On using leverage to purchase financial assets

[Mountaineer]

Classic!  ;

[Ad Orientem]

+1  LOL

[moda0306]

That's great! 

Pay off the house.  There is no good debt; only bad debt and really bad debt. 

While I totally agree with Cullen on this, I think it begs the question, how much should we really put down on our house?  Maybe we should rent until we can pay cash.  Anything less than that is probably justification to live beyond your means.

In my mind, it's all about opportunity cost and cash-flow.  Debt is just one factor.  I'm always going to need a place to live, so I'm ALWAYS going to have some cash-flow for rent, but if I rent an apartment for $1,000 per month (let's say this is 15% of my income), or I could buy a similar condo, with taxes, insurance, maintenance, and association dues for $700 per month, $250 of which is paying down principal, it's a good deal.

Even if I do 0% down.  This almost surely lowers my overall risk.  Now, at this point, I am saving a ton every month, and I have some options around whether to allocate more to principal, at (let's say) an illiquid 4.5% (maybe 3.5% net of taxes at worst).  Or I can invest in t-bonds in a Roth IRA and get a similar guaranteed long-term rate of return, and (with some principal risk, of course), keep my liquidity, and get (today) 3.61%.  Why the hell would I pay down the debt, all things being equal, even from a pure risk-management standpoint?

I see no reason to assume this debt as toxic.  It's just a tool.  Use it right, and it works wonderfully.  It actually INCREASES your risk to pay the loan off quicker (ahead of scheduled payments)... you lose liquid wealth with which to weather a storm, and you increase the favorability to the bank if you get behind on future payments if they've got a lot of equity to play with.

A few things that could screw this up:

- Deflationary depression where rents drop (though this could be phenomenal for your bonds, and you could use that to refinance to lower mortgage rates, possibly, if your condo drops in price).

This doesn't really favor paying down debt, though.  Moreso not having bought the property in the first place.  This depression could bring unemployment and a fallen condo value, having bonds on the side that have boomed, and an under-water condo, leaves you in a phenomenal bargaining position with the bank if you get into a tough time.

- "Need to move" risk.  Still doesn't really warrant paying down your mortgage.  Moreso just don't buy.  It's actually more likely a liquidity crunch will, once again, show its ugly face.

- Some legal rule that can take your IRA but not your home equity if you get sued... but you should have good liability insurance for this .

Anything else?

To me, the main issue with people who take on debt, is the REASON they're taking it on is fundamentally flawed.  There's usually some other outside economic error happening, and the "debt" is just the thing that stays on and looks ugly when someone assesses the situation and says "you have way too much debt."  The debt is usually the symptom of some larger set of decisions not made on market fundamentals.

The problem is people use debt to speculate, or take more risk, rather than use it to remove risks from their balance sheet.  They use it to invest in stocks to get a higher RoR, rather than invest in bonds and break even but obtain liquidity. 

Debt, or assets, are just the natural result of "What you earn" - "What you spend" over a period of time.  I can't just "create" a liability on my balance sheet.  I have to incur an expense to do so, or offset it with an asset.  It's the "income (or growth)" and "expenses" of those decisions and others that play out over time.

I love debt the way I love any other financial tool with a unique ability to make certain things possible that otherwise would have been.  Used incorrectly, just like ANYTHING we talk about, it can fail on you.  I don't like its existence on my balance sheet.  But I don't like my rent's existence on my P&L.  What the hell am I to do?

[Pointedstick]

That's great! 

Pay off the house.  There is no good debt; only bad debt and really bad debt. 

While I totally agree with Cullen on this, I think it begs the question, how much should we really put down on our house?  Maybe we should rent until we can pay cash.  Anything less than that is probably justification to live beyond your means.

Agree 100%. In fact, I agree so much that it's what I did!

The great thing about it is that the biggest monthly expenditure is eliminated. Poof! All the money you were paying on the mortgage/rent can go straight to savings or the vacation fund or something (like the ammo fund ).

[WildAboutHarry]

Pay off the house.  There is no good debt; only bad debt and really bad debt.

I think I am pretty close to good debt.  3.25% 30-year mortgage (with about 27 to go).  If we do get to 8% 10-Year Treasuries in a few years, whoo hoo!

We could pay it off.  Do you think we should? 

Would your answer change if most of the funds would come from a Roth IRA?

Would your answer change if most of the funds would come from a Roth IRA and my wife and I will be retired within the next year or two?

[WildAboutHarry]

Desert,

I am with you on the debt thing.  The mortgage is the only debt we have, and I suspect we will pay it off in the next couple of years.

Since the mortgage on our first house was north of 13%, though, it is hard for me to give up the "opportunity" to only pay 3.25%

[ns3]

Desert,

I am with you on the debt thing.  The mortgage is the only debt we have, and I suspect we will pay it off in the next couple of years.

Since the mortgage on our first house was north of 13%, though, it is hard for me to give up the "opportunity" to only pay 3.25%

If you pay off that 3.25% mortgage early you will probably be providing a windfall profit for some bond trader. I recently learned this in the book Liar's Poker which has a lot of interesting insider information about trading in mortgage bonds. In the firm the author worked for they had a group of statisticians who did nothing but predict which mortgage holders were likely to pay off early. Those were the mortgages they wanted to buy, preferably at a discount - the more the discount, the more the immediate windfall upon payoff - and if current rates were high it was doubly profitable due to re-investment opportunities. (And they also thought those people were idiots, BTW).

If you have a high interest rate it obviously works the other way around. The worse possible mortgage to own was one with a high rate and a homeowner likely to pay off early.

I currently have a 4.25% mortgage and no intention of paying it off. If I ever do it will be with inflated dollars many years from now(A strategy I am learning from the USG, BTW. Didn't Janet Yellen just announce the other day that she intends to reduce the amount of my principal in REAL dollars by 2% every year).

[Tyler]

I guess it doesn't surprise me that a bond trader would fully support keeping the mortgage. It's like asking a pharmacist if pills are the best solution to your headache.

I totally understand the arguments for buying stocks with a mortgage balance, especially with low rates and long duration. Mathematically, you have a good chance at making more money with the investments in the long run. However, I personally hold the philosophy that each layer of financial complexity you add to a plan increases the opportunity for something to break. At some point once you have all the liquidity you need, I advocate fully deleveraging and enjoying the freedom of debt-free living.

I'm sitting on a 2.875% 15-year mortgage. But with the remaining principal less than 15% of my investments, I'm not sure the point of keeping the mortgage any more. I already have plenty of money, so playing interest rate arbitrage in perpetuity just on principal is starting to feel silly verging on greedy. Sure my risk is low, but the reward isn't that substantial, either. 

In contrast, a poster on a different message board recently stated that his ideal retirement plan is to carry $1mm in mortgage debt on multiple rental properties, get a HELOC against the growing equity, invest all of his money in the stock market, and make leveraged profit on both the rentals and the stocks. It may look great on paper, but let's just say I prefer my debt-free plan.

[ns3]

I guess it doesn't surprise me that a bond trader would fully support keeping the mortgage. It's like asking a pharmacist if pills are the best solution to your headache.

Actually, according to what I read in Liar's poker you have it backwards. The bond trader prefers that you pay it off early. That's how he makes a quick profit - the margin being the discount he was able to buy your mortgage for and his profit on re-investment.

[Tyler]

I guess it doesn't surprise me that a bond trader would fully support keeping the mortgage. It's like asking a pharmacist if pills are the best solution to your headache.

Actually, according to what I read in Liar's poker you have it backwards. The bond trader prefers that you pay it off early. That's how he makes a quick profit.

True. But based on your post I'm sure the bond trader would keep the 30-year mortgage on their own home.

[ns3]

I guess it doesn't surprise me that a bond trader would fully support keeping the mortgage. It's like asking a pharmacist if pills are the best solution to your headache.

Actually, according to what I read in Liar's poker you have it backwards. The bond trader prefers that you pay it off early. That's how he makes a quick profit.

True. But based on your post I'm sure the bond trader would keep the 30-year mortgage on their own home.

Probably true. I doubt that many people in that business pay off their mortgages.

[Libertarian666]

I refinanced into a 15 year 2 5/8% mortgage and have no intention of paying it off early. Since it is a non-recourse mortgage, if my house loses a significant part of its value in a depression or the like, I can "put" it to the bank. Of course this would hurt my credit rating, but would have no other liability. Why would I give up such a valuable put option voluntarily?

[moda0306]

I don't see how it's necessarily "freedom" to pay off a mortgage if I'm netting a higher rate in my long-term fixed-return investments.

I realize there is a "hassle" factor of having a payment, but I can think of far more scenarios where my freedom is limited or strained by having paid off the mortgage.  I think this feeling of "freedom" might be more due to some false emotional signals our bodies might be telling us.

For example, it might give me some feeling of conquering, ownership, or accomplishment, but if I get past the false emotional signals, and dig into what I should actually value to maximize mid/long-term emotional happiness in an uncertain future, having the money on hand to address risks/opportunities that might pop up, if I don't have to pay for it through decreased long-term RoR, is the best route.

Not that you'll need the money, necessarily.  But this isn't about need... it's about maximizing freedom in an uncertain future.  Liquidity at a given RoR is always going to beat illiquidity at the same RoR, if there is no risk.  There is the potential default of treasuries (if one thinks this is plausible), but in this world, who knows what kind of financial craziness is going on with property values, foreclosures, etc., and I think there is probably a higher risk of a long-term care event wiping out one's assets, where liquidity will be ideal rather than a paid-off house (even though, given Medicaid spend-down rules, paying off your mortgage might be a better strategy... not sure).

However, I don't really have a problem with paying OFF debt in some of these scenarios where there is plenty of liquid wealth on the side.  I have a big problem with paying it down.  Your payment stays, your taxes go up, and the bank looks upon your property as far more appealing in a foreclosure scenario than if they might take a loss.