Owning a house is a central part of the American Dream. It is a bastion of security in a wild world to know your family will have a roof over its head no matter what may come.
Somewhere along the way, though, particularly in the early retirement community, the American Dream became: own your own house without the benefit of leverage. “House paid off” is the rallying cry, and I think for most families this is a huge mistake.
There is only one acceptable reason to not take mortgage if you have enough money to purchase the house in case:
You are unable to find ways to deploy your capital that exceed the interest rate of a mortgage.
If this is not the reason that drove your decision and you still do not have a mortgage, read on. A lot of the problem has to do with mental allocation.
Mortgage As Your Source of Workers
There is a mental barrier for many people when it comes to thinking about mortgages. They think: Mortgages are to help me buy a home, let’s think about whether I need help buying a home.
A mortgage is simply a loan of capital to you with your house as collateral. But that loan – those dollars – are fungible.
You can deploy these dollars however you wish.
Think of it this way: you are liquidating positions somewhere to free up cash to buy your house. If you didn’t have to do that because of a mortgage, then you could keep those dollars out in the market working for you.
The real question is this: the bank wants to give me dollars at an X% interest rate. Can I deploy those dollars, in the purchase of a home or otherwise, that will net me a return greater than X%?
People who have savings that total less than the purchase price of their home are taking a mortgage and saying “I believe I deploying these dollars in the purchase of a home will result in a return that exceeds the interest I’m being charged.” They could not make this investment without the loan, so the dollars from the loan help them make this investment.
People who have savings that total more than the purchase price of their home are taking a mortgage and saying “I believe I can deploy these dollars somewhere other than this home that will result in a return that exceeds the interest I’m being charged.”
Read that again.
If you have $500k of savings and are buying a $300k house, that means you have $500k that you are putting to work somewhere already. If you take a mortgage on the house of $260k, you free that cash to stay out in the world and work for you elsewhere, perhaps as a down payment on a rental property, in the stock market, or to buy bonds. Anyone who is not taking a mortgage out when they have liquid assets that exceed the purchase price of the house is saying “I can’t think of a way to deploy more money effectively.”
My Home Is My Safety Net
Many of us have a desire to feel secure in our home ownership. We want to know our home can’t be taken away from us, and I think this is the feeling from which “house paid off” springs. You might ask “what if I absolutely want the security of knowing I can’t lose my home?”
If you have assets that exceed the total purchase price of your home, you should realize that you will likely have money to pay off your house down the road even if things go bad.
Say you have $500k of savings again, and are buying a $300k house. You could buy the thing outright and have $200k to deploy in the markets. Or, you could take a mortgage to free at at 3% to free up 260,000 more workers, and have a total of $460k to deploy in the stock market. If things go well and the market goes up by 10% a year, then hooray! You get 7% on $260k for free for years. You get 10% a year, and you pay 3% to the bank.
Now let’s say things go badly. You borrow $260k, and park all $460k in the stockmarket. Somehow, over ten years the stock market loses 25% of its value (by the way, since 1970 there have only been 4 10-year periods out of 40 where the market ended below where it started, and only one of them touched this level of decrease;there have been no 20 year periods where Year 20 has been lower than Year 1). You now have $345k left. You have more than enough to pay off the rest of the mortgage plus any interest due during that period. So you would not lose your house.
If something like this were to occur, you still wouldn’t have to worry about losing your house, but you might ask yourself whether the risk was worth the reward. This is why the only valid reasons are that you emotionally can’t stand to lose your house and have no investments outside the house. Even in downturn scenarios you would likely still have enough to pay off an own your home outright.
By the way, you could also choose to hold longer if you were in one of these truly black swan scenarios and trust the stock market to rebound in a 20 year time frame.
Deploying Workers: Risk vs Reward
The above doom and gloom scenario may have raised a few hairs on the back of your neck. That’s fine. It’s all about risk vs reward.
Historically, in 90% of cases since 1970, you would have made out like a bandit by taking a mortgage and deploying that money in the stock market for 10 years. The CAGR of the S&P since 1970 is 10.28%. If you had an interest-only loan at 3%, you would would have made 7.28% every year for 10 years, or roughly $265,002 for your troubles after paying back the principle you borrowed. For free. Are you willing to leave that kind of money on the table?
Some people look at those eye-popping numbers and still aren’t convinced. Maybe they’re older and have retirement in their sights. The risk level of investing in the stock market just doesn’t seem worth it to them, despite the fact they could make hundreds of thousands.
That’s okay. Highest risk for highest reward is not always the right mode for all people and all stages of life. There are, however, other points on the risk/reward spectrum they could deploy their capital.
Take municipal bonds, for example. If you purchase your state’s bonds, you will be federal and state tax exempt for your dividends. In New York, muni bonds are currently yielding about 5-5.25%. Home mortgage rates are 3.25% as of July, 2016. The bet you would have to make is that your state government and its projects do not default and go under. That is a vastly different, more conservative risk profile than parking the money in the stock market. This is about as close to free money as I’ve ever seen in a legitimate investment. I would take this risk gladly.
Interest Only vs Traditional Mortgages:
Source: Nerd Wallet. Data from Freddie Mac.
Having laid out a case for taking a mortgage, you might wonder what type of mortgage makes the most sense.
With the logic above, you are trying to borrow the workers from the bank at a cheap rate and arbitrage by deploying them at a higher rate. It stands to reason that you will want to keep them as long as possible, not return them to the bank. An interest-only loan is the purest form of that arrangement.
If there were a fixed-rate interest only loan I could pick up that was not materially more expensive than a traditional mortgage, I would go for it in a heartbeat.
Unfortunately, interest-only mortgages tend to come in one particular flavor – adjustable rate mortgage. This means that every year the interest rate you will be charged will be adjusted against some major benchmark. It could go up or down in future years. I don’t love this. The point is to lock these new workers in at an attractive rate. You would be taking some additional risk of the unknown with an ARM – you’d have to be mindful that if you deploy that cash in something long-term, you might find yourself squeezed for a while. And given how low interest rates are today, they are more likely to go down than up.
So for me, the real determining factor is fixed rate vs adjustable rate, and that may rule out an interest-only loan for now. Drat. If that means going with a traditional mortgage that involves paying back some principal with each monthly payment, then my recommendation would be to get the longest term loan possible. You want to pay back the actual principal as slowly as possible, and keep them working for you as long as possible.
In summary, I would recommend an interest-only loan if you could get it at a fixed rate that was not much higher than a traditional loan. If that is not possible, the next best bet for most scenarios would be the longest fixed mortgaged possible (30 yr loan), or in some select cases, an adjustable rate interest only loan if you have a plan to deploy the capital in avenues that themselves also adjust to the interest rate every year (for example, short term bonds).
In today’s low interest rate environment, I can think of very few people who could legitimately raise their hand and say “I have nowhere to deploy more capital effectively at this interest rate.” Frankly, if they did, I would be very concerned from them.
In order to be retired, you will have to have many years’ worth of income in your nest egg, which means you will have to find a place to deploy capital outside of your principal residence. If you can’t find a play to deploy 3% money which is the current home interest rate, you have much bigger problems on your hands.
There have been periods where the interest rate is so high that people legitimately find parking their money in cash and not borrowing any money is the best way to grow their capital. When that time comes, I will be right there alongside you. But today is not that time. So go out and do the math on a mortgage. Your retired self will thank you.