The mortgage dilemma revisited

Why would you want to borrow money to buy a house, even if you could cut a check?

First and foremost, it's cheap.   Money is a commodity, and the use of a commodity has a price.  With money, that price is the interest rate a borrower pays to have use of the money for some fixed period of time.  Then, she has to give it back.  Regardless of the era you examine, borrowing money to purchase a primary residence carries a lower interest rate than any other money an individual can borrow.

This is with good reason: mortgage borrowers are highly likely to pay it back on time.  Even with foreclosures at record levels, the overwhelming majority of people pay their mortgage on time and in full.  Don't do it, and sooner or later you are on the street.  Mortgage lenders that engage in reasonable underwriting get paid back.   Like all good investors, lenders have expected returns on their capital.  When risk of failure is low, the expectations can be met with lower interest rates.  Further bolstering this is the federal government-backed entities that guarantee the returns to investors who end up holding the notes from America's homeowners (thank you, Fannie & Freddie).  STILL IMPLICIT in the system is the idea that if masses of homeowners stop paying the mortgage each month, the American taxpayers will put a bottom under the system.

We have built numerous, powerful incentives into the tax code that incent persons to buy homes and take on large sums of debt to do so.  A person can borrow up to $1 million to buy a residence (or even two residences) and an additional $100k of home equity debt and receive a full tax deduction against federal and state income tax for the interest paid on the loan.

This has the very deliberate effect of subsidizing home ownership, and what was created as a enticement has morphed into an entitlement.  Want to see otherwise calm, quiet middle-class Americans turn into a frothing mob?  Offer to end the tax deduction for mortgage interest, and most politicians will find themselves at the mercy of torch- and pitchfork-wielding rioters before the sun rises the next day.

Less exciting is the tax break given for property taxes (less exciting because for many people the alternative minimum tax kills this one), and a myriad of other nickel and dime tax bennies for home owners.

So now, thanks to the miracle of science, the internal revenue code, Fannie and Freddie, that 6% mortgage really only costs about 4% after taxes, making the ownership of your home about the sweetest land deal since the Russians telegraphed Secretary Seward about a few hundred million acres they wanted to unload up north.

This is the end of the analysis for most folks: they take on a mortgage because they want to own a home (that is another argument for another day) but don't have the cash to do so.  What if you are among the fortunate ones for whom a mortgage is not a necessity, but a choice?

You are probably thinking that your money will work harder for you in the market than it will in your house, and from a cold-blooded analytical perspective you would be correct.

Even with the last few years of housing volatility, your home is a pretty boring asset.  It will probably appreciate ever so slightly more than overall inflation.  That's it.  That's all you can expect.  However, if prices were to remain stable, it would be the perfect asset to leverage.  No, I have not been under a rock for the past decade, but the 2000s have been the exception among real estate prices, not the rule.

If your house increased in value by 3% each year, and you borrowed 80% to purchase it, your return on your equity would be 15% that first year.  If it went up 3% the next year, your ROE would be 13% for that year.  Those are pretty snazzy returns in a world of low inflation.

Expected returns in equities over long periods of time range from 7 to 10%.  Future returns are anyone's guess; since I believe that capitalism still works, I will maintain I still have the expectation of a positive return on my capital, but exactly what that return is remains unknowable.  Some times it doesn't happen, even for a long time.

Consider the total return of the US total stock market for the ten years ending 12/31/2009:

2009   29.1%

2008  -36.7%

2007     5.5%

2006   15.4%

2005     6.2%

2004   11.9%

2003   31.8%

2002  -21.3%

2001  -10.9%

2000  -10.8%

The total, compounded return of $1 invested over that period of time is -0.3% per year.  Ouch!  Although that is an unusually high concentration of negative years, if you are not prepared financially and psychologically to take a good, sound beating about one year of every three, you have no business being in the stock market.

Virtually all of the families I work with do not have all of their liquid assets in stocks, for a variety of reasons.  First among them is the volatility shown above.  Bonds, cash, real estate, alternative assets all form a truly diversified portfolio that can help reduce volatility most of the time.

Diversified portfolios rebalanced periodically also give you a better shot at buying low and selling high, something that seems simple enough except for the fact that hardly anyone ever seems to do it.

Mortgages have to be paid whether or not the market is up.  For my above-mentioned families with some of their assets in bonds, consider also what your expected returns are for bonds: perhaps 4-6% over time.

Now, borrowing money at 4% only to invest it at 4% may not be such a great deal, even with all of the Halloween candy you get from the government to do it.

I have clients who have come out on both sides of this argument, and the longer I do this the more convinced I am that the economics of it have much less to do with it than the emotions involved.  Most people have a different relationship with their homes than they do with their mutual funds.  Giving up a house would be an entirely different matter than selling a fund from your laptop.  Not having to pay a mortgage check makes them happier.

Others really like seeing another few hundred thousand in liquid assets than they would otherwise have if they put the money into their home.  Knowing they will probably create more wealth over time, as well as having the asset at their fingertips, makes them happier.

The bottom line is by all means do the math, then throw the math away.   Figure out which makes you happier, and do that.