WCI #13: Fixed versus Variable Rates

This is the White Coat Investor Podcast where we help those who wear the white coat get a fair shake on Wall Street.

We've been helping doctors and other high.

Income professionals stop doing dumb things with their money since 2011.

Here's your host, Dr. Jim Dahli. Welcome to White Coat Investor podcast 13.

Did you know that the White Coat Investor not only has a podcast and a blog but but several books that will help you on your way to financial independence. These books cover topics such as asset protection and minimizing your taxes to keep more of your hard earned money. They discuss plans for insurance, housing spending, student loan elimination, investing and estate planning. You can learn how to become a millionaire within five to 10 years of leaving residency and how to invest in a sensible, low cost and effective manner with or without the assistance of a financial advisor. There's even a book geared directly toward medical and dental students so you can start optimizing your finances earnings early in your professional journey. Find the book that is right for you at the WCI store, at shop.whitecoatinvestor.com or on Amazon. You can do this and the White Coat Investor can help.

Thanks for what you do. You're probably on your way into work, maybe you're on your way home, maybe you're out running errands, maybe you're running or at the gym. But either way what you do is difficult. You spent a lot of time training to do it and what your daily work is really matters in the world. Even though sometimes you don't feel like you're making a big difference, even a little bit of reassurance for a few patients makes a difference. Our quote of the day today comes from Socrates. He says employ your time in improving yourself by other men's writings so that you shall gain easily what others have labored hard for. A lot of wisdom there. Today's podcast is going to deal with variable versus fixed rate loans. We're going to be talking both about student loans and about mortgages. I think the classic example of what is usually recommended out there comes from Dave Ramsey where he tells people to only buy a home on a 15 year fixed rate mortgage. It's kind of grandma style advice to always get a fixed rate just in case rates go up. But really got me thinking about it was when I was pretty darn proud of myself for getting a 2.75% fixed 15 year mortgage and then started talking to one of my buddies who had a 0.9% variable rate mortgage and I realized wow, I'm paying a lot more than you even though I did everything right and I did the smart thing and I had excellent credit, and I'm still paying over twice as much in interest on the same amount of money. And so I started thinking a lot about variable loans and when they might be appropriate. In reality, it's not a variable rate versus a fixed rate loan. It's a variable rate versus a variable rate plus an insurance premium. In essence, when you get a fixed rate loan, you're paying somebody else to run interest rate risk for you. You're buying insurance against interest rates going up. You're usually paying the bank or the lender some money to do that. In my case, I was paying over 2% a year to insure against the possibility of interest rates going up. So anytime you're buying insurance, you need to ask yourself if you need the insurance. My general rule with insurance is insure against financial catastrophes and self insure against everything else. So in reality, when you're talking about a variable rate, whether it's student loans or a mortgage, what you're really asking is, would it be a financial catastrophe if the rate maxed out on me? For example, if you need to borrow $100,000 for 15 years, what's the highest the monthly payment might ever be? If that variable loan that is currently 2% can rise to 10%, can you still afford the payments? So you have to figure out what are the payments at 2%? Well, at 2% on 100,000 for 15 years, the monthly payments are about $650. At 10%, they rise to about $1,100. So if you can afford the $1,100 payments, you can afford to take this risk yourself. You don't have to buy insurance against it. So let's make the case for self insurance. Very briefly. If you're already making extra payments on the loan, that risk becomes even lower. First, you obviously can afford payments. Even if they go up, you can afford higher payments. Second, all the principal you paid down lowers the maximum payments since the interest portion of the payment is calculated only on the remaining principal. And third, most fixed rate loans can't go from their current rate to the maximum in one jump. There's usually a maximum annual increase. So even in a period of skyrocketing interest rates, it might still take several years to reach the maximum interest rate. During those years, the principal is naturally being paid down as you go. Fourth, if rates start rising, you can always readjust your financial priorities to throw more money at the loan or possibly even refinance it. Fifth, Money now is worth more than money later. If you can lower your payments as a resident or young attending when there are so many competing needs for your extra cash, that can be really valuable. So consider all the scenarios that could happen with interest rates. Rates can fall, in which case the variable rate loan wins. Rates can stay the same, in which case the variable loan rate. Variable rate loan wins. Rates can rise, but not until late in the loan. And in that scenario the variable also wins. The rates can also rise, but not rise by much. And if that's the case, variable wins again. So really, the fixed rate loan only wins in the fifth scenario where rates rise dramatically and quickly. So you've got to really determine your breakeven point. Consider being presented with a Choice between a 3% variable 10 year loan and a 4.5% fixed 10 year loan. If the variable rate loan terms were such that rates can go up 2% a year with a cap at 9%, how much can interest rates rise before you lose by taking the variable rate? Well, obviously, if the variable rate never goes above 4.5%, the variable rate will win. And if rates don't go up until late in the loan, the variable rate loan will also win. Especially when you consider the time value of money. In order for that variable rate loan to lose, the rates must go up a lot and they must do so early. So, using that $100,000 loan, let's assume the interest rates rise as quickly as possible. Let's simplify things by making only one payment a year and calculate the entire year's interest payment off the balance at the beginning of the year. After one year, the variable rate loan is paid $8,723 in principal and $3,000 in interest, while the fixed rate loan is paid $8,138 in principal and $4,500 in interest. The difference in wealth, not counting the time value of money, is $2,085. In the second year, the interest rate on the variable loan increases to 5%. Despite the higher interest rate, the variable rate loan still comes out ahead in year two as it is calculated on a smaller amount of principal, further increasing the wealth of the variable interest rate loan holder by $505, for a total of $2,590. In year three, the interest rate goes up to 7% and the fixed rate loan finally starts to outperform the variable, but only by $1,612, leaving the overall advantage still to the adjusted rate loan. Despite a rapidly rising interest rate in year four, the interest rate goes to 9%, and the advantage finally shifts to the fixed rate loan with the difference in wealth after four years of $4,285. But what if the interest rates stayed flat for three years before that process of rapidly rising interest rates? Then which loan would be better? Well, by the time rates start rising, the variable rate loan has already built up a war chest. A wealth advantage of $7,687 composed of $4,500 less in interest paid, $1,433 more in principle paid down. Because of that three year head start, even after 10 years, the adjustable rate mortgage still comes out ahead by over $8,000. So that example really demonstrates that rates have to rise not only dramatically, but also early in the term of the loan. You should also consider all your other financial resources. If the rates skyrocket, can you redirect money that's going elsewhere at this loan? Now, everybody seems to think that interest rates are going up. We've been talking about interest rates going up now for eight years, and in the meantime, they've mostly fallen. Only in the last few months have they gone up at all. And even that's a pretty minor rise. Keep in mind that financial pundits, they've been predicting rates to go up for a long, long time. And in fact, interest rates have fallen. In some countries, such as Japan, interest rates have been very low for over two decades. Interest rates certainly do not have to rise and they don't have to go anywhere near what they were in the 80s. So there's certainly significant incentive for the US government to keep them low, given that it owes a lot of money to its own citizens and people in other countries. And the last thing it wants to do is see those rates get particularly high. Besides, the market is very much aware of the risk of rising rates, the Fed's pronouncements. So that information is really baked into the difference between available fixed and adjustable rates. The bottom line is that an adjustable rate loan is going to win most of the time. And the more flexible your financial life, the more you can afford the consequences when it does not win. So particularly if you're committed to living like a resident and getting rid of your student loans in less than five years, I think you can very much afford to run a variable rate loan. You can afford to run that interest rate risk. If you're going to stretch out your mortgage payments for 30 years, maybe it's worth paying the insurance premium to fix that loan's rate. Let's Talk briefly about a mortgage Charlie Munger said. If you have a $2,000 monthly mortgage payment, Grandma can help. If you have a $20,000 monthly mortgage payment, no one can help. That illustrates an important principle. If you don't have a very big mortgage, it simply isn't that much of a consequence to have the rates go up. If you have a huge mortgage, the consequences are much bigger. So you have to consider when you're looking at risk, not only the likelihood of that risk showing up, but also the consequences to you personally of it showing up. So 30 years is a long time to run interest rate risk, but if you're planning to pay it off in five or 10 years, then maybe it's not so bad. Again, consider the worst case scenario. If you're the type of person that buys a 30 year mortgage over a 15 year mortgage, even though you're planning to pay the house off in 15 years just because you're worried something could happen, you probably want a fixed rate loan because again, something could happen. But you know what? If I had it all to do over again, I'd get a variable rate loan. I would have paid thousands less in interest over the seven years I had a mortgage. And at this point in my life, if rates skyrocketed, I could just throw some money at the mortgage and pay it off. Part of it obviously just depends on how much you stretch to get the house. My house value is less than 3/4 of my annual income. My remaining mortgage as of today as I record this podcast is less than 10% of my annual income and the mortgage payments is less than 5% of my monthly income. There's just not a lot of risk there for me. But if you're in California and you own some huge monstrous home and having the rate go up on that is a big deal, then you might want to be a little more careful taking on the risk of a variable rate loan. So a fixed rate loan can be better, but only if rates rise rapidly early in the life of the loan. The break even point is usually far later than most borrowers assume without running the numbers. If you can afford the worst case scenario, and especially if your loan length is less than 5 to 10 years, you should give some serious consideration to an adjustable rate loan, whether it's a student loan refinance or a mortgage. Certainly it's worth running the numbers yourself or hiring someone to do so before you make your decision, rather than making it based on an irrational fear of a rising payment. Alright, let's get into a couple of questions we have. The first is a lengthy one that comes from a pediatrician in Los Angeles. Says I've been working very hard for about five years now out of residency getting paid around $150,000 at a non profit here in LA, getting what we call the sunshine tax out here. Previously worked in the private sector for a while making 200,000, but after taxes that left him with a pretty modest lifestyle and it honestly wasn't enough to realistically pay down a large student loan balance, he says I have $450,000 in student loans just from med school and I'm on the public Service loan forgiveness track. I had a few concerns and sleep depriving stressful thoughts that I don't think are isolated to me and I'd like to see them discussed on the podcast specifically. A lot of people don't know that not only must it be a 501c3 entity, but the loans also have to be direct loans before the payments count as part of the 120 payments. I didn't know that when I was a resident, so I spent and wasted those three years of residency and none of those 36 payments counted. So now I've only been paying for five years despite the fact that I'm five years out of residency working for a 501. The most stress inducing issue for me about Public Service loan forgiveness is that no payments are reducing the balance as you go along, it's just something you apply for after the 120 qualifying payments. The concern I have is that I may owe over a million dollars ten years from now on the IBR payments. So if Public Service loan forgiveness goes away or I can't find another 501 job in year nine or I get disabled, I'd be stuck with a huge balance that my family and I can't get rid of. So my choices are to stick it out in public Service loan forgiveness and stress out for 10 years or sign up for one of those high paying jobs with loan assistance out somewhere else in the country moving me away from my family and friends. I was born and raised in LA for a period of five years or more. I'd likely be working harder and be writing post tax checks for 10 to $12,000 a month for that duration. Would have very little liquidity or investments for the amount of work I've done. I've spoken with many CFPs and CPAs but it is truly difficult if not impossible to get sound advice on anything regarding Public Service Loan forgiveness because no one gets paid to learn, know or gain expertise in this stuff. My seasoned CFP and CPA know very little about any of this and just proceed to sell me on insurance products and or incorporation while I educate them on public service loan forgiveness, IBR and student loan issues. I'm sure there's a lot of white coat investor docs in my camp and I'd love to hear about this on a future podcast. I graduated near the top of my class and specifically chose to work with and for children. I love caring for kids and wouldn't change my specialty for any other vastly more lucrative specialty, but it would be great to hear some advice and commentary regarding my options in my doomsday scenario. Well, let me make a few comments about this. First of all, I kind of agree it is a bit of a doomsday scenario. He's got three times his income in student loans. That's crazy. The limit, I tell people, is try to keep it to one times and at most two times. Three times requires some extreme solutions and you get beyond four times and it basically becomes impossible. But I've been seeing a lot of three to four times income student loan balances, particularly with dentists. So the reason you are feeling stressed out is is because you're in a very bad place financially and that is being compounded by being in California. You're also essentially completely reliant on public service loan forgiveness at this point. Since you're really relying on it, you got to be an expert on it. You really need to understand the ins and outs. It only applies to direct federal loans. You need to get into the lowest payment plan you qualify for, which is usually the pay as you earn or the revised pay as you earn program. For those who are in residency now, you want to consider changing out of revised pay as you earn after residency because the full payments are your payments after residency are not limited by the 10 year maximum like they are with pay. So at the end of residency, if you're really going for public service loan forgiveness, you may want to get out of repay. In addition, during residency, if you're married, you might want to consider doing the married filing separately thing with your taxes and being in the pay as you earn program. What that allows you to do is have a lower declared income and maybe have much lower payments during residency, which will maximize the amount that's left to be forgiven afterwards. And of course, be sure to certify your public service loan status every year. In reality, this doc went to residency for three years and he's now five years out of residency. He could be eligible for forgiveness in as little as two more years. But in reality, because he didn't get enrolled in the programs that really lead to forgiveness, he's almost 10 years away still from getting this debt forgiven. There's a certain amount of risk out there when you're going for a million dollars in forgiveness. If the rules changed, you're basically hosed financially. Remember that the Obama budget back in 2013 proposed capping forgiveness under Public Service Loan forgiveness to just $57,000 a year. For that reason, although that's never become law, I recommend you invest in a side account so that you can use that side account money to pay off the student loans in the event something happens to the Public Service Loan forgiveness program. But there's no way that this pediatrician is going to be able to acquire a million dollar side account in the next 10 years. It's just not going to happen. I think he would probably be grandfathered into the program, but there's really no guarantee. And as he pointed out, there's very little expertise out there about student loan management, including among traditional financial adv advisors. Yet advice on this topic is super high yield. In fact, I can think of no better time to pay for professional financial advice than determining how to manage your student loans as you come out of medical school. Alright, our second question today is what are your thoughts regarding municipal bonds and buying holding them to maturity versus using Pimco or another company to actively manage them? Well, I'm not a big fan of either buying individual bonds or paying somebody to actively manage them. My general default if you want to invest in municipal bonds is to use a passively managed municipal bond index fund such as the excellent low cost ones available at Vanguard. I wouldn't pay Pimco to actively manage my bonds, nor would I try to buy them individually. Now some people do like owning individual bonds. They like knowing that at least they'll get their principal back at the end, even if everybody else in the bond fund decides to do something crazy like bail out of it at the worst possible moment. But in general, I prefer keeping my life a little bit simpler by investing through mutual funds. It's really very inexpensive to invest in a Vanguard bond mutual fund. It's a few basis points a year and that gives you daily liquidity. It gives you the expertise of the managers there doing the buying and selling. And I assure you they get much better prices when they buy and sell bonds than you do. Appreciate you listening to the podcast today. That was interesting information about variable as well as fixed rate loans I hope you can use it in the future as you decide what type of a loan to do with both your student loan refinancing as well as taking out a mortgage and want to encourage you to continue to listen to the podcast. Give us a great rating on itunes and anywhere else podcasts can be found.

Did you know that the White Coat Investor not only has a podcast and a blog, but several books that will help you on your way to financial independence? These books cover topics such as asset protection and minimizing your taxes to keep more of your hard earned money. They discuss plans for insurance, housing spending, student loan elimination, investing and estate planning. You can learn how to become a millionaire within five to 10 years of leaving residency and how to invest in a sensible, low cost and effective manner with or without the assistance of a financial advisor. There's even a book geared directly toward medical and dental students so you can start optimizing your finances early in your professional journey. Find the book that is right for you at the WCI store, at shop.whitecoatinvestor.com or on Amazon. You can do this and the White Coat Investor can help.

Head up. Shoulders back. You've got this. See you on the next podcast.