What am I missing? I go around the table and ask each of the executives whether they have a fixed-rate or an adjustable-rate mortgage (ARM). Everyone responds fixed-rate. There are picturesque answers such as “I own two of my properties outright, but on the third one, I have a fixed-rate mortgage” and “I’m paying it off in one year but yea, it’s a fixed-rate” but they all belong in the same bucket. Indeed, only about 10% of all mortgages outstanding are ARMs (source: Freddie Mac).
When we leave the room, my boss comes to me and says: “listen to me, yes, we agreed that floating rate is always better for the company, but for your house you should always go fixed."
Thirty minutes before, I had persuaded the big boys in the room to enter into several billion-dollar swap contracts that effectively transformed the company’s fixed rate debt into floating rate instruments, similar to ARMs. Only a little bit of logic and intuition was needed, and a “hair chart” for the hard-headed.
In close to 100% of the situations, a rational investor will demand a higher rate to lend money the longer the term of the contract. It makes sense: she needs to be compensated for giving up liquidity (she’s delaying consumption or investment), she is also taking additional interest rate and credit risk the longer the term of the contract (what if the borrower goes bankrupt? what if there’s hyperinflation?). This compensation is called term premium.
When we take a 30-year fixed-rate mortgage, we are paying term premium to the lender. We rationalize it as “peace of mind” of knowing our mortgage payment will not change. In reality, over such a long period of time, we will be shelling out quite a bit for peace of mind. Take a $500K, 30-year, 4% fixed mortgage for example. Assuming the average term premium over the life of the mortgage is just 0.5%, peace of mind would cost us $51K. No pocket change.
Then there’s the hair chart for interest rate swaps. The dark blue line is the “adjustable rate” paid over the life of the contract, and each light blue “hair” represents the path that the adjustable rate should have followed to make the fixed-rate vs. adjustable-rate decision equivalent. In English: when the light blue line is above the dark blue line, an ARM would have been the correct decision. It happens most of the time… and it must happen most of the time due to term premium.
So why then my boss and everyone else in that room had expressed the opposite view in their personal finances? Why the cognitive dissonance? Well, I think that’s because we’re humans, and the pain we experience when losing is multiple times more intense than the pleasure experienced when winning. So, even though our rational brain concludes that, if we were to live 100 lives and in 99 of those lives we would be better off following the ARM path, we see our life as one and only one, and let’s not risk feeling unlucky or dumb.
Leave your scientific mind outside, take your shoes off, and don’t forget to lock the door.