Rule #7 Leverage and Mortgages: Is it broken?

[craigr]

On the 16 Golden Rules Sticky, user MarkV wrote:

Rule #7: Don’t use leverage.
Using margin accounts or mortgages (for other than your home) puts you at risk to lose more than your original investment.

I have an 82 year old friend who followed this rule and the eviction from his home of 18 years will be next month.  

That statement, in its entirety, is simply not true.  

We all have seen the real estate market fall in the U.S., U.K., and now in China.  This exception to the rule was a mistake.  Don't you think it's time we corrected the error and removed the words (for other than your home) from this rule?

I thought the topic should be brought out to be on its own for others to comment on specifically.

[craigr]

I'm sorry to hear about your friend's situation.

Of course I didn't write the rules, but I largely agree with Browne's advice. A mortgage can be used safely for most but yes it has risks. The traditional metrics people use to determine whether they can afford a home are way too high. IMO. Of course, they are set by the banks and real estate industry to be somewhere around 30% of your estimated monthly income if I recall. This is probably not conservative enough. Yet, without a mortgage many young people just starting out cannot afford any type of home and many successful businesses could not have built their companies. So there is a balance.

With that said, I personally encourage people to hold no debt at all and to pay off mortgages as quickly as possible regardless of what rate they have. Making an extra payment a year (or more) can shave off significant amounts of interest and dramatically shorten the time it takes to own your home:

Extra Payments Calculator

The above advice assumes you paid off higher interest debt first (like credit cards).

So is there an exception to the rule? Well maybe there should be another rule added about keeping out of debt and getting out of debt as quickly as possible if you are able.

[KevinW]

I helped a family member do damage control on a similar situation, so your friend has my sympathy.  This stuff isn't pretty.

I agree with Dave Ramsey's home buying guidelines* ( http://www.daveramsey.com/article/how-m ... ou-afford/ ):

- pay off all debt and have an emergency fund** before buying a house
- ideally buy with 100% cash
- if using a mortgage, put at least 10% down
- use only a 15 year fixed rate loan
- keep payments below 25% of take home pay

I don't think Rule #7 is wrong, but I do think Browne should have elaborated on what constitutes an acceptable mortgage.  The rest of his advice is very conservative and guards against unexpected market events, so I think it's strange that he didn't dedicate a little space to this issue.

The hard part about these rules is that they say that a lot of people can't afford buying a house.  It isn't nice, but I think that's reality.  FWIW I've personally followed these rules, and while it can be uncomfortable to be renting when your friends, family, and government are encouraging you to buy, ultimately I think it's for the better.

* I definitely DO NOT agree with Ramsey's investing advice.
** As discussed on another thread, I think a separate emergency fund is unnecessary if you have an equivalent chunk of a Permanent Portfolio in a liquid account.

[SmallPotatoes]

A lot of people cannot afford to buy a home.  Have we all but forgot the recent real estate bust?

A 30 year mortgage is a HUGE financial burden for all but the most successful entreprenuers and tenured employees, but this is only my opinion.  Renting might be the best option for many Americans.

[Pkg Man]

* I definitely DO NOT agree with Ramsey's investing advice.

I'm a fan of Ramsey on most things but totally agree with you on his investing advice.  His belief in the ability of fund managers is totally misplaced, IMHO, and he completely ignores others investments - long term treasuries and gold.  But his admonition against debt is admirable, and reinforces what I was taught by my parents and grandparents.

[Libertarian666]

Aside from a car lease that I will pay off when it expires, and then own the car (at a total cost less than buying the car for cash in the first place), my only debt is a mortgage (amounting to about 7% of my net worth) that I could pay off next week if I wanted to.

Why don't I? Partly because it is "hyperinflation insurance" to hedge my cash position. If (when?) the Fed manages to destroy the dollar, that will take both my cash position and my mortgage with it. The other reason is that it is at 5%, and my compounded investment return over the last decade is about twice that, so why should I pay it off early?

[Pkg Man]

I don't necessarily think you should pay off a mortgage early, but avoiding other types of debt is more obviously the best approach. 

One thing about mortgages that I did not realize is that a fixed rate mortgage is basically a bet on inflation and could turn out badly in the event of a deflation.  This is why HB advocated a variable rate mortgage.  Not sure I agree with him on that, but I do understand the logic.

[craigr]

Any time you can get into a position where you are receiving interest instead of paying it that is a good thing.

I don't understand the advantages of variable rate mortgages though. With a standard fixed rate mortgage if rates go up due to inflation you just hold on and continue as before with the locked in lower rate. If rates drop, you refinance. It's a winning bet no matter what happens for a home owner which is why I don't own mortgage bonds for investing purposes.

Someone with no debt is always going to be in a better financial position than someone with debt. IMO. If you could pay off a house I'd do it and use the extra cash for other investing purposes. 

[Pkg Man]

I think HB was referring to a situation of deflation where home prices fall and you may not be able to refinance.  A variable rate mortgage would help in this scenario.  HB said that gold would protect you in the event of inflation.  But at times rates can go up by a sizable amount even when inflation remains tame and gold stays flat, so I personally would not want a variable rate.  I guess it also depends on what you think is the more likely scenario, inflation or deflation.  While we don't know for sure, I would rather make an inflation than deflation bet.  And if I really thought deflation was likely I might not even want to own a home.

To me the best thing to do is start off with a 15 or 20 year mortgage.  IMHO this is a good middle-ground approach.

[PP4me]

I live in FL and if you ask anyone here, they wish they would have heeded Harry's advice.  Homes in my neighborhood are selling for approximately thirty cents on the dollar from their peak!  One of my neighbors has $600k into an equal home to another of my neighbors who just refinanced with an appraisal of $212k. $212/600=35%.  This is the norm and not the exception in Florida.  My advice, if you buy a home with a mortgage, make sure you can easily afford it and be ready to stay in the home for a long, long time.  How long do you think it will take for a home to gain 300% in value for the neighbor who bought at the top?

[Wonk]

I live in FL and if you ask anyone here, they wish they would have heeded Harry's advice.  Homes in my neighborhood are selling for approximately thirty cents on the dollar from their peak!  One of my neighbors has $600k into an equal home to another of my neighbors who just refinanced with an appraisal of $212k. $212/600=35%.  This is the norm and not the exception in Florida.  My advice, if you buy a home with a mortgage, make sure you can easily afford it and be ready to stay in the home for a long, long time.  How long do you think it will take for a home to gain 300% in value for the neighbor who bought at the top?

Therein lies the rub.  Before I start, I'm not 100% against paying off a mortgage.  I think it makes sense sometimes, depending on the situation.  But I also think there are times when paying it off isn't the smartest move.  If the majority of a person's net worth is wrapped up in a primary residence, they are exposing themselves to various "black swan" events.  This housing bust was one of them.  Another could have been toxic gases from the oil spill, making the land uninhabitable for years.  Or a hurricane.  Or a terrorist event.  There are many.  The point is, you can't just pick up your house (and your land) and take it with you, nor can you call up your broker and liquidate it in a nano second. 

With a mortgage at, say, 75% of the home's value (fixed rate), the bulk of your net worth can remain in a well diversified PP.  In your friend's case, let's say they paid off their mortgage at 600k and the value is now at 212k.  They just lost 388k!  But if they had a mortgage at $450k and hit hard times, they could choose to walk away and limit losses to $150k.  Sure, credit is shot for a few years, but how long will it take them to earn $238k in post-tax dollars?  They could probably rent the house next door for 1/3 the cost of their mortgage to boot!

In the end, I think a mortgage-free house is nice to have as long as it doesn't represent more than 20-25% of your net worth.  Otherwise, I think it's a gamble.

[pplooker]

One of the problems with housing prices is that people need to realize your home is not an investment, your home is an asset you use to facilitate your livelihood.  Its cost is a sunk cost.  You agree to buy it under certain terms and that's the end of it.  People have this fantasy sometimes that a pet asset is always the best thing and will never fail them, and no asset is more overvalued in the minds of its owners than residential real estate.

It's a consumer good.  If you paid too much, well that's life.  Every time I buy anything I always find out it's not resell-able for what I paid for it, and I could have got it cheaper if I'd only done X.  I've learned to just make the best decisions I can at the time I have to make them and go forward.

You spend $1200 on a computer with 4 GB of RAM 2 years ago, only to find out today you could get 8 GB for the same price.  Do you emotionally feel like you spent too much or are upside down in your computer?  Probably but you swallow it and move on, realizing you bought the best computer you could 2 years ago.  So I don't understand why people freak out when their 100k house is now only worth 75k.  You got the best deal on it you could at the time, you knew you were taking a calculated risk and adjusted your affairs accordingly in case it worked out badly for you, so why fret?

The price of cars dropping like a stone would be a good thing.  The price of a fish taco dropping like a stone would be a good thing.  The price of residential real estate dropping is also a good thing.

I personally am building up the PP more in a taxable account now to save for a home.  I hope to buy it outright but I don't know if that'll be realistic or viable.

[Reido]

One of the problems with housing prices is that people need to realize your home is not an investment, your home is an asset you use to facilitate your livelihood.  Its cost is a sunk cost.

I couldn't agree with you more!!  Where I live, traditionally the value of real-estate has risen only 0.5% per year faster than inflation.

While you can look at your house as an investment, generally I think it is best not to.
For example - you buy a $100k house with a down-payment of $10k - initially the house appreciates $3,000 the first year (inflation plus .5% in this example) and you can net a return of 30% on your initial investment - all the while you view the morgage payments as simply replacing your usual rent payments.

I've found many people I talk to tend to overlook taxes, closing fees, HOA dues (if applicable), Maintenence (a BIG deal when that roof starts to leak), garbage collection, and so on...

In my experience, these fees are only very slightly less than what you'd pay in rent if you lived in a medium sized complex.  This seems reasonable, since there is an added efficiency to having a single building with multiple units, rather than a free-standing house.

IMO - a house is a luxury purchase which has attached risk, and therefore a small reward associated with it.

Still, I just moved out of a condo which I rented from someone who was trying desperately to sell it...  Even though the condo had appreciated 10% in value over the prior 3-4 years, he made no money after closing costs...

[Wonk]

Here are a few more observations about housing:

1. The structure itself depreciates while the land keeps pace with inflation (generally).  Caveats include changing local trends: if the neighborhood is getting less popular, land values suffer.  Conversely, more popular = more value in land over inflation.

2. Raw materials and labor (in normal economic environments) generally keep pace with inflation.  While the structure itself is depreciating, the replacement costs are on par with inflation--which from the lay observer seem to be appreciating.

3.  Including generic assumptions of inflation (3%), transaction costs (9-10% round turn) and a normal housing environment, it would take the average buyer about 3 years to break even on a purchase.  For the majority of people planning to be in a neighborhood for a period of 4+ years, it most likely makes sense to purchase.  If <4 years or the outlook is uncertain, it would make more sense to rent in order to secure the option of moving in about 1 year.  Consider a purchase to be a minimum 3 year lease whereas renting is a 1 year lease (although sometimes negotiated as 6 mos or monthly).

[k9]

I know it's an old post, but I'd like to talk about it.

Even if I understand the rationale, on a purely theoretical point of vue, can we really distinguish mortgages and leveraged investing ? I mean, if I take a mortgage to buy my home and then invest my savings in a PP or anything wise, it's good. But if I pay my home cash and then leverage my investing by borrowing money on the very long term to invest it, it's bad. But it's the same thing in the end ! If I have a mortgage and save some money every month that I use to invest in a PP rather than pay back the mortgage earlier, I'm actually using borrowed money to invest, which contradicts rule #7.

Shouldn't we be totally debt-free before investing any money at all beside an emergency fund ? OTOH, doing so means at the end of your payment, almost all you have is a paid-down house, which is not very diversified... So you have to choose between being diversified with debt or not diversified but debt-free.

So, what should we do ?

[WildAboutHarry]

This concept has always perplexed me. My house is payed off currently. And mortgage rates are at historic lows. Would it make any sense to do a cash-out refi and invest the $ in PP?

Any thoughts?

I wouldn't.  You are earning tax-free imputed income from your paid-off house, and that is a wonderful thing.  Further, not having to generate the (taxable) income to pay a mortgage means you can potentially live in a lower tax bracket than otherwise, especially if you are at or near retirement.

That said, I do like the inflation-hedging properties of the mortgages that are available today.

[moda0306]

I know it's an old post, but I'd like to talk about it.

Even if I understand the rationale, on a purely theoretical point of vue, can we really distinguish mortgages and leveraged investing ? I mean, if I take a mortgage to buy my home and then invest my savings in a PP or anything wise, it's good. But if I pay my home cash and then leverage my investing by borrowing money on the very long term to invest it, it's bad. But it's the same thing in the end ! If I have a mortgage and save some money every month that I use to invest in a PP rather than pay back the mortgage earlier, I'm actually using borrowed money to invest, which contradicts rule #7.

Shouldn't we be totally debt-free before investing any money at all beside an emergency fund ? OTOH, doing so means at the end of your payment, almost all you have is a paid-down house, which is not very diversified... So you have to choose between being diversified with debt or not diversified but debt-free.

So, what should we do ?

This concept has always perplexed me. My house is payed off currently. And mortgage rates are at historic lows. Would it make any sense to do a cash-out refi and invest the $ in PP?

Any thoughts?

Investment earnings are also at historic lows.  Bond yields are crap, and the earnings yield of the s&p for 1 and 10 years prior is 6.5% and 4.5%, respectively.

Actually, though, I would make sure I'm maxing out tax shelters before accelerating non-callable (by the bank, callable (by you), low-interest,  tax-deductible debt.  Between your roth basis and a 401k loan, giving up all that potential liquidity and tax-shelter that may not be available in the future seems like a mistake to me, especially when missing a couple payments someday will hurt your credit whether or not you paid them extra in previous months.

Paying off debt can be great.  Paying down debt can can actually make that debt more of a burden for what it does to your liquidity and the bank's bargaining power if the shtf and you can't make payments.

[k9]

Paying off debt can be great.  Paying down debt can can actually make that debt more of a burden for what it does to your liquidity and the bank's bargaining power if the shtf and you can't make payments.

That's a good point ! But I think that kind of shtf scenario is the raison d'être of the emergency fund.

[Pointedstick]

I know it's an old post, but I'd like to talk about it.

Even if I understand the rationale, on a purely theoretical point of vue, can we really distinguish mortgages and leveraged investing ? I mean, if I take a mortgage to buy my home and then invest my savings in a PP or anything wise, it's good. But if I pay my home cash and then leverage my investing by borrowing money on the very long term to invest it, it's bad. But it's the same thing in the end ! If I have a mortgage and save some money every month that I use to invest in a PP rather than pay back the mortgage earlier, I'm actually using borrowed money to invest, which contradicts rule #7.

Shouldn't we be totally debt-free before investing any money at all beside an emergency fund ? OTOH, doing so means at the end of your payment, almost all you have is a paid-down house, which is not very diversified... So you have to choose between being diversified with debt or not diversified but debt-free.

So, what should we do ?

That is exactly my line of thinking, and I have no intention of buying a house on credit. I plan to either buy a small one outright in cash, or else pay cash for a piece of land and build the house myself.

[Peak2Trough]

I'm a big fan of Harry Browne's, but there are plenty of good reasons to have a mortgage on one's home.  Not in all cases, I agree, but it's short-sighted to suggest that everyone should own their home outright and forgo mortgages, even if such a thing were possible.

If you are in the (soon to be) 39.6% tax bracket and you *must* recognize your income, then it would be foolish to overlook today's record low rates.  Your effective interest rate on a 30 year mortgage today would be about 2.1%.  If you don't believe you can beat 2.1% nominal over 30 years, I'd suggest you need to reevaluate your investment plan. 

So now let's talk about risk... everyone says there is more risk in "leveraging" one's home with a mortgage.  In certain circumstances, that's true.  It is also true, however, that owning a home outright has potentially *more* risk than owning one with a mortgage.

Let's use an extreme example and say you own a home outright and the value goes to $0 on that home.  Your loss is 100%.

Now assume you live in a state which provides for non-recourse residential mortgages and you cash out 80% of your equity.  Your loss is now limited to 20% of the home value, with the bank assuming the rest of that risk.  In taking out the mortgage, you have effectively purchased an out of the money put on your home equity.

Consider also that it doesn't have to be a real estate market crash that causes this loss... a flood with no flood insurance (as happened in Nashville in 2010 to thousands of homeowners), an act of terrorism (not covered under standard casualty insurance), an act of god, mold, an encroachment issue, a title problem, etc.  Any and all of those could easily wipe out your entire investment in your home. 

Am I saying everyone should have a mortgage?  No, I'm not.  What I'm saying is that it's not as cut and dry as Dave Ramsey's "no debt" mantra, and every situation bears personal scrutiny in making this decision.

[Pointedstick]

You're right about all of that, Peak2Trough. And I have struggled with my position due to record low rates. But it's not just about whether or not I can beat 2.1% with my investments (I can); it's also about the necessity of working to support the principal + interest. If you own outright, you don't have to worry about that. If your house is mortgaged, then you do, no matter how small the interest component may be.

You also bring up good points about potential disasters that can wipe out the house. To me, these are good reasons to build your house as cheaply and durably as possible, out of materials that can't rot or mold, don't mind water, and block bullets. Owning a house that costs multiple hundreds of thousands of dollars that's made out of plywood and dimensional lumber with a shingle roof on a concrete foundation seems very risky to me. I don't have a good answer to the issue of title problems and other legal snafus though.

[notsheigetz]

it's also about the necessity of working to support the principal + interest. If you own outright, you don't have to worry about that. If your house is mortgaged, then you do, no matter how small the interest component may be.

I think this is a matter of personal choice and what gives you the most peace of mind.

If I put an amount of money aside equal to what it would take to pay off my mortgage then to my way of thinking I have bought the same peace of mind you are seeking but with the added advantage of liquidity that I don't have if I pay off my mortgage.  As I have said before, I can take my money and run but I can't take my house and run and so my comfort lies more with the money in the bank than it does with the house.

[melveyr]

As I have said before, I can take my money and run but I can't take my house and run and so my comfort lies more with the money in the bank than it does with the house.

Yeah where you are in your career is huge as well.

I think the most important HB rule is that your career is the main provider of your wealth. I am really young so buying a house would be putting a ball and chain on my career. I might want to move around if different jobs present themselves.

[Alanw]

You're right about all of that, Peak2Trough. And I have struggled with my position due to record low rates. But it's not just about whether or not I can beat 2.1% with my investments (I can); it's also about the necessity of working to support the principal + interest. If you own outright, you don't have to worry about that. If your house is mortgaged, then you do, no matter how small the interest component may be.

You also bring up good points about potential disasters that can wipe out the house. To me, these are good reasons to build your house as cheaply and durably as possible, out of materials that can't rot or mold, don't mind water, and block bullets. Owning a house that costs multiple hundreds of thousands of dollars that's made out of plywood and dimensional lumber with a shingle roof on a concrete foundation seems very risky to me. I don't have a good answer to the issue of title problems and other legal snafus though.

I live in an earthquake prone area of Southern California; therefore, I keep a 70-80% loan on my home.  I use to carry earthquake insurance but with a 15% deductible, it made no sense to continue the coverage.  Either the home is slightly damaged and I have to pay for the repairs or the whole thing is destroyed and I have to rebuild paying 15%.  If the home is destroyed, then I have to decide whether I want to rebuild out of pocket, give what's left of  the house back to the bank, or rebuild with bank assistance.  Then there is the moral issue.  Do I want to default on a loan that I'm obligated for or continue paying on a home that no longer exists.

[melveyr]

Then there is the moral issue.  Do I want to default on a loan that I'm obligated for or continue paying on a home that no longer exists.

When doing financial transactions with a bank I think morality is the last thing that would be on my mind