Gyroscopic Investing

Housing pimps say a house is an investment and you are "throwing your money away" by renting.  But is it? 

I submit that owning a mortgage  is made up of two parts: part forced savings (principle) and part rent (interest).  Whether or not a person decides to pay off a mortgage depends largely on whether they want their assets in their concrete, wood & shingles or in a portfolio such as the permanent portfolio. 

So here's the controversial part: in some cases, I believe it could make more sense to use an interest only (IO) mortgage rather than a fixed rate (FR) mortgage--even in a rising interest rate environment. 

Let's say you decide to build your own house and act as your own GC(which anyone can do, no license needed).  If you do it right, you build 25-30% equity by the time you walk in (GC's margin).  Instead of a traditional refi from the construction loan to a FR mortgage, you go with IO to cut your monthly payment. In such a case, you are making no payments on principle, but you are paying rent (interest) to the bank to use the house while staking a claim on the future inflation gains while you live there.  With all costs included (Interest, taxes, maintenance, insurance, water/sewer) you should be paying less than a comparable rental in the neighborhood.  Instead of paying down principle, you invest the difference into a well diversified portfolio like the PP. 

What are the advantages?

1. Lower borrowing costs in IO (3.5%) over FR (4%). Enough time to live and move (5YR reset).
2. Monthly savings are compounded at the rate of inflation +3-5% instead of only the rate of inflation (principle payment).
3. The 25% equity cushion insulates you in the event you need to sell in a down market.
4. You still get the use of the house as shelter just as any other owner or renter would.
5. Future inflation would pay for your transaction costs.
6. In the event of a local (nature/terrorist) catastrophe or national political (Hitler II) catastrophe, you could walk away from the property with most of your assets safely held in a permanent portfolio.

Here's how it would work in an example from my local market

Appraised value: $400K
Construction costs: $300K
Cost of taxes/insurance/W&S/maintenance: $650/mo
Cost of IOM (5YR reset) at 3.5%: $875/mo + $650/mo = $1525
Cost of FRM (30YR) at 4%: $1432/mo + $650/mo = $2082
Comparable rent: $2300 (include 5% vacancy & 5% management fees)
Investable assets over housing costs (IO): $557/mo

Example 1: 2% annual inflation

IO assets value with 4% real return @ 5 yrs = $37678
FR assets value with 0% real return (principle payments) @ 5 yrs = $28656

Difference @ YR 5 = +$9000

House value @ YR 5 = $441K
Sell - transaction costs (8%) = $405K
House basis @ YR 5 = $300K
Equity = $105K

Example 2: 0% Inflation

IO assets value with 4% real return @ 5 yrs = $37678
FR assets value with 0% real return (principle payments) @ 5 yrs = $28656

Difference @ YR 5 = +$9000

House value @ YR 5 = $400K
Sell - transaction costs (8%) = $368K
House basis @ YR 5 = $300K
Equity = $68K

As you can see, in either scenario, you win.  By year 5, you can do it all over again.  If interest rates are rising, the cost of money would be more expensive so it would depress affordability for all borrowers.  You can take solace in the fact that there's nowhere to hide: rents would be going up along with all mortgage rates.

The Caveats

1. Will not work for the undisciplined investor.  If a person needs forced savings, a FRM is a better bet.
2. Unlikely to be satisfying enough for someone who wants no debt.  It would take a certain mindset to be comfortable with this plan.
3. The examples provided are for normal inflation and slight deflation environments.  If you buy at the top of a bubble, you're screwed with either IO or FRM as your home value would drop substantially. 
4. If you take out a 30YR FRM immediately before a hyperinflation, you'd probably win with a FRM by comparison.  Will you be betting on hyperinflation?

The reason why I went through this exercise is because I'm in the planning phases of building a house in my local market.  I'm still undecided which way I'll be going on the refi. 

Any thoughts?

I have struggled with this one myself, but I lean more on the "debt is bad" side.  I used a 20 year fixed mortgage and am within 6 years of having my house paid off.  I tend to think that a middle of the road strategy is preferable, i.e., don't pay off your house early but don't stretch it out forever either.  But this is a personal preference - do what makes you feel comfortable.

It sounds good on paper, but you need to take into account maintenance costs which will most likely eat up the 1-2% annual returns you would normally get due to inflation.

IMO, a house is a terrible investment, unless used as a rental property.  The depreciation in value of the construction itself, inevitable maintenance costs such as a new roof, carpet and flooring, paint, siding, etc, make it unlikely you will ever turn a positive profit over time.

I see the value of using the money you would pay for principle as investment capital for PP or otherwise, however I would use this calculator to determine whether it's truly better to rent or buy in your market:

http://www.nytimes.com/interactive/busi ... lator.html

To summarize, there seem to be a few factors that would make this less than ideal:

• Difficulty in getting a construction loan from the bank.
• Ongoing maintenance costs eat any inflation based returns
• No increasing equity means even a small decrease in the housing market eats into your 25% cushion

Be sure to click "Advanced Settings" and set your investment rate of return (I used 9.3%).  The condo the wife and I live in now is $1950 monthly rent but would sell for $400-500K.  When I put in this rate of return, with 20% down, buying is never better than renting.

@ Pkg Man: Your position is totally understandable. 

@ Storm: I agree a primary residence is usually a bad investment vehicle.  The reason it can be a good vehicle is because of leverage.  In other words, a rental with an average cap rate of 6 doesn't sound like much.  But if you only put 20% down, that's a 30% return annually + inflation.  On a primary residence, not so much. 

About the maintenance, it was factored into my numbers.  In new construction, not much should go wrong in less than 5 years, so I kept maintenance projections low.  The beauty is if you constantly build new every 5 years, you don't have to deal with very much maintenance.  Moving can be a pain, but so can stuff that breaks...