From the previous two posts on investing and home ownership — The Difference Between Asset And Investment and Is Imputed Rent Income? — we determined that buying a home is partly an investment and partly prepaying an expense.
Why does it matter whether it’s an investment or a prepaid expense or how much of it is which? Because if it’s investment, especially if it’s a good investment, you normally want more of it. $100k in stocks and bonds is good. $300k would be better. On the other hand if it’s an expense, you normally want less of it.
Therefore buying may be more cost efficient than renting a home of the same size in the same neighborhood, but if you buy a larger home in a nicer neighborhood than you need, you increase your housing expenses and you simultaneously invest more in residential real estate.
Now let’s look at the mortgage.
Mortgage = Negative Bond
Your mortgage is a debt, which is the opposite of an asset. Unless you are contemplating a clever move to get rid of it, as a well known financial advisor, book author, and New York Times columnist pulled off (see The Best Way to Lose Your Home and Financial Advisors Support Peer Who Lost His Home), it’s really just a negative bond. As you pay it down, you are making it less negative, which has the same effect as investing in bonds.
As such, it doesn’t make sense to borrow at 4% interest and invest in bonds at 2%. Does it mean that you should stop contributing to your 401k beyond getting a match before your mortgage is paid off? No. Investing in stocks still gets a higher expected return. Even fixed income investments can get close depending on the rates. My CDs earn 3% while my mortgage rate is 2.5%.
If my mortgage rate is 4% or higher and I can’t refinance it down to 3% or below, I would pay extra on the mortgage instead of investing in bonds after I max out my 401k and IRAs.
Buying Stocks On Margin
Some say if you buy stocks while having a mortgage outstanding, you are really buying stocks on margin. See Why Is It Risky To Buy Stocks On Margin But Prudent To Buy Them “On Mortgage”? by Michael Kitces and Paying Down Your Mortgage vs Investing More by Matthew Amster-Burton.
I said in a previous paragraph investing in stocks still gets a higher expected return. The keyword is expected. There’s a risk it doesn’t materialize.
What you do with this information is the question. The mortgage in a large part results from prepaying future housing expenses. We also have many other expenses in the future, such as our annual food expenses or utility bills. As I learned in finance class, any future payment streams can be calculated into a net present value. The mortgage is an explicit net present value of future housing expenses. It’s already calculated for you. The net present value for your other expenses in the years to come isn’t shown to you but it still exists.
Therefore it doesn’t make sense to single out the net present value of one type of future expenses (housing) but ignore the other types. A renter also has a net present value of future housing expenses. That value may very well be higher than a homeowner’s mortgage balance. If a homeowner with a mortgage is buying stocks on margin, so is a renter.
There’s no law against buying stocks on margin. When you have a stream of future expenses still unpaid, you are buying stocks on margin. And that’s OK. You stop buying stocks on margin only when you have all your future expenses fully accounted for with fixed income investments (a “Liability Matching Portfolio”). You won’t have that option until your portfolio gets to a very large size. You need the growth before you reach that point, if ever.