When Interest Rates Matter and When They Don’t

By Dr. Tyler Scott, WCI Columnist

Albert Einstein’s work is beyond my comprehension. A woefully incomplete list of his contributions includes Avogadro's Number, Quantum Theory of Light, General Theory of Relativity, Special Theory of Relativity, The Photoelectric Effect, Wave-Particle Duality, Brownian motion, the relationship between mass and energy (E = MC2 ), and the Bose-Einstein Condensate.

I have spent hours turning over these ideas, and I often feel dumber when I stop reading than when I started. I find him and his work fascinating. Thus, I am fascinated by what he was fascinated with.

One of the things he was most riveted with and passionate about is something that this community can understand and relate to—the power of interest. His inquisitive and mathematical brain understood better than most the profound impact of compounding interest.

Two famous quotes pertaining to compound interest are commonly attributed to Einstein.

“Compound interest is the eighth wonder of the world. He who understands it, earns it . . . he who doesn’t . . . pays it.”

“Compound interest on debt was the banker’s greatest invention to capture and enslave a productive society.”

When reading statements like these from someone with such a transcendent mind, it is understandable that conversations about interest rates are so pervasive in financial circles.

My goal today is to invite some context to those conversations, to try to quantify Einstein’s observations, and to help focus our attention on when those observations matter most and when they can be reasonably ignored.

 

When Interest Rates Don’t Really Matter

 

Cash

If I had a nickel for every email from a client that read something like the following, I’d have enough for a cocktail at The Chandelier Bar.

“Hey Tyler, thanks for the reminder to get some own occupation long-term disability insurance. I’ll get to that eventually, but in the meantime, I have a pressing question. I was noticing that the Vanguard Federal Money Market is paying 5.1% right now and my high-yield savings account is only paying 4.1%. I was thinking it makes sense to move my $60,000 emergency fund over to Vanguard to take advantage of this much better interest rate. What are your thoughts?”

I understand the impulse to ask this question and to consider making this change. As we will see shortly, a 1% interest rate difference can have a significant impact on a financial plan.

This is not one of those times.

A total of $60,000 getting an extra 1% earns an extra $600 per year before considering taxes. Remember that interest paid from a financial institution is subject to ordinary income taxes. Assuming a 40% marginal tax rate, this $600 becomes $360.

My email response to clients first quantifies the value of the proposed action and then usually says something like:

“I’m not here to scoff at $360; I just don’t think ~$300-$400 this year is going to make or break any of your short- or long-term financial goals. Also, from what you told me last time about wanting to prioritize time with your kids, I imagine the hours you would spend moving money around over the years chasing interest rates would likely bring you more happiness/value if you were checking off that list of local hikes you wanted to do as a family.”

The response that follows is often, “Wow, I didn’t realize the difference was so minimal. I’ll definitely opt for the hike instead of the extra financial chore. And I promise I’m gonna get that own occ disability insurance here soon.”

To be clear, having cash earn a reasonable rate is important. If you have a large five-figure or six-figure amount of cash parked at a local bank earning 0.02% interest, moving that money to a high-yield savings account is worthwhile. At least half of the new clients I meet are functionally earning 0% on their cash.

More information here:

Restoring the Balance Between Savers and Borrowers

 

Mortgage Payoff vs. Cash

A similar version of this conversation comes up when considering whether to pay off a mortgage with existing cash. Here is a comment from a recent blog post WCI founder Dr. Jim Dahle wrote about the value of a paid-off home.

“I owe $170,000 on my mortgage at fixed 3.9%. I could pay it off tomorrow, but it doesn’t make sense for me, especially considering with tax deduction that 3.9% is actually about 2.8%. The Schwab money market is paying 5%.”

First, let’s clean up a couple of issues with that comment.

Cleanup No. 1: It only makes sense to consider the after-tax interest rate on the mortgage if you itemize your taxes. The Tax Cuts Jobs Act that passed in late 2017:

Doubled the size of the standard deduction ($29,200 for Married Filing Jointly in 2024 and $30,000 in 2025), so if your itemized deductions don’t exceed $29,200 or eventually $30,000, there is no reduction in your mortgage rate. Removed all itemized deductions except charitable contributions, state and local taxes (SALT), and mortgage interest for mortgages of $700,000 or less. (Note, if your mortgage is more than $700,000, you are not getting a deduction on the portion above $700,000.) Limited the SALT deduction to $10,000.

As a result, far fewer people itemize these days, with nearly 90% of taxpayers taking the standard deduction. Admittedly, many of those 10% who itemize are likely readers of this blog because of sizeable mortgages and/or charitable mindsets.

Cleanup No. 2: We need to reduce that 5% interest rate from the Schwab Money Market for taxes so we are making an apples-to-apples comparison: the post-tax mortgage rate they are paying vs. the post-tax interest rate they are earning. For many readers here, the after-tax interest rate being earned is likely close to 3.6%.

With our cleanup complete, we can compare the difference between:

Paying off a $170,000 mortgage with an after-tax rate of 2.8% Keeping $170,000 in a safe, liquid account (i.e. money market) paying an after-tax rate of 3.6%.

How much is this 0.8% delta worth? It'd be $170,000 x 0.8% = $1,360 in the first year and a little less each year after as the mortgage balance gets ever smaller.

Again, $1,360 is nice. I’m not disparaging that amount of money. It is just my observation that most people making these kinds of decisions have routinely underestimated their pet care, gasoline costs, hair and beauty, or any other expense for the year by more than $1,360. In other words, this dollar figure is not consequential to most who are in the privileged position to contemplate this “pay off or invest” decision, but the decision gets a tremendous amount of time and energy devoted to it despite its ultimate irrelevance.

Sorry, Einstein . . . no eighth wonder of the world here.

 

Aggressive Student Loan Paydown

Another area I see people stress too much about interest rates is when they are looking to aggressively pay off their student loans and are considering privately refinancing their federal loans.

Let’s say a newly minted lawyer, engineer, or attending physician has $250,000 of federal loans at 6.8%. Being fully indoctrinated WCI consumers, they are committed to living like a trainee and paying these loans down within 3-5 years. They come to me as a financial planning client or during a consult at Student Loan Advice asking, “Is it worth it to privately refinance my student loans?”

The answer, of course, is, “It depends.” But in general, it usually does not make sense in these cases.

Why? Because you just don’t save that much money on a refi when you are paying down your debt quickly. This is true of all debt. In the case of federal student loans, you are also giving up a lot of flexibility and a number of protections when you leave the federal arena for the private sector.

In this example, let’s assume the best offer our new professional can find to refinance their $250,000 over five years is 5.5%. That’s 1.3% lower than their federal loans. That sounds like a lot, but how much savings does that represent? It's about $1,800 per year.

Once again, I do not mean to deride $1,800. I’m just saying that for someone making $200,000, $300,000, or $400,000, it doesn’t move the needle that much over a 3-5 year period. And, in the case of federal student loans, that $1,800 is acting as a pretty inexpensive insurance policy should your financial plan change during those five years (move, change jobs, get married, get divorced, have a baby, get disabled, etc.).

More information here:

The Benefits of High Rates on Cash

 

Credit Card Optimization

While we are talking about percentages, please forgive me for this brief, semi-related tangent.

I’m baffled by the lengths people will go to and the complexity they are willing to add to their lives by having eleventeen credit cards to get 3% back on gas, 4% back on restaurants, and 5% back from Home Depot vs. just having a single 2% cash back credit card. That extra 1% on gas or 2% on restaurants is not the difference between winning and losing the single-player game of personal finance.

Now, if optimizing every percentage point in every area of your financial life is a hobby that brings you joy, I love that for you, and I would never ask you to give up something you enjoy. I’m just gently pointing out that if you are doing it because you think it has a material impact on when you will reach financial independence, it’s likely not helping accomplish that goal. There are far more impactful hobbies and side gigs than saving 1.5% a year on pad thai.

In short, don’t fight small. Fight the fights that matter and leave the rest behind.

 

When Interest Rates Do Matter

Don’t fight small; fight big! Let’s talk about when to fight back against those bankers Einstein warned are here to enslave us with their interest rates.

 

Mortgages

A house is the most expensive thing most of us will ever buy. If ever there was a purchase to be hyper-fixated on its impact to your financial plan, it’s this one. Justifiably, the element of housing most people think about is the purchase price of the home. This is obviously important, and WCI has offered up several posts, podcasts, and rules of thumb when it comes to the variable of purchase price. Perhaps the rule easiest to remember is: don’t borrow more than 2x your annual income for a house. This is good advice.

The purchase price is just one factor in housing costs. Property taxes, insurance, maintenance, HOA fees, etc., are also significant, but those are largely not within our control. After the purchase price, the mathematical factor most within our control is the interest rate, and its impact is enormous. Even small changes can make a very large difference given the amount of money being borrowed and the duration over which it is paid back.

Consider a 30-year, $800,000 mortgage:

At 7%, the total interest paid after 30 years is $1.116 million. At 6%, the total interest paid after 30 years is $926,700. That’s a 30-year savings of ~$190,000 compared to the 7% loan. At 5%, the total interest paid after 30 years is $746,700. That’s a 30-year savings of ~$370,000 compared to the 7% loan and a savings of $180,000 compared to the 6% loan.

Now we are seeing where Einstein was coming from. But remember his quote wasn’t just, “He who doesn’t understand {compound interest} pays it.” It was also, “He who understands it, earns it.”

If we were to put that monthly savings to work in an investment account earning a modest 5% annualized, what would the impact be? On the 6% loan, after 30 years, the homeowner would have an additional $438,000. On the 5% loan, after 30 years, the homeowner would have an additional $855,000.

Total difference in wealth for the 6% mortgage owner = $190,000 + $438,000 = $628,000 Total difference in wealth for the 5% mortgage owner = $370,000 + $855,000 = $1.225 million

E = M[ucho]C[ash]2. Preach Albert!

You might be saying, “Fun numbers experiment, Tyler, but I don’t get to choose the interest rate on my mortgage. What do you mean this is within my control?” It's true you don’t get to pick your interest rate like a shirt at Target, but you have far more ability to shop for deals than you may realize.

First, you don’t have to buy a house when interest rates are “high.” Renting is a completely reasonable housing plan and often the right one for many. Most of the urgency to buy a home is self-imposed, and being willing to ride out periods of higher rates may prove prudent. So can waiting for your credit score to improve or to establish a couple of years of income in a new job which can result in lower rates.

When you decide to buy a home, every coupon-cutting, deal-hunting, flea-market negotiating bone in your body should be primed and ready to drive down your interest rate. Far too often, people get their mortgage by asking their realtor who they recommend, calling that person, and accepting the first rate that is offered by one single mortgage broker or, worse, one single bank.

I’m astonished at the number of people in our country who are willing to sleep overnight in a snowy Best Buy parking lot to save $500 on a TV but who won’t take a couple of hours to shop far and wide to save $100,000 on their mortgage.

At 40 years old, I have purchased three homes (all primary homes; I find real estate investing radically overhyped and mathematically inconsequential for most, but that is a WCI fight for another day). In each case, the interest rate I ended up with was at least 1% lower than the initial offer presented to me.

After gathering the contact information for 20-30 mortgage brokers, I sent them each an email saying, in effect,

“I apologize in advance for what it will be like to work with someone like me. I am a personal finance enthusiast who is in rabid pursuit of the best deal I can find on my mortgage for the property 1234 Frugal Lane, Anytown USA. As a high earner in a very stable healthcare profession, I expect to be offered your very best rate. I also will not be paying any loan origination fees, points, or for services you can cover in order to earn my business; i.e. appraisals, inspections, etc. Your company will be competing with at least 20 others to provide the lowest rate and lowest fee option on this loan. I will be 100% transparent with you about the other offers I receive, and you will have the option to match or beat any offer. I will be taking the next 10 days to field and discuss the offers. All interested parties will have their best and final offer due on Monday the 15th at 5pm Eastern. I look forward to working with you.”

Admittedly, this has been a hectic 10 days in each instance. There are a lot of emails, phone calls, and dealing with various documents. The 20-30 contestants get whittled down pretty quickly to the five or so who want to join me in the fantasy suite of savings and who are really devoted to getting that final rose.

It’s taxing work and hearts are broken, but by my account, it has and will save me about $300,000 across those three homes. That’s a pretty good side hustle. I make a little less than $100 per hour as a financial planner, and I think I make about $10,000 per hour as a mortgage negotiator. That $300,000 in savings has been and will continue to be invested, resulting in ~$2 million of additional wealth when our current home is paid off in December 2036. It’s the Avogadro’s number of personal finance.

Fight big. Win big when and where it matters most. Don’t let those bankers capture you with their productivity-killing interest rates when the stakes are highest.

More information here:

Here’s How Much We Make, Save, and Spend as ‘Moderate Earners’

 

Cars

If a house is the most expensive thing we ever buy, the next most expensive things for most of us are cars. Unlike a house that typically holds its value or hopefully appreciates in value, cars do not. Over time, they depreciate to $0.

Due to the total amount we will spend on cars in our lifetime, the same Einsteinian rules apply here. The difference with cars is that the interest rate we pay for this expense should (almost) always be 0% because, in a well-functioning financial plan for a working professional, we should strive to buy our cars with cash.

This is fairly easily done with the use of “squirrel funds.” For years, I have had an automatic monthly transfer set up from my checking account to my high-yield savings account which gets deposited into different “buckets.” I “squirrel” away money for large future expenses that I know will happen; I just don’t know precisely when the expenses will show up or exactly how much they will be. I have buckets for Home Repairs/Upgrades, Healthcare, Cars, College (529s are a type of squirrel fund), Weddings, etc.

To figure out how much to transfer to the car bucket, I simply take the number of cars I will be replacing in our household (I’m not replacing the kids’ cars; they can buy their own once the high school beater dies after college), the number of years I intend to drive those cars, and the expected replacement cost. That gives me an amount to automatically transfer to my car squirrel fund each month.

We have two cars in the household, anticipate driving them for 15 years, and expect the replacement cost to be $25,000 (we buy boring, used cars). That's (2 x $25,000/15)/12 = $278 per month. Arguably, I could save less since the money is earning 4.25% (pre-tax) in my high-yield savings account but that makes the math too clunky, so I just keep it simple.

Then when it’s time to replace a car, we buy it in cash with the money already squirreled away in its duly appointed bucket.

I have written previously about how buying cars with cash and driving them for a long time is a vastly underrated way of building wealth. Paying 0% and earning 4+% on the second-largest expenses of our lives is a good way to beat the bankers. I like to believe earning interest on my car savings and not paying it warms the quarks in Albert’s ghostly heart.

Our approach to cars is estimated to result in $3.3 million more dollars over our lifetime compared to the average American’s approach to car ownership. That, along with an extra $2 million from negotiating our mortgage rates, illustrates Einstein’s’ point and shows the value of fighting/winning big.

More information here:

My 27-Year-Old Car Will Make Me a Multimillionaire

 

A Word About Adjustable Rate Loans

I wonder if adjustable rate loans are the most misunderstood and most underutilized financial instrument in our country. People HATE adjustable rates, and I understand why. We like certainty, we prefer knowing what the payment will be, and we enjoy the peace of mind those fixed rates offer. If that is you and you know you are paying more for this peace of mind, that is totally reasonable. But most people are not making this choice intentionally.

I believe the most rational way to think about a fixed-rate loan is to consider it as an insurance product. You are buying insurance against rising rates and transferring the possibility of that risk away from yourself and to the lender. Like any insurance product, this costs you something.

How much? Just look at the difference between what the lender is offering on an adjustable rate vs. a fixed rate. For example, a 10/1 ARM is an Adjustable Rate Mortgage (ARM) that has a fixed rate for 10 years. Then, the rate can adjust based on current rates 10 years from now, and the rate can adjust once per year. It’s not unusual for the ARM to have a 1%-2% lower rate to begin with than the fixed rate. (Note, this assumes “normal” economic conditions, not the inverted yield curves we have seen the last couple of years).

As discussed above, 1%-2% on a mortgage can add up to a lot of money over time. In other words, a fixed interest rate can be pretty expensive insurance.

Jim has previously talked about how we should only insure against financial catastrophe, including death (term life insurance), disability (own occupation long-term disability insurance), liability (auto, malpractice, and umbrella insurance), injury/illness (health insurance), etc. We should not insure against anything that is not a catastrophe (scratching our cell phone screen, our refrigerator going out, travel insurance, etc).

This begs the question: is a future interest rate increase going to represent a financial catastrophe? Maybe, but probably not.

There are four things that can happen to interest rates, and in three out of the four scenarios, the adjustable rate comes out ahead.

Rates go down: If you start with 5% instead of 7% and rates go to 4%, you win (and, as a bonus win, you don’t have to pay five figures to refinance your mortgage). Rates stay the same: If you start with 5% instead of 7% and rates don’t change, you win. Rates go up slowly: If you start with 5% instead of 7% and rates slowly climb to 6, 7, or 8% after your rate adjusts, you win. You win because you have been paying a lower rate for some period of time and the principal on which you are paying a slightly higher interest rate in the future is on a lower balance which still results in an overall win. Rates go up quickly: If you start with 5% and rates rise quickly to 9% or 10% after your rate adjusts, you likely didn’t win. You will have wished you had a 7% fixed rate.

What if you are on board with the logic described here and are considering an adjustable rate but you are worried about that fourth situation? The key is to determine if you can afford the worst-case scenario. In other words, is the worst possible outcome actually a financial catastrophe, and, thus, do you really need this insurance product (the fixed rate)?

When it comes to ARMs, you will see in the loan document how much the rate can increase each year and what the maximum rate can be. You’ll see products described like this: 7/6 ARM 3/1/5. The first number refers to how long the rate stays fixed at the beginning of the loan—in this case, it's seven years. The second number is how often the rate adjusts after the fixed period—every 6 months.

The last three numbers listed are the caps and floors. In this case, your rate won’t go up or down more than 3% on the initial adjustment. The rate can’t increase or decrease more than 1% with each adjustment after the first. Finally, your rate won’t rise or fall more than 5% over the life of the loan. Make sure you know all your interest and payment caps when considering an ARM.

Do the math and ask, can I afford the house payment at 11% and still reach my goals? Or, if the rate adjusts to a problematic level, am I willing and able to cut other expenses to compensate?

If you didn’t buy “too much house,” you may be surprised to learn that the answer is yes. Thus, no catastrophe and no need for interest rate insurance. If the answer is no, buy the insurance and get the fixed rate.

Ultimately the decision is up to each person, and how we all value peace of mind will result in different “right” answers. There are no wrong answers, and the mathematically right answer will only ever be knowable in hindsight. My invitation is simply to make this decision—and every decision—intentionally.

 

TL/DR

Context is everything. Put the decision in context and let us devote our ever-dwindling executive bandwidth in proportion to the actual impact of the decision.
Don’t fight small. Bask in the sublimity of simplicity. Go hiking with your loved ones, and occasionally indulge in the Chandelier Bars of life. Don’t chase small (1%-2%) interest rate differences on your cash. Feel free to pay off that mortgage instead of sitting on cash. It will feel so good, and if you regret it, let us know because you are likely the first. Cancel all but one or two of your credit cards. No one ever got rich saving an extra 3% at Lowe's. Fight big. Win big. Harness your Brownian motion for the contexts when it really matters. Be the most annoying, intransigent person to ever purchase a home in the history of mankind. Make sure mortgage brokers are screenshotting your conversations and making fun of your insanity with their other broker friends. Other than a house, don’t buy stuff you don’t have the money for. Save up the money, let it earn interest on your behalf, and then stick it to the bankers who are looking to ensnare and repress you with their interest rates. Fear not the adjustable rate; it turns out in your favor more often than you may realize. You may not need the insurance product that is a fixed rate loan. Learn about how time can never be linear in the presence of gravity and feel all your cares slip away across the event horizon of the space-time continuum.

How do you use interest rates to your advantage? Are there other times when interest rates matter and when they don't? What are your thoughts on ARMs? Comment below!

The post When Interest Rates Matter and When They Don’t appeared first on The White Coat Investor - Investing & Personal Finance for Doctors.