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  • Would I Rather Buy A Home Or $50,000 Worth Of Bonds?

    The Connection Between Interest Rates and Housing Prices

    I have seen a number of articles recently about the impact of rising mortgage rates on housing prices. Since January, the average interest rate on a 30 year loan has risen dramatically , from 3.41% to 4.37% on a 30 year mortgage, according to Freddie Mac. There have been a few articles suggesting the housing market recovery will be derailed by rising interest rates, which effectively increase the cost of buying a house. However, the chart below which compares mortgage interest rates versus prices, does not support the premise that an inverse relationship exists. Reading the chart, one would come the conclusion that housing prices are much more impacted by the state of the economy and markets than interest rates. (Hat tip: Calculated Risk)

    HousePricesMortgageRates

    What are the characteristics of a house as an investment?

    I am going to look at this question from the perspective of buying the place that you intend to make your home. Buying investment properties or investing in real-estate investment trusts (REITs) may or may not be good investments, however, they have different characteristics than buying a house with a mortgage. Specifically, there are two major benefits which are sometimes overlooked:

    • Owning a home provides a hedge against inflation
    • A mortgage allows you to borrow money at a very low cost
    If you don't own, your biggest monthly expense is rent!

    Around 30% of average family income goes toward paying rent. While housing prices can go up or down in value, rents tend to go in one direction - higher. Since 1953, the cost of renting (shelter in CPI lingo) has been slightly negative in only one year. As you can see in the chart below, generally the cost of renting follows very closely overall inflation as measured by CPI. When buying a house with a fixed rate mortgage, you are replacing a variable, but generally rising monthly expense, with a fixed monthly payment.

    Let's say that you currently pay $3,000 per month in rent and can buy your place for $400,000 per year. You are able to borrow $350,000 for 15 years at an interest rate of 4.2%. Let's assume that inflation for rentals increases on average 2% per year for the next 10 years.

    (click to enlarge)

    Likely Monthly Rent In 10 Years $3,656.98

    Monthly Mortgage Payment In 10 Years (fixed) $2624.13

    While the mortgage payment starts out at about $400 less than the rent, the monthly difference increases to over $1,000 in ten years when factoring in a modest degree of inflation. This example may overstate the difference a bit. There are some costs associated with owning a home that do increase over time, like the cost of repairs and maintenance. However, overall owning a home and paying a mortgage does provide a large degree of protection against inflation.

    A Home Allows You To Borrow Money At A Very Low Cost & Buy An Investment With A Very Good Yield

    I want to think of buying with a mortgage as two distinct transactions:

    1) You are purchasing an asset that provides a yield. In fact, you are your own tenant. Building on the example above, the assets costs $400,000 and starts paying $3,000 per month in "interest". The initial yield is 9% ($36K / $400K). The example is providing a yield which is better than you will find in your personal case. In many places, the home price to rent ratio is around 18 or an initial yield of 5.5%. Essentially, this is very close to the yield on long-term, higher rated high yield bonds.

    2) You are borrowing money at a very low interest rate, both in absolute terms and compared to treasuries. At 4.37% for a 30 year mortgage, you are borrowing money for only 0.66% more in interest than the US government can borrow with a 30 year bond. Without the home as collateral, your borrowing costs would be dramatically higher. Its unlikely that you would be able to borrow money for less than 10%.

    Borrowing Money at 4.37% To Buy An Asset That Yields 5.5% Equals A Positive Return, Assuming The Value of Your Home Stays Flat or Rises Over Time

    Plus, you get to hedge your biggest monthly expense against inflation!

    OK, but what does this have to do with $50,000 worth of bonds?

    In the example, I mention that you are buying a house for $400,000 and borrowing $350,000. In the example, you have to come up with $50,000 to provide as a down payment for the house. You could cash in bonds, stocks or other investments. Bank are currently requiring down payments between 15 and 20%.

    For more great bond news and education be sure to visit us at Learnbonds.com.

    Aug 31 11:23 AM | Link | Comment!
  • Bond Fund Ladders: Using Them To Prepare For Higher Rates

    If you have spent much time studying the bond market you have likely heard of bond ladders. If not the concept is pretty simple. You buy individual bonds with maturity dates that are spaced out over a number of years. When the bonds with the shortest maturities mature, you roll them over into the longest maturity you have chosen for your ladder.

    One of the purposes of a bond ladder is to protect you from rising interest rates. When interest rates go up you are able to invest money at the higher rates as your short term bonds mature, helping to offset the losses on your longer term bonds.

    A primary issue with bond ladders however, is that unless you are using treasuries for your bond ladder, you need to spread your purchases out over a large number of bonds in order to minimize credit risk. For many people with smaller investment sizes, creating a well diversified bond ladder using individual bonds is not possible.

    To help with this issue, BMO Financial Group recently came out with an article outlining how you can create a ladder using bond funds instead of individual bonds. As most bond funds are invested in hundreds if not thousands of individual bonds, you can get similar protection to rising rates with smaller investment sizes.

    As BMO points also points out, that is not the only benefit of using bond fund ladders instead of individual bond ladders. Other benefits are:

    • Liquidity: If you are using an individual bond ladder and need to exit some of your bonds before maturity, then you are likely to incur large transaction costs in order to do so. Most bond funds on the other hand have daily liquidity, meaning that you can exit your bond fund at anytime for minimal transaction costs.
    • Floating Rate Exposure: The BMO funds used in the article include around 20% exposure to floating rate bonds. The interest paid on floating rate bonds adjusts up and down along with market interest rates on a daily basis. This means that a portion of your portfolio will be investing at the higher rates much faster in your bond fund ladder than when individual bonds are used.
    • Potentially Higher Income: In this example a significantly higher yield was obtained by using the bond fund ladder vs. individual bonds.

    Keep in mind that the floating rate exposure component is key to the bond fund ladder. If the funds that you use for the ladder do not contain this floating rate exposure, then you will be subjecting yourself to greater interest rate risk than you would be with the individual bond ladder.

    You can read the full article from BMO here. For a free guide on investing in bond funds go here.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Tags: bonds
    Aug 05 1:27 PM | Link | Comment!
  • Why Are Lending Club Yields Starting To Head Down?

    Lending Club recently sent me an email about their borrowing rates moving lower. The lowest rate offered to the highest quality borrowers is now only 6.78% APR for a 3 year loan. Lending Club is the leader in the peer-to-peer lending space, where individual borrowers can ask "strangers" to fund loans. Ironically, there are plenty of "strangers" willing to lend money. Lending Club is having trouble with getting more borrowers.

    Yields Will Be Coming Down By 0.2% On Average

    In a move to attract more borrowers, Lending Club has lowered its average rate. The CEO of Lending Club, Renaud Laplanche, said he believed that on average rates would come down by 0.2%. While this was good news for borrowers, this doesn't look like good news for lenders. If borrowers are being paid less shouldn't investors be making less?

    This is the question that I ask Laplanche at the Lendit conference. His response (paraphrasing his answer) was twofold:

    1) Not necessarily. He argued that reducing rates might attract on average a higher quality borrower to the Lending Club platform. Higher quality borrowers would mean lower default rates on loans. The lower yields on loans might be offset by lower losses on loans.

    2) Yes. There has been a large gap between the perception of risk of default for Peer to Peer loans and the actual loans. The perception of risk is much higher than the actual risk. Over time the perception of risk will closer the reality pushing rates lower.

    Why I Think Yields Will Be Coming Down Quickly For Peer-to-Peer Loans

    The Lendit Conference, a conference dedicated to P2P lending, was sold out with the average ticket costing a few hundred dollars. Most conference attendees were from hedge funds and financial firms. There was no shortage of deep pockets at the conference. One of the buzzwords of conference was "securitization" or grouping individual loans together into new "securities". Bottom line, institutional investors are now actively involved in the peer-to-peer space. While the "stranger" that loaned the money was once a retiree in California, the stranger is increasingly becoming a hedge fund in Manhattan. As these funds see good results, they will pour money into lending. As the supply of money will be greater than the demand for loans, Lending Club will continue to reduce rates to attract more borrowers.

    What Should You Do

    The good news is that the process that I describe has just started to happen. Peer-to-peer loans still offer a fantastic return. That return will go down over time but, returns can fall a long way before they become average. Peer-to-Peer loans have an expected return around 8% after default (by Learn Bonds' calculations).

    For more on peer-to-peer loans see our free course on the topic here.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Tags: bonds
    Jul 14 8:00 PM | Link | Comment!
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