Rule #7 Leverage and Mortgages: Is it broken?

[Peak2Trough]

Agreed.  The risk of default is built into the interest rate, so it's a business decision rather than a moral one, in my mind.

[moda0306]

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 

+1.  Unless its your home town credit union or something similar.  If its Bank of America or their ilk it's a business decision.  We have bankruptcy rules for a reason, and you paid for bank bailouts with your tax dollars (forgetting monetary realism for a second).

[Pointedstick]

If you've already got enough money to retire, what would you really need to use that refi money for?

[melveyr]

MangoMan,

There might be some tax benefits for taking out a mortgage, but part of me feels it is kind of strange to borrow money and put part of the proceeds into Treasuries that are giving you a lower rate than your cost of capital. By borrowing money you are kind of reducing the power of your Treasuries because you are simultaneously being long debt (Treasuries) and being short debt (your mortgage) locking in risk free losses!

You are putting yourself in a situation where you are basically just long stocks and gold... I haven't spent much time wrestling with these thoughts because I am young and live in an apartment. Anyone have thoughts on this cancelation effect?

[Pointedstick]

If you've already got enough money to retire, what would you really need to use that refi money for?

While it certainly carries an element of risk, my thought is that more to invest = more gains = better lifestyle with less worry in retirement and/or better inheritance for kids.

And that risk is why I haven't done it yet.

If I were in your situation, my thoughts might be to sell the house, buy a smaller, cheaper one in cash, and then invest the profit. This would also have the benefit of reducing your property tax and utility bills too.

[melveyr]

My parents took out their one and only mortgage in 1961 at a rate of ~4%. By the time I was a teenager in the 70's, they were earning 10% on a passbook savings account and it was better to not pay off the note because the were earning 5+% on the spread. I guess the whole thing amounts to a play on inflation and rising rates. Pay off the note with future dollars that are worth less and earn mor on the loan than the rate you were lucky enough to lock in for 30 years. The only snafu might be if the US turns Japanese.

Yeah I guess it would have been more correct for me to say that you end up being net long cash, gold, and stocks. The mortgage and long bonds have some cancelation in my mind though.

[Tyler]

Mortgages are not inherently evil.  Like any financial decision, you just have to be smart and work through your alternatives to find what makes most sense.

I bought a modest house on a 15-year fixed mortgage recently, and chose that over paying cash for a myriad of reasons based on our financial situation.  The sub-3% rates certainly helped.

I also have every intention to pay that off early once I reach some other financial goals and no longer want any debt on my books. Again, it comes downto your personal situation. 

[craigr]

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 ?

Here are some major differences between a mortgage and leveraged investing:

1) Margin rates are much higher than mortgage rates.
2) When you miss a mortgage payment the banks give you time to make it. When you get a margin call the brokerage will go into your account and liquidate whatever they want to get their money immediately.
3) You have a lot more legal protections against foreclosure and working with a bank on reduced payments, etc. than working with a broker that wants their money.

I personally would never take money out of my house to invest. But I'm pretty conservative about these things. I wouldn't want to pay interest to borrow from my paid off house to wager in the markets.

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.

I think the reality is most people that want a home will have a mortgage and will invest. I think this is probably OK if you can actually afford the house. Problems happen when people take a mortgage out to the maximum and find their disposable income each month is completely consumed.

Then there is the argument that a paid off house with no savings makes you "House rich and cash poor." Meaning your liquid net worth is tied up in a house and it can be hard to get to those funds. For one, you can't sell off your driveway to raise money. Secondly, if you get into an emergency and need a home equity loan, that's the exact time the banks won't make you one as you are now a high credit risk due to no job, health problems, etc.

So really I think if you can pay off your home and save/invest that is great. But if you can only afford to do one or the other, then it may make sense to invest money but also make an extra mortgage or two a year to really knock down the principal and save a lot on interest payments.

[murphy_p_t]

So really I think if you can pay off your home and save/invest that is great. But if you can only afford to do one or the other, then it may make sense to invest money but also make an extra mortgage or two a year to really knock down the principal and save a lot on interest payments.

Rather than making extra mortgage payments, why wouldn't you invest those additional funds in the HBPP. Of course, this is assuming your mortgage is, say 4%...if the historical performance of the PP is 9%? Isn't that a better use of the excess funds?

[craigr]

So really I think if you can pay off your home and save/invest that is great. But if you can only afford to do one or the other, then it may make sense to invest money but also make an extra mortgage or two a year to really knock down the principal and save a lot on interest payments.

Rather than making extra mortgage payments, why wouldn't you invest those additional funds in the HBPP. Of course, this is assuming your mortgage is, say 4%...if the historical performance of the PP is 9%? Isn't that a better use of the excess funds?

These are all subjective answers I'm giving. I don't know that the markets will give me 9%,  but I do know the bank for certain is going to want their 4% a year. So given the two choices I'll punt and make extra payments just because I know it can dramatically cut down on paid interest even if you can do just one extra a year.

[Thomas Hoog]

To make the mortgage dilemma more harsh
In Holland the tax service governement reduces your paid mortgage rent about 50 %.
So if your rent is 5 %, you only pay 2,5 %

On the other side on your free financial means you have to pay 1,2 % taxes.

Will you still make the extra payment ? The investement must make above 3,7 %

[dragoncar]

MangoMan,

There might be some tax benefits for taking out a mortgage, but part of me feels it is kind of strange to borrow money and put part of the proceeds into Treasuries that are giving you a lower rate than your cost of capital. By borrowing money you are kind of reducing the power of your Treasuries because you are simultaneously being long debt (Treasuries) and being short debt (your mortgage) locking in risk free losses!

You are putting yourself in a situation where you are basically just long stocks and gold... I haven't spent much time wrestling with these thoughts because I am young and live in an apartment. Anyone have thoughts on this cancelation effect?

It's a bit more complicated.  The mortgage is more like a callable bond -- you can refinance if rates go down, or pay it off if rates go up -- so it's not apples to apples.  I agree that there's some cancellation effect, but it's less pronounced than it might appear at first glance.  And remember, much of the portfolio is based on negative correlation.

[melveyr]

MangoMan,

There might be some tax benefits for taking out a mortgage, but part of me feels it is kind of strange to borrow money and put part of the proceeds into Treasuries that are giving you a lower rate than your cost of capital. By borrowing money you are kind of reducing the power of your Treasuries because you are simultaneously being long debt (Treasuries) and being short debt (your mortgage) locking in risk free losses!

You are putting yourself in a situation where you are basically just long stocks and gold... I haven't spent much time wrestling with these thoughts because I am young and live in an apartment. Anyone have thoughts on this cancelation effect?

It's a bit more complicated.  The mortgage is more like a callable bond -- you can refinance if rates go down, or pay it off if rates go up -- so it's not apples to apples.  I agree that there's some cancellation effect, but it's less pronounced than it might appear at first glance.  And remember, much of the portfolio is based on negative correlation.

Great point! I haven't spent much time mulling over the implications of callable bonds  That appears to me be the only reason they wouldn't "cancel" each other out.... Interesting stuff to think about 

[D1984]

1)Margin rates are much higher than mortgage rates.

Never heard of Interactive Brokers?

Their highest margin rate (for funds in USD borrowed on margin) is about 1.5% over the current federal funds rate (which is 0 to 0.25%) and goes lower if you borrow enough. The current 30-year fixed is at about 3.25 or 3.375% and even 3/1 and 5/1 ARMs (so we are comparing variable to variable and not fixed to variable) aren't any lower than 2.375 or 2.50%.

So unless you're Mark Zuckerberg (he of the 1% mortgage), margin rates at at least one broker are lower than current mortgage rates. I know rising rates would raise the margin rate but if that was the case mortgage rates would rise as well.

None of the above was intended to justify investing on margin or encourage it; i was just poiinting out a slight error of fact.

[dragoncar]

1)Margin rates are much higher than mortgage rates.

Never heard of Interactive Brokers?

1) No margin calls on your mortgage

[Peak2Trough]

1) No margin calls on your mortgage

Yes and no.  Many of them are callable by the mortgagee under the default provisions under the note.  Bear in mind that "default" could potentially be something as minor as letting your home owners insurance lapse...

[dragoncar]

1) No margin calls on your mortgage

Yes and no.  Many of them are callable by the mortgagee under the default provisions under the note.  Bear in mind that "default" could potentially be something as minor as letting your home owners insurance lapse...

Ok, but that's not a margin call.  Most if not all jurisdictions will let you cure any "default" as minimal as insurance issues.  I've never heard of a home loan with an acceleration clause based on equity/market value.  In fact, in non-recourse states, attempting to foreclose an underwater house would be a terrible idea.

[Peak2Trough]

Ok, but that's not a margin call.  Most if not all jurisdictions will let you cure any "default" as minimal as insurance issues.  I've never heard of a home loan with an acceleration clause based on equity/market value.  In fact, in non-recourse states, attempting to foreclose an underwater house would be a terrible idea.

Sure, I agree with all of that.  Just trying to distinguish that mortgages are callable in certain circumstances...