a better time to explain the relationship between fixed interest rates and the Wall Street Prime Index!  On Tuesday, the 22nd of January, 2008 the DOW Jones Industrial Average opened up down nearly 500 points.  This, in conjunction with the foreign markets tumbling the day before, sent the Federal Reserve Bank in motion to cut the Prime Interest Rate by .75%.  This was a fairly drastic move. 

As per usual, when the Fed cuts rates I normally receive phone calls from my clients asking if they should refinance because they heard that interest rates were lowered.  While it is sensible to think that this is the time to move, it’s often the opposite.  Unless you move fast……or wait a little while. 

The Fed primarily moves interest rates to control inflation or to stimulate the economy.  When they cut rates, it usually stimulates the stock market and the economy.  When they raise them it is to control inflation.  OK, I realize that this is about as entertaining as watching paint dry, but here is where it gets interesting.  So when the Fed cuts rates, the stock market usually reacts favorably because it allows businesses and the public easier access to money.  When that happens, money is moved from bonds to stocks forcing rates to go up.  However, there can be a window of opportunity in this transfer to get a good rate while the money is flowing from one side to the other.  This is typically a short lived window.  Though longer term, rates tend to go back down.  So when I was talking circles in the previous paragraph, this is why.  So to further explain this, I need to explain the relationship between Stocks and Bonds. 

OK.  Everyday the stock market and the bond market compete for the exact same dollar.  Bonds are relatively safe investment vehicles.  They do not produce massive returns, but they’re safe.  And people like safe when they’re nervous about their money.  Stocks tend to be safe over the long term, though they can be volitile at times.  There are times that fortunes can be made in stocks (actually, you can always make a fortune in stocks if you have a lot of money and know which direction the market is going, but I’ll save that for another post.)  So when people feel that they can make more money in stocks with an acceptable amount of risk they take money out of bonds and put it in the stock market.  Conversly, when they get nervous about the market, they turn around and put it back into bonds.  This can happen daily.  When there is a big swing towards bonds, fixed interest rates go down (which are the kind that effect your mortgage.)  When money is moved from bonds to the stock market, fixed rates tend to trend upwards (this is bad for your mortgage.)  The Prime rate effects your equity line, credit card, car loan, etc.  Short term rates.  It also affects the rate at which banks can borrow from the Federal Reserve.

So let me break this down:  Money in bonds, rates go down.  Money in stocks, rates go up.  If this still seems complicated, it is.  Give me a call, I love talking about this stuff!

I see a lot of negative press regarding Interest Only mortgages.  People talk about them like they are the plague.  Most feel that if you took an interest only loan that you are inevitably in trouble and shouldn’t have bought a house in the first place. 

In some cases, they are right.  There are a lot of people who took out interest only mortgages who had no business doing so.  There are a lot of people who were coerced into a mortgage that they couldn’t afford.  There are a lot of people who will default on their mortgage.  But interest only mortgages will not necessarily be the cause of it.  Believe it or not, you typically don’t save that much money monthly by avoiding principle (the part you don’t pay initially in an interest only mortgage.)  Furthermore, most of the people defaulting on their mortgage right now were probably doing “light” or even “no” documentation loans.  Meaning that they, or their Loan Officer misled the Lender.   Basically, a lot of people got mortgages who shouldn’t have.  And that’s what’s causing the mortgage meltdown and credit crisis.  Not interest only loans. 

Let’s crunch some numbers to shed some reality on this subject.  Let’s assume that you are an honest person and can actually afford a $250,000 loan (100% Loan to Value) with a 6.25% amortized interest rate.  Let’s also assume that you will follow the normal trend of keeping this mortgage for 5 years (most people do something with their mortgage or move every 3-5 years.)  In 5 years you would have paid $75,700.74 in interest and $16,656.66 towards priciple.  $16,656.66!  That’s $3,331.33 per year!  Do you find that to be a significant amount of money?  Perhaps, let’s proceed.  Now, let’s try an interest only mortgage of $250,000 at 6.25%.  In 5 years, with an appreciation rate of 2%, you would have made $21,020.  If you took $278 ($3331.33 broken down monthly) a month and put it in an account with a 5% return you would make an additional $18,894 over the 5 year period.  So basically you just made $39,914 by using an interest only mortgage.  And that doesn’t factor in your tax savings.  This is often referred to as equity repositioning.  It’s not for everyone.  It’s not for the undisciplined.  Though if you are disciplined, than this is very much for you.

OK.  I know this is dry.  But it will make you money.  Over time, a lot of money.  Possibly enough money to retire on or buy your next home.  The power is the difference between simple interest (interest only) and compounded interest.  Here is the best example I can use:

If you borrow $100,000 at 7% simple interest for 15 years, you would be required to pay $105,000 in mortgage payments.  If you took that $100,000 and invested it with an average compounded return of 7% for that same 15 years, you would have $275,903.  You just made $170,903!  That’s the difference between simple and compounded interest.  And again, that doesn’t factor in the tax deduction.

Dry content?  $170,903 worth of dry content. 

If you made it through this post, congratulations.  I know it’s boring content, but it’s good to know if you’re willing to do the work.