-- Moderation
in all things
-- Avoid
extremes
-- Don’t
put all your eggs in one basket
These
are some of the lessons we grew up with and, hopefully, have served us well.
Happily, the same advice mom taught us also comes in pretty handy when managing
our assets and liabilities – specifically houses, investments, and
mortgages.
There
are two extremes when it comes to mortgages and the use of financial leverage.
One extreme is to use the smallest down payment you can, borrow as much as you
can, and after you have paid your mortgage and other bills, invest all your
extra funds as aggressively as you can. Then, if your house appreciates in
value, borrow more on a second mortgage and invest that as well.
The
idea behind financial leverage is to borrow low with your mortgage and invest
high in the financial markets. For example, if your mortgage is 5% and your
stock portfolio returns 8%, you have profited from financial leverage to the
tune of three percentage points. The more aggressive your investments, the
greater the potential return. But what if you take too much risk and your
investments crash? You can still hang on to your house as long as you can make
the payments. But what if you lose your job, too? Since you have lost your
savings and now have no income, sadly you will also be losing your home.
Okay,
so using leverage is not for you, you say. There is no way you want to put your
house at risk. So the safest thing is to go to the other extreme. You want to
get as far away from leverage as possible. This will be the safest route,
right? Well…
The
opposite extreme to maximum financial leverage is to use all of your savings to
make your largest possible down payment and then add as much as you can to your
mortgage payment each month. The goal is to pay off your house as fast as
possible. However, at this extreme, you are putting all your eggs into one
basket. You have absolutely no diversification and, unfortunately, this also
leaves you exposed to the risk of losing your home. Here’s why:
- We are only five years removed from the burst of the housing bubble. Yes, we learned that it isn’t only the financial markets that can tank. When house prices dramatically fell, many home owners were left owing more on their homes than they could sell them for (this is called being underwater). This was not a problem for those who were dug in and had no plans to move, but those who had to sell were hit very hard and realized large losses. Those who had elected to put everything they had into their mortgages and therefore had no retirement savings, no education savings, and no emergency savings (if you have a mortgage AND any type of savings, you are using financial leverage) were hit especially hard as they had nothing to draw upon to cover their losses.
- You don’t need a bubble burst and ensuing recession to lose your job. Throughout history, new technology has displaced workers as new and better ways of doing things were created (these days with high technology it can happen at lightning speed). Buggy whip makers lost their jobs when the automobile was invented; Pony Express riders lost their jobs when the telegraph was invented; tens of thousands of secretaries lost their jobs when the desk top computer was invented; and our entire world economy was restructured during the internet boom of the 1990s. The moral of the story is that few jobs are safe. There will always be new technologies and new industries replacing the old. Those who put everything into their mortgages are especially at risk since losing a job will mean no income AND no savings from which to make mortgage payments while they look for, or train for, a new job.
The key to success here is to avoid both of these extremes (moderation in all things). The safest strategy is to employ prudent amounts of leverage, at least enough to fund a retirement plan and emergency savings. Do not wait until your mortgage is paid off before you start saving. You may need to use these funds to stay in your home.
Fortunately,
you don’t have to take my (your humble Prof. M. Max) word alone. Here
is what the professional journals have said about the use of financial
leverage (excerpts compiled by ricedelman.com):
Thus,
a homeowner with a long time horizon and a willingness to assume some risk will
likely have a much higher net worth than someone who selects the less risky
option of the 15-year mortgage.
-- The
Effects of Income Tax Rates and Interest Rates in Choosing Between 15- and
30-Year Mortgages. The CPA Journal #65, 1995.
… home
owners may not be adequately considering the opportunity costs of the
investment in their home. Individuals should not attempt to analyze the
mortgage decision in isolation from their overall personal financial plan.
Instead they should consider the mortgage decision along with their plans for
long-term investing, insurance needs, tax planning and so forth. If the only
way home buyers can afford the higher 15-year mortgage payment is by delaying
long-term investments or by limiting the funds they commit to a long-term
investment plan, they may be better off in the long run by taking the 30-year
mortgage with the lower payment and investing the difference... the
30-year mortgage is clearly the best financial choice for many home buyers.
-- 15-Year
Versus 30-Year Mortgage: Which Is the Better Option? Journal of Financial
Planning, April 1998.
Planners
must consider many factors when analyzing the 15-year versus 30-year mortgage
option, but certain issues deserve mention. First, even if the mortgage is held
to maturity, the argument that the 15-year option is optimal because fewer
total dollars are spent to purchase the home is seriously flawed. The fact that
a smaller total dollar expenditure is required for the 15-year loan is
irrelevant to the maturity decision.
-- Including
a Decreased Loan Life in the Mortgage Decision Journal of Financial Planning,
December 2003.
Advantages
of the 30-year mortgage include lower monthly payments and accumulated wealth,
in an investment account available to help alleviate hardships. Withdrawals
from the investment account would be free of penalties for the non tax-deferred
accounts, and free of penalties for the tax deferred….The data showed that a
borrower…willing to invest with a risk level associated with the S&P 500
would benefit from a 30-year mortgage.
-- Effect
on Net Worth of 15- and 30-Year Mortgage Term. Journal, Association for
Financial Counseling and Planning Education, 2004.
The
popular press, following conventional wisdom, frequently advises that
eliminating mortgage debt is a desirable goal. We show that this advice is
often wrong…mortgage debt is valuable to many individuals.
-- Mortgage
Debt: The Good News. Journal of Financial Planning, September 2004.
Better
financial results accrue to some borrowers when they select a 30-year mortgage
coupled with a simultaneous investment plan rather than a 15-year mortgage term
and a subsequent investment plan…for the vast majority of borrowers, there
remains a significant probability that the 30-year mortgage is the better
mortgage product even in higher mortgage rate scenarios. Further, the financial
benefit associated with a 30-year mortgage increases as the borrower’s marginal
tax rate and risk tolerance increase.
-- Is
a 30-Year Mortgage Preferable to a 15-Year Mortgage? Journal, Association of
Financial Counseling and Planning Education, 2006, Volume 17 Issue 1.
… U.S.
households that are accelerating their mortgage payments instead of saving in
tax-deferred accounts are making the wrong choice…in the aggregate, these
mis-allocated savings are costing U.S. households as much as $1.5 billion
dollars per year.
-- The
Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings.
Federal Reserve Bank of Chicago, August 2006.
In
future posts, I will be talking about risk and return (and how understanding
this simple but powerful principle can help you identify scams), the risk
reduction qualities of diversification, and why your house should not viewed as
a retirement asset. Stay tuned.
MM
