Resurrecting the debate of Leverage using a house

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DragonJoey3
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Resurrecting the debate of Leverage using a house

Post by DragonJoey3 » Fri Mar 11, 2016 12:48 pm

So I know this has been mentioned here before in another thread, and I am also aware the one of Harry Browne's rules is to not use leverage.  However, I am about to take out a mortgage at around a 4% interest rate.  I am still in the accumulating phase of the PP, and at the moment I am putting about 40-60% of my income per year into it.  Obviously this savings rate says something about my ability to pay down the mortgage quite quickly.

The last time I saw an analysis done on this board about whether to invest vs pay down mortgage the analysis was for 5% mortgage rates and was more around the idea of "pay cash for a house, or invest?".  I have two questions for the group:

#1. Should I direct all available cash flow at prepaying the mortgage, or into the PP, or some mix of both?

#2. As Harry was so against leverage to buy assets, should I even withdraw money from investments (taxable) to bolster my down-payment further?

Having a mortgage and pouring money into investments at the same time feels a lot like leverage to me, but at the moment I wouldn't have enough touchable assets (outside 401k/IRA) to pay off the home completely without penalties.

Thoughts?

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Re: Resurrecting the debate of Leverage using a house

Post by Pointedstick » Fri Mar 11, 2016 12:55 pm

It depends on you, really, and specifically, your preference for liquidity vs a lack of debt. I made the decision to accumulate enough in cash and skip the mortgage, but if you're saving more than 50% of your income, then you could pay down the mortgage very quickly and it's not too different. Do whatever makes you feel the most comfortable.
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Re: Resurrecting the debate of Leverage using a house

Post by moda0306 » Fri Mar 11, 2016 1:51 pm

DragonJoey3 wrote: So I know this has been mentioned here before in another thread, and I am also aware the one of Harry Browne's rules is to not use leverage.  However, I am about to take out a mortgage at around a 4% interest rate.  I am still in the accumulating phase of the PP, and at the moment I am putting about 40-60% of my income per year into it.  Obviously this savings rate says something about my ability to pay down the mortgage quite quickly.

The last time I saw an analysis done on this board about whether to invest vs pay down mortgage the analysis was for 5% mortgage rates and was more around the idea of "pay cash for a house, or invest?".  I have two questions for the group:

#1. Should I direct all available cash flow at prepaying the mortgage, or into the PP, or some mix of both?

#2. As Harry was so against leverage to buy assets, should I even withdraw money from investments (taxable) to bolster my down-payment further?

Having a mortgage and pouring money into investments at the same time feels a lot like leverage to me, but at the moment I wouldn't have enough touchable assets (outside 401k/IRA) to pay off the home completely without penalties.

Thoughts?

DragonJoey
So do you already own the home, or are you "about to take out a mortgage" for a home you are purchasing?

Also, as a quick aside, are you sure 4% is the best rate you can get?  I'm seeing 3.7% for a 30 year on bankrate.  2.8% for a 15 year!!!
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Re: Resurrecting the debate of Leverage using a house

Post by technovelist » Fri Mar 11, 2016 8:10 pm

Is this a recourse or a non-recourse mortgage?

If it's the former, I agree that you have to consider the downside of leverage, i.e., that if the house price drops you are on the hook for the difference. In that case, I would prefer paying it off as quickly as possible, if not withdraw from assets to pay it off even faster.

But if it's the latter (as in my case), that is not a problem, so I don't see much downside other than the possible negative spread between the mortgage rate and your actual investment return rate.
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Re: Resurrecting the debate of Leverage using a house

Post by Tyler » Fri Mar 11, 2016 8:49 pm

Recapping my personal rules of thumb:

1) If you can't afford to pay cash for the home, you can't afford it.  Don't twist logic to justify your mortgage as "investing the difference" when in reality you're just signing up for a bunch of debt that exceeds your investments.  Be honest with yourself, and consider renting or buying a less expensive home.  Your future self will thank you later.

2) If you can afford to pay cash for a house and choose to do so -- great!  Enjoy being debt free with no rent.  It's awesome. 

3) If you can afford to pay cash for a house and choose to get a mortgage -- great!  Perhaps you can make more money in the long run by investing that money instead.  At that point it's about finding the right balance of home equity and investments.  I like the general rule of maintaining your home equity (ignoring home value appreciation) at 20% of your net worth.  So if you pass rule #1 and have $200k to buy a $200k home, put 20% down.  That will leave you with a nice home, a well-funded investment account of $160k, and plenty of financial flexibility.  If your investments do very well and/or your income increases, put more towards the mortgage to keep the equity at 20%.  And when your total original $200k purchase price eventually drops below 20% of your net worth in the future, go ahead and pay off any remaining mortgage.  You can stop playing the interest rate arbitrage game as you've clearly already won.

Of course there will always be exceptions and RE markets all vary, but IMHO following these general rules would keep a lot of people out of trouble.  The house issue drives lots of otherwise very smart people to make completely irrational financial decisions. 
Last edited by Tyler on Fri Mar 11, 2016 9:49 pm, edited 1 time in total.
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Re: Resurrecting the debate of Leverage using a house

Post by Desert » Fri Mar 11, 2016 9:12 pm

Tyler, I like your rules, particularly #1 and #2. 

One thing I do is mentally separate the mortgage from the house.  You own a house, and you hold a negative bond.  Paying off the negative bond doesn't affect one's exposure to real estate; that exposure was locked in on the closing day.  I think the key is liquidity, as moda has pointed out a few times.  If one can pay off the mortgage, and maintain a sufficient liquidity buffer, it's probably going to be a decent decision.  Using the OP's numbers, I would have a very tough time holding a 4% negative bond while investing in a combination of cash and LTT yielding less than 2%.  Yes, there can be tax advantages that reduce the 4% to a lower effective rate, but typically the whole annul mortgage interest amount is not deductible, only that which exceeds the standard deduction. 

Tech has a good point regarding recourse vs non-recourse states, but I personally throw out that consideration out since I don't plan to walk away from a mortgage.  But it is a consideration to think through carefully. 

Another mental exercise to try:  Imagine you have your house paid off; now imagine getting a HELOC to invest in the HBPP.  Would you do that?  I wouldn't.
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Re: Resurrecting the debate of Leverage using a house

Post by technovelist » Fri Mar 11, 2016 10:35 pm

Desert wrote: Tyler, I like your rules, particularly #1 and #2. 

One thing I do is mentally separate the mortgage from the house.  You own a house, and you hold a negative bond.  Paying off the negative bond doesn't affect one's exposure to real estate; that exposure was locked in on the closing day.  I think the key is liquidity, as moda has pointed out a few times.  If one can pay off the mortgage, and maintain a sufficient liquidity buffer, it's probably going to be a decent decision.  Using the OP's numbers, I would have a very tough time holding a 4% negative bond while investing in a combination of cash and LTT yielding less than 2%.  Yes, there can be tax advantages that reduce the 4% to a lower effective rate, but typically the whole annul mortgage interest amount is not deductible, only that which exceeds the standard deduction. 

Tech has a good point regarding recourse vs non-recourse states, but I personally throw out that consideration out since I don't plan to walk away from a mortgage.  But it is a consideration to think through carefully. 

Another mental exercise to try:  Imagine you have your house paid off; now imagine getting a HELOC to invest in the HBPP.  Would you do that?  I wouldn't.
I don't plan to walk away on my mortgage either, and have no reason to believe that I will need to do so.

But I could do so without violating any contract or other agreement I have made, so I don't worry about the leverage that would otherwise bother me.

E.g., if there is a deflationary crash that reduces the price of my house to 1/10th of what it is now, would I still pay off the mortgage in seriously revalued dollars? Probably not, because I wouldn't have to.
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Re: Resurrecting the debate of Leverage using a house

Post by Desert » Fri Mar 11, 2016 10:41 pm

technovelist wrote:
Desert wrote: Tyler, I like your rules, particularly #1 and #2. 

One thing I do is mentally separate the mortgage from the house.  You own a house, and you hold a negative bond.  Paying off the negative bond doesn't affect one's exposure to real estate; that exposure was locked in on the closing day.  I think the key is liquidity, as moda has pointed out a few times.  If one can pay off the mortgage, and maintain a sufficient liquidity buffer, it's probably going to be a decent decision.  Using the OP's numbers, I would have a very tough time holding a 4% negative bond while investing in a combination of cash and LTT yielding less than 2%.  Yes, there can be tax advantages that reduce the 4% to a lower effective rate, but typically the whole annul mortgage interest amount is not deductible, only that which exceeds the standard deduction. 

Tech has a good point regarding recourse vs non-recourse states, but I personally throw out that consideration out since I don't plan to walk away from a mortgage.  But it is a consideration to think through carefully. 

Another mental exercise to try:  Imagine you have your house paid off; now imagine getting a HELOC to invest in the HBPP.  Would you do that?  I wouldn't.
I don't plan to walk away on my mortgage either, and have no reason to believe that I will need to do so.

But I could do so without violating any contract or other agreement I have made, so I don't worry about the leverage that would otherwise bother me.

E.g., if there is a deflationary crash that reduces the price of my house to 1/10th of what it is now, would I still pay off the mortgage in seriously revalued dollars? Probably not, because I wouldn't have to.
Yeah, I understand.  I didn't mean to sound judgmental on that point.  I do think it's worth considering carefully.  And I agree it dramatically affects the risk/reward of the negative bond exposure. 
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Re: Resurrecting the debate of Leverage using a house

Post by EdwardjK » Sun Mar 13, 2016 12:07 pm

Tyler wrote:
1) If you can't afford to pay cash for the home, you can't afford it. 
Tyler, I completely disagree with your rule #1.

Putting aside whether it is best to rent or purchase, mortgage financing  is the best way to purchase a home.  This is especially true at today's historically low interest rates.

I view debt as a tool that allows me to purchase something I need with the added benefit of the Federal government helping with the payments through a tax deduction.  There is no other means to purchase a home with this benefit. 

And using a mortgage makes even more sense at today's historically low interest rates.  My father purchased our family home in 1964 with a 5% interest rate.  Compare that to my first mortgage at 14.25% and today at 3%.

I am retired today and still have a mortgage.  Sure, I can pay it off if I wanted to, but I figure I can earn more than 3% on the cash I would otherwise use to pay off the mortgage.

Lastly, several sites say the average retirement savings for people over 55 is around $200,000.  Coincidently, $200,000 is also about today's average home price.  Your rule suggests that a person can finally buy a home when they want to retire, and then spend their life savings doing it. 

Not a great plan.

The only issue a person should consider before entering into a mortgage is whether they will have continued income to make the payments.  But, I guess a rent payer would have the same concern.
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Re: Resurrecting the debate of Leverage using a house

Post by Tyler » Sun Mar 13, 2016 1:28 pm

EdwardjK wrote: I am retired today and still have a mortgage.  Sure, I can pay it off if I wanted to, but I figure I can earn more than 3% on the cash I would otherwise use to pay off the mortgage.
Note that I don't have a problem with mortgages but with excess debt.  You already pass my rule #1.  Nice work!
EdwardjK wrote:Lastly, several sites say the average retirement savings for people over 55 is around $200,000.  Coincidently, $200,000 is also about today's average home price.  Your rule suggests that a person can finally buy a home when they want to retire, and then spend their life savings doing it. 
Well, the financial choices of the average person are abysmal.  I believe that if people didn't rush to buy the most house they can qualify for, the average retirement savings would be way more than $200k.  Living with non-stop debt payments equal to a third of your income is an avoidable choice, and doing that while you have no other savings can hamstring your accumulation ability for life.  Take the time to save up before getting that mortgage, and you'll be in a much better position in the long run.  Rules #1 and #3 are really about balance. 

I personally believe that many people twist the mental mortgage math simply to justify jumping the gun on consumption.  Rule #1 is mostly about being honest about what one can afford vs. what is only possible with large amounts of debt.  Once you can truly afford it either way, the choice between a getting a mortgage and paying cash is a personal choice where there's no bad answer. 
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Re: Resurrecting the debate of Leverage using a house

Post by dragoncar » Sun Mar 13, 2016 1:37 pm

EdwardjK wrote:
Tyler wrote:
1) If you can't afford to pay cash for the home, you can't afford it. 
Tyler, I completely disagree with your rule #1.

Putting aside whether it is best to rent or purchase, mortgage financing  is the best way to purchase a home.  This is especially true at today's historically low interest rates.

I view debt as a tool that allows me to purchase something I need with the added benefit of the Federal government helping with the payments through a tax deduction.  There is no other means to purchase a home with this benefit. 

And using a mortgage makes even more sense at today's historically low interest rates.  My father purchased our family home in 1964 with a 5% interest rate.  Compare that to my first mortgage at 14.25% and today at 3%.

I am retired today and still have a mortgage.  Sure, I can pay it off if I wanted to, but I figure I can earn more than 3% on the cash I would otherwise use to pay off the mortgage.

Lastly, several sites say the average retirement savings for people over 55 is around $200,000.  Coincidently, $200,000 is also about today's average home price.  Your rule suggests that a person can finally buy a home when they want to retire, and then spend their life savings doing it. 

Not a great plan.

The only issue a person should consider before entering into a mortgage is whether they will have continued income to make the payments.  But, I guess a rent payer would have the same concern.
I'd use a broader interpretation of rule #1 (not endorsed by Tyler) that includes effective affordability.  For example, I once bought a home at 2x my annual salary.  I only had 20% saved, but my savings rate was 80%.  So in my mind, even though I didn't have the cash to buy it outright, I could effectively "afford" it. 

Was this riskier than a situation where I had 100% in savings?  Yes, I might have lost my job and ended up with an underwater house.  Of course I'm in a non-recourse state so my exposure was fairly small (6 months worth of savings).

However, I'd argue that given any normal analysis of affordability, the risk was very low.  It was worth jumping on a time-limited deal rather than wait another 2 years to buy a house.
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Re: Resurrecting the debate of Leverage using a house

Post by barrett » Sun Mar 13, 2016 1:42 pm

Tyler wrote: I personally believe that many people twist the mental mortgage math simply to justify jumping the gun on consumption. 
I think most people still look at real estate as a "great investment." Old ways of thinking die hard. I've tried talk to people about a house being a consumption item instead of an investment and they look at me like a I am out of my mind.
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