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.
It’s true.
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.
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Matthew Amster-Burton says
That’s a clever way of looking at it, TFB, but I don’t think it makes sense.
It doesn’t make sense for exactly the reason you said: a mortgage makes the NPV of future housing expenses explicit, and other words for explicit in this case are “illiquid” and “inflexible.”
A homebuyer with a mortgage is simply more likely, all else being equal, to sustain a “margin call” while investing in stocks than a renter.
Futhermore, “leverage” vs “no leverage” isn’t a binary distinction. You want to know how MUCH leverage, right? And the homebuyer is clearly taking on more leverage than the renter, because they’re putting more money toward housing now in anticipation of spending less money on housing later. More leverage means a riskier portfolio.
This is not “risk” in a hypothetical academic sense. It happened over and over again during the financial crisis, to people I know and probably people you know, too: a person’s portfolio got hammered at the same time they wanted to sell their house, but they found that their house had become extremely illiquid. Renters just can’t get screwed in the same way, and neither can homebuyers who maintain a portfolio of CDs and cash or take other steps (such as prepayment or a large down payment) to avoid an underwater mortgage without the liquid assets to cover the deficit.
The use of fuzzy terms like “leverage” is an attempt to get a real phenomenon: who is taking too much risk? And a person with a substantial mortgage and a stock portfolio is taking too much risk.
This is cliche by this point, but the best way to see this is to turn the question around: would you advise a person with a paid-off home to take out a HELOC in order to invest in stocks? Heck, I think this might be an appropriate move in some situations, but I’ve never heard a financial advisor tell anyone to do that, and most financial advisors I spoke to thought it was crazy. If that’s crazy, then investing in stocks “on mortgage” is also crazy.
It’s also unnecessary. A homebuyer doesn’t have as much capacity to take portfolio risk as a renter, but they don’t have as much need, either. A homebuyer will presumably become a homeowner by retirement and will have lower living expenses, requiring a smaller portfolio to meet them.
Harry Sit says
Matthew – Thank you for your detailed comments. I agree locking in a high expense isn’t good. That’s why I wanted to put it down as largely prepaying future expenses as opposed to investing in real estate. However, there’s also a cost to liquidity and flexibility, which is captured in the buy-vs-rent calculation. The landlords took on the illiquidity and inflexibility. They are paid for it. The risk of margin call is also mitigated by non-recourse loans, either by law or by practice, as the referenced short-sale story showed.
I asked that mortgage-or-not question to the Vanguard financial advisor when I had my consultation: “If we buy a home after we retire, should we pay cash or get a mortgage?” Pay cash is the same as having a paid-off home. The answer was that it depends on the mortgage rate. “Get a mortgage if the rate is low (3-4%). Pay cash if the rate is high (7-8%).” It shows not all financial advisors think it’s crazy to borrow when you already have a paid-off home.
Dave R. says
My issue with the net present value argument of the mortgage is that you are likely committing to a higher standard of living when you purchase a mortgage. Most everyone buys a house and takes out a mortgage when times are good (steady job, good health, etc.). However, if times are tough, while the renter has the option of downgrading her lifestyle by moving to a cheaper rental, the homeowner remains committed to paying his mortgage.
So, while some amount of the mortgage is for future living expenses, a good portion of those prepayments is actually a standard of living premium. Perhaps it would make sense to pay off the standard of living premium before investing in stocks. This would go hand-in-hand with Matthew’s argument that a homebuyer does not need the portfolio risk of a renter since he/she would have prepaid the standard of living premium along with their actual living expenses.
Alskar says
All of this seems interesting to me in an academic sense, but it leaves what I think of as “The Big Question” unanswered: Do I include my mortgage as a negative bond when I am calculating my asset allocation?
In other words, if I have $300K in fixed income assets like CD’s and a $200K mortgage at 2.75% APR fixed for 15 years do I then only have $100K in my fixed income allocation?
Harry Sit says
You do. That’s the only way to make you indifferent (other than the interest rate) between buying fixed income and paying down mortgage. But you also adjust your benchmark and not worry about deviating from the common rule of thumb such as “age in bonds” when you throw in a negative bond.
Alskar says
What does “adjust your benchmark” mean in this context? Are you saying that if I had a 70/30 (equity vs fixed income) allocation without my mortgage I should adjust it to something different with the negative bond included? If so, what’s the thinking on that?
Harry Sit says
I meant if I have a 60/40 portfolio and I decide that prepaying my housing expenses is better than renting and that getting a mortgage is better than paying cash, I don’t worry that my asset allocation with the mortgage included as a negative bond is now 90/10. If I’m tired of making payments and I want to sell some bonds to pay off the mortgage, I don’t worry that my asset allocation with the negative bond removed is still 90/10.
Alskar says
Thanks for the clarification. It seems to me that what you’re proposing is functionally identical to NOT including one’s mortgage as a negative bond when calculating one’s asset allocation. If I’ve decided that I want a 60/40 allocation, but I ignore the fact that my mortgage (as a negative bond) effectively makes my allocation 90/10, then I’m ignoring the mortgage as far as AA is concerned. Do I have that right?
Matthew Amster-Burton says
I’d be curious to know if the same advisor would advise someone with a paid-off home to take out a margin loan or HELOC in retirement in order to buy stocks. I suspect they wouldn’t, and that’s a glaring inconsistency. Not just a “ha ha, gotcha!” but a genuine misunderstanding of how risk works.
Of course, this is a total a straw man, so I should probably go out and ask again. I haven’t written about this in too long anyway.
Harry Sit says
The status quo bias is well documented. If you have money in your portfolio, you keep it there unless the borrowing cost is too high. If you have a paid-off home, you keep it paid-off no matter how low the borrowing cost. Be sure to ask both questions and see who answer them consistently without any prepping.
Matthew Amster-Burton says
Hey, look, I’m replying to my own comment!
This is really an unrelated issue, but I want to mention it anyway, because I think Harry’s way of thinking about a mortgage as prepaying for housing helps shine a light on it.
As Harry said, we all have a bunch of future food expenses. Let’s say we could take out a “food mortgage” and prepay those expenses via a fixed-rate loan.
This would create a perverse effect: people with food mortgages would want the cost of food to increase and would be unhappy when the price of food went down. It would also lead to bubbles, because people would be able to speculate on food prices using someone else’s money.
A large group of people agitating for higher food prices would be bad for society. We might want to allow “food mortgages” anyway, but because of the negative externalities, we’d want to make sure some of the societal cost is baked in. Perhaps each payment of interest on the “food mortgage” would incur a little extra income tax.
This is all obvious, right? So why, exactly, should we be encouraging house mortgages?
steve says
Two nuances though, a mortgage is only a ‘negative bond’ if you get the principal back (which is pretty likely, and even tracks CPI historically, so I’m not going to ‘dwell’ on this downside). Bigger for me, if I’m a renter, although I most likely start off paying less annually, over 30 years I’m not entirely sure of my liability (not living in a rent controlled area). I can relocate, but that also has cost.
As for prepaying future liabilities, it sounds like we are starting to talk about derivatives. We all know what happens when you disconnect a physical good and it’s net expected value… People start to speculate, bend the rules, and play with other people’s money. I know why we have derivatives, but how did credit default swaps, collateralized debt / mortgage obligations, and all their ilk start getting packaged and traded?
Are you going to look into the infamous ‘rent and invest the difference’ scenario? Having a low mortgage rate and high CAPE / low bond return has made this more complicated…
The Wallet Doctor says
I do think its worth considering the additionally costs of owning a home, as well as just the mortgage payment. You will need to consider maintenance as well as possible reselling costs. I think it depends to some extent on whether you can financially handle buying a home, as well as if you have the time and resources to do it right.
Howie B . says
Contrary to the usual pattern, I up-sized my home a few years before I planned to retire. I could have used the proceeds from the prior home and dipped into my retirement savings to own the new house outright. Instead, with mortgage rates at historic lows, I chose to maximize the mortgage on the new house, opting for 15 years at 2.875%. The key attraction to me is that it offered a way to add some inflation protection to my portfolio and have it subsidized by the mortgage interest tax deduction.
As you suggest, I treat the funds required to pay the balance owing as a negative bond balance in a fixed-income allocation that is short-term. I am fortunate to have room to hold that allocation in tax-deferred accounts.
In the low interest rate and inflation environment of recent years, this has proven to be a mildly losing strategy thus far, but should inflation return, I’ll have no regrets.
pop says
I view this differently. My monthly expense is a sum of
1. Opportunity Cost for Principal payment on mortgtage
2. Property Taxes
3. Interest expense less tax benefit of interest expense
4. Incremental utility expenses
5.House maintenance expenses
All my interest expenses has a tax benefit as the Property Taxes+State Income taxes equal standard deduction.
If I add all of them, I am paying a 20% premium to the rent on a two bedroom house (the one I had before buying home) However my house has more space and two more bedrooms, garage and a full (unfinished basesment) and is definitely contributing to the increased standard of living I am enjoying now.
The benefit is also that my principal and interest payments are locked for till I sell or payoff so there is no inflation risk. Property taxes and utilities might go up but the town has to run a referendum every year to increase property tax and utilities cannot raise rates arbitrarily. I feel I am somewhat protected from inflation for the largest part of my expense.
The point is you might still come out ahead even if you buy a bigger house than you rent and you can enjoy the increased standard of living and not worry about a landlord increasing rent each year.
Nightvid Cole says
Having real estate with a mortgage carries deflation risk (or inverse inflation risk). Even if there is no deflation, you face a risk from having less inflation than you expect.
Renting does not have this risk, and as long as your INCOME source is expected to be something in REAL terms rather than NOMINAL terms, renting carries no inflation or deflation risk, while owning (with a mortgage) does.
I simply do not buy the argument that a mortgage locks in your cost; actually quite the opposite. Renting locks it in, not a mortgage,
Unless your income is fixed in NOMINAL terms, the rent is less risky in terms of future changes than the mortgage!
Note that I am using an unpredictability notion of “risk”.
Sam Seattle says
Harry, your mortgage rate is only 2.5%? Wow! Awesome! How many years is the duration?
Harry Sit says
15 years.
Fred says
Margin is only similar in that it is a form of credit. The rights of borrower and lender are significantly different.
If you have any debt and save a cent you are using debt to fund your savings. Whether this is good or bad purely depends on the spread between the interest rates plus fees.