Planning a Mortgage Mixture During Recession and/or High Interest Rates

The world of financing in general, and the mortgage market in particular, is highly volatile. In the years since the 2008 financial crisis, we saw unprecedented growth in both the number and the size of mortgages taken out. Thanks to low mortgage rates and years of low inflation, people could take out larger, bolder mortgages. When financing conditions were that comfortable, we used to say it was both the best and the worst time to take out a mortgage. The best, because mortgage rates and inflation were at such a deep low that you could take out large mortgages at low financing costs. The worst, because rates and inflation were so low that if they moved at all, they could only move up.

And as we write these lines (2024), the bad times have arrived. We find ourselves in a "perfect storm" of high mortgage rates combined with high inflation, on the cusp of an economic slowdown. Anyone who needs to take out a mortgage in a period like this has to face a whole series of challenges — financial and, above all, psychological — that their peers never did. Which mortgage should you take in such a tough period? How much down payment should you put up? How do you cope with soaring monthly payments? This article tackles those questions.

The common actions we take during periods of inflation and rising interest rates

A mortgage is a financial product that already suffers from poor public relations, and its image is twice as bad during periods of high interest rates and inflation. Our aversion to large debts pushes us to seek certainty and stability — and that drives two common reactions, neither necessarily right, at a time like this.

We'll go through them in detail shortly, but it's worth noting right away that the mindset we recommend is remarkably close to the one for investing in the stock and capital markets. Both a mortgage and capital-market investments are very long-term plays, and managing them by reacting to short-term crises is a mistake. Anyone who believes they can earn an excess return in the capital market should keep buying shares even in times of recession and crisis — and anyone who thinks a mortgage is still the best way to get cheap, convenient financing would be well advised not to follow the approaches we're about to describe.

Common reaction one: chasing stable, safe, but more expensive loans

In tough economic times, when the newspapers are full of grim, gloomy news, our appetite for risk plummets and we run for safe harbor. Some people decide (and this is a mistake) to sell their investment portfolio or cut their exposure to risk assets, and on the mortgage side we reach for mixtures heavily weighted toward safe loans — meaning the fixed unlinked loan track (Kalatz).

This loan does provide stability, but the price can be very high. Just as rates rise, they can also fall, and when they do, the early prepayment fee — especially on this loan — can soar to tens of thousands of NIS. Anyone who later refinances a mixture overweight in fixed unlinked loans will be forced to pay steep discounting fees that wipe out many months of mortgage payments.

Fixed-rate loans are exposed to a particularly high early prepayment fee because of a lethal combination — the way the interest rate depends on the loan term, and the way the early prepayment fee is calculated (under the Banking Ordinance (Early Repayment of Housing Loans) - 2002). As noted, the average discounting rate on the prepayment date is based on the time remaining on the loan. If the original loan ran for 22 years and 3 years have now passed, you've dropped into a lower rate band. The rate has fallen, and an early prepayment fee arises before there's been any rate reduction in the economy at all.

Note this point: in variable CPI-linked and unlinked loans, the rate used to calculate the early prepayment fee is always pulled from the same column — so unless rates in the economy have actually fallen, you won't face an early prepayment fee.

Let's now look at a few examples that show the size of the early prepayment fee if the interest rate fell by 0.5% three years after the loan was taken out. This is a real, plausible decline (because of the direct link between the rate on the Kalatz track and the loan term), even if financing conditions in the economy haven't improved at all:

So what should you do? Get clear on your future intentions for the mortgage. If you plan to refinance down the line, lean toward a mixture with greater exposure to the prime-linked track or the variable unlinked loan, which will keep your early prepayment fees to a minimum. On the other hand, if you believe high rates and inflation are here to stay, then choosing conservative tracks is the more sensible call.

Common reaction two: taking a smaller mortgage

We try to take out the smallest mortgage we possibly can. We scrape together extra down payment, stretch our finances to the limit, and borrow from family, friends, employers, study funds, and pension funds — all to keep the mortgage as small as possible.

Is this the right move? Is it smart to take a small mortgage? In our view, no. Mortgage rates are dynamic. We can't always control the timing of taking out the mortgage, and therefore the quality of the rates we get, but we can always refinance and lock in better, lower rates (if and when they come along).

By contrast, choosing a smaller mortgage is almost irreversible. The money you've sunk in can't be pulled back out (except in very limited cases) for whatever you might need it for.

What should you do? Allocate capital to your current mortgage based on your next financial move. Picture yourself three years from now, long after this mortgage is behind you. What's your next step? If you're headed toward investments or new, ambitious ventures, you'll likely want the financial resources on hand to make them happen. Yes, the mortgage right now is expensive and risky, but it won't necessarily stay that way. The mortgage market is very flexible.

Good luck!