Mortgage/Home For Young Investors

[moda0306]

I'm 26, and I just bought a home with a 90% LTV 30 year 5% mortgage.  Here's my dilemma:

I feel, at this point in my life, I'm over-hedged for inflation, so if I were to go into a PP, I feel like I should be less exposed to Gold and more to LT Treasuries.  I know homes aren't the best inflation hedge by any means, but to own an asset with a 30-year fixed mortgage seems like a pretty solid hedge when it represents a big chunk of my net worth....

So ok, instead of 25% gold I go 5-10%, theoretically, and expand my exposure to LT Treasuries... well here's my problem with that:

I am paying 5%, and could maybe refi to 4.1%, but even then, that's still higher than 30 year treasuries are paying, so I feel like I should pay down a decent chunk of my mortgage before investing in LT Treasuries (Yes, I realize, unlike my mortgage, LT Treasuries can also go up in value if interest rates drop, but it's still hard to invest like that).

So now I'm stuck with a modified PP where I have very little gold & LT Treasury exposure until I pay down a decent portion of my mortgage.. how much?  I don't know.


I just don't think that people who have just taken out a mortgage at any less than 20% down are in a position to be considering a PP allocation appropriate given their exposure to deflation by having a 30 year fixed mortgage.  Has anyone ever analyzed this?

[Storm]

I don't think you should consider your home an investment or inflation hedge at all.  The reason is that it's very possible to have deflation in real estate (which we're still going through now) and inflation in other places of the economy.  Gold is probably the best inflation hedge because it is also money, and is very liquid.  A home is neither money, nor liquid.

Harry Browne had very good reasons why he chose gold instead of REITs or other real estate for use as an inflation hedge.  I would hate to see you change the balances of his well thought out portfolio, and end up looking back after 5 or 10 years with some losses.  Just as a hypothetical - what if we have some bad inflation over the next 10 years, but real estate stays relatively flat because we are still deleveraging from the excess valuations of the last decade?  You might end up in a situation where your house is worth a lot less than what you paid for it, your LT bonds have gone way down in value, and you're showing a net negative return for the last decade (after inflation).

Of course, you could turn out to be lucky and predict that deflation takes hold over the next decade, and since you're overweight LT bonds, your portfolio has great returns, but the PP isn't about luck or prediction - it's about a mix that performs well in all economic climates.

[BobS]

I did an analysis for a friend of mine who was saying that his house was still worth quite a bit after paying 20 yrs on his mortgage and doing
improvements.  After taking away interest, maintenance, inflation, etc. he's ahead 2%.  Other studies show that if one is lucky, the average
return on a primary residence is 1%.

A primary residence is a home and a commodity.  The structure itself is a declining asset, while the land always remains the property of the
sovereign state that lets you pretend you own it and will happily relieve you of it should you stop paying your taxes or should they want to put
a shopping mall, road, or green space where you happen to live.

[Saluki]

Keep in mind that the interest on your mortgage is likely tax deductible.  So if you can invest in LT Treasuries in a tax deferred account, you could easily come out ahead by going with treasuries.  For example, if your tax bracket is 25%, the after tax cost of your mortgage is (1-.25)*5% for a net cost to you of 3.75%. 

[moda0306]

Saluki.... Touche!

[moda0306]

That really changes things, and being a tax guy, I can't believe I didn't think of that...

[walkerjks]

I don't include my home in the investment portion of my portfolio at all (much less as an inflation hedge).  yes, you do have some equity in your home.  The house is simply a place to live.  And a mechanism to have increased cash flow once it is fully paid off.  Now if things get desperate in retirement, I would absolutely consider getting a reverse mortgage - so in certain cases, the home does become part of my "investments", but I see no reason to include it in my asset allocation. 

[Wonk]

I'm also in the camp that sees a house outside of an investment.  If you live there, it's not an investment since you are consuming the yield.  I think it's important for people to also keep an eye on opportunity cost.  Paying off a (post tax) 3.5% mortgage instead of investing in higher expected return investments can be good for peace of mind, but might also leave you behind the curve in long term capital appreciation.  I do think it's wise to have at least 80% equity in a personal residence, though.

[moda0306]

I'm not so much saying that my house is an "investment," but if 1) your largest single expense is your rent/mortgage, and 2) you are protected from inflation for at-least that cost by having a 30-year fixed mortgage, then you have different exposure to inflation that someone renting.

I am not saying "own a house instead of gold" as much as "if you have a house with a 30-year fixed mortgage you're insulated somewhat from inflation."

I think that gold is much more important for a young person to own if they rent an apartment than if they own a house witha 30-year fixed mortgage, whether you want to call the house an investment or not, it is at least an asset you use to avoid being exposed to inflating rental costs.  Your risks are different than someone renting year-by-year.  Shouldn't your portfolio change as your risks change? 

Between my wife and I, when we rented, 19% of our after-tax (including payroll) income went to rent.    That's a pretty huge expense to ignore your exposure to inflation.  I eliminated that exposure when I bought a house.  So if 20% of my expenses are now insulated from inflation, I think I should consider a different portfolio (remember this is money you "can't afford to lose") than if that 20% was still exposed.

One could argue I was dumb to buy a house instead of gold, but that's in the past (plus her dad is a carpenter and helps with all sorts of projects).  My risks are different now that I own a house, whether you want to call it an asset, liability, mistake, investment, etc.  I think the PP is great, but maybe it should be skewed a bit to every persons exposure to the different macroeconomic trends.

[Sleeping at the Wheel]

I'm 26, and I just bought a home with a 90% LTV 30 year 5% mortgage.  Here's my dilemma:

I feel, at this point in my life, I'm over-hedged for inflation, so if I were to go into a PP, I feel like I should be less exposed to Gold and more to LT Treasuries.  I know homes aren't the best inflation hedge by any means, but to own an asset with a 30-year fixed mortgage seems like a pretty solid hedge when it represents a big chunk of my net worth....

Sorry to dig up this ancient thread, but this is a really good point and none of the responses really answered it.

A fixed rate mortgage is an inflation hedge. (Assuming that the fine print on the mortgage checks out and the bank can't just call it in.)

If the original poster invests according to the standard PP allocation, then he will prosper more in an inflationary setting than in a deflationary setting. The performance of his PP will be even, but his mortgage will be more of a burden in the case of deflation than in the case of inflation. Isn't the point of the PP to prevent this sort of imbalance? Isn't the point of the PP to make the investor neutral about the economic environment?

If on the other hand the original poster went for something like 50% bonds, 25% stocks and 25% cash, then his overall situation would have a better balance. In a deflationary setting, his portfolio would do very well, compensating for his then-troublesome mortgage. In an inflationary setting, his portfolio would do poorly, but that would be compensated by the relief of his mortgage.

It would be interesting to see some discussions about how to adjust the PP to blend with the rest of one's assets and liabilities. In many cases, these other assets and liabilities outweigh the size of one's portfolio.

[stone]

I'd guess that the best deflation protection  for someone with a mortgage would be to pay off the mortgage? Not from a tax point of view perhaps but surely from a "what if" point of view. We bought our house with a 95% mortgage but had one of those "money pit" current account mortgages where your mortage is the same as your current account. Then didn't think about savings until that account was in credit.

[Storm]

As I think was mentioned earlier, it is very possible to have asset deflation and currency devaluation at the same time.  In this case, the housing market continues to deflate, while money printing devalues the currency relative to gold.

All you have to do is look at the 50%+ rise in gold over the last 2 years and ask yourself what housing has done in that same time period.

I also believe HB said "housing is a consumption item, not an investment."

[Sleeping at the Wheel]

I'd guess that the best deflation protection  for someone with a mortgage would be to pay off the mortgage? Not from a tax point of view perhaps but surely from a "what if" point of view. We bought our house with a 95% mortgage but had one of those "money pit" current account mortgages where your mortage is the same as your current account. Then didn't think about savings until that account was in credit.

Sure - but paying off a mortgage has all sorts of other disadvantages. In many cases it makes sense to keep the mortgage and compensate in the portfolio.

[Sleeping at the Wheel]

As I think was mentioned earlier, it is very possible to have asset deflation and currency devaluation at the same time.  In this case, the housing market continues to deflate, while money printing devalues the currency relative to gold.

All you have to do is look at the 50%+ rise in gold over the last 2 years and ask yourself what housing has done in that same time period.

I also believe HB said "housing is a consumption item, not an investment."

It's not the house which is the inflation hedge, it's the mortgage. The mortgage is more of a burden during deflation than during currency devaluation.

The PP is supposed to keep its purchasing power in all environments. During deflation, a mortgage grows in terms of its "purchasing cost".

I'm not sure how well I am explaining this but the point is that if you have a mortgage + PP, you will hope for inflation and fear deflation.

[TripleB]

I do think it's wise to have at least 80% equity in a personal residence, though.

Wonk,

What is your rationale behind this statement? My belief is that one should have as little equity as possible in their personal residence. As mentioned above, the return on investment is 1% to 2%. Thus every dollar you have in equity of the home is a lost opportunity cost of 5% to 8% depending on how good you expect the PP to return going forward.

Also, every additional dollar of equity you have in the home reduces the built-in "put option" of a mortgage in a non-recourse state. If you have 10% equity in the home, and the value drops 50%, and you decide to walk away, you lost your 10% of the initial value. If you have 20% equity in your home, and same situation happens, you lost twice as much money.

You also have reduced flexibility because walking-away may require an additional 30% drop in value in order to allow the value of the "put" to be "in the money." Note that the 30% number I cited is not 30% of the home value but 30% of the drop in value. Thus, imagine a $100k home with $10k equity in it. The home drops to $70k. You are $20k underwater and decide to exercise your put-option by walking away.

Now imagine the same situation but you have $20k equity in the home. The drop in home value would have to be ~30% greater (than the previous examples $30k drop), in order to get $20k underwater with 20% equity. i.e. The $100k home with $20k of equity would have to drop $40k, down to $60k, to give a $20k "value" of the put option.

Thus, the greater equity you have in the home, the decreased value of the put option. Since all options have value, that one may estimate using Black Scholes, the greater equity you have, the less the asset is worth. i.e. You're better off with $10k in a high yield savings account plus $10k of equity in a $100k house and having a $5k option value to walk-away, rather than $0 in a high yield savings plus $20k of equity and a $2k option value to walk away.

This discussion ignores PMI, that typically kicks in at under 20% equity. Depending on the cost of PMI, which I've seen friends who have 10% of their monthly mortgage payment going to PMI, then it may be worthwhile to put exactly as much equity into the home as necessary to avoid PMI.

[clacy]

I did an analysis for a friend of mine who was saying that his house was still worth quite a bit after paying 20 yrs on his mortgage and doing
improvements.  After taking away interest, maintenance, inflation, etc. he's ahead 2%.  Other studies show that if one is lucky, the average
return on a primary residence is 1%.

A primary residence is a home and a commodity.  The structure itself is a declining asset, while the land always remains the property of the
sovereign state that lets you pretend you own it and will happily relieve you of it should you stop paying your taxes or should they want to put
a shopping mall, road, or green space where you happen to live.

I completely agree.  I think investment value of home ownership is way overvalued.  My in-laws sold their primary residence in 2004.  They had lived there for almost 20 years.  They saved every single receipt from repairs and improvements.  They calculated their payments and of course knew their original purchase price as well as the price for which they sold it.  It was astounding.  They sold it for a price within a few thousand dollars of what they paid out over the 20 years.  Except for their tax deductions, they were pretty much flat on the purchase/sale of their home.

With that said, I am a home owner and will continue to be for at least the next 30 years (I'm 36).  But I look at my home as strictly a place to live and do not view it as an investment.  I am also a believer in paying down/off your mortgage.  It is nice to have another layer of security built in to your financial situation and I know that if I own my home outright, I have less than a 1% chance of ever being homeless!

[Wonk]

I do think it's wise to have at least 80% equity in a personal residence, though.

Wonk,

What is your rationale behind this statement? My belief is that one should have as little equity as possible in their personal residence. As mentioned above, the return on investment is 1% to 2%. Thus every dollar you have in equity of the home is a lost opportunity cost of 5% to 8% depending on how good you expect the PP to return going forward.

You're absolutely right--I'm glad you brought this to my attention.  I meant to say "20% equity" instead of 80%, so it was a typo.  My suggestion for 20% equity is in reference to PMI.  Aside from that 20%, I don't favor paying off a mortgage unless the equity represents 10% or less of your net worth.