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Home Mortgage Leverage SUCKS!
| December 28, 2011 | Posted by Roshawn Watson under Uncategorized |
By: Roshawn Watson
An article was circulated last week where the author lamented losing the leverage benefit of having a home mortgage; he paid off his mortgage in less than 2 years and regrets his decision. He wishes he would have invested the money instead, so it would have doubled like his other investments. Now, from my few interactions with the author, he really seems like an insightful guy who has done some wonderful things in his former career and currently as a money coach. I’m also a subscriber and a personal fan of the blog that it was published on, so I have some inherit bias. Nonetheless, my reason for writing this post is simply to provide you with a counter-perspective: home mortgage leverage sucks!
I Would Have Paid Off My Mortgage Rather Than Invest More Because Opportunity Costs Are Part of The Costs Of Doing Business
Barb Friedberg made a particularly insightful comment on 4 Things To Stop Doing With Your Finances. She wrote that it’s important to “ignore sunk costs,” as they are “part of doing business.” With that framework coupled with one of the most important lessons in Rich Dad, Poor Dad, which is “Mind Your Own Business,” there is a powerful and relevant takeaway: since your household finances are your business, there will likely be some opportunity costs necessary in order to ensure sustainability. Thus, these lost opportunities are indeed expected in most healthy businesses, including your household. This is the very same reason it is pointless to bemoan maintaining an adequate emergency fund (EF). Yes, it is true, keeping an EF means you forgo the opportunity to put those dollars to work (i.e. in the market), but the EF also provides you a better foundation to withstand the storm.
I Would Have Paid Off My Mortgage Rather Than Invest More Because I Consider Risks When I Compare Returns
If you are going to use a hypothetical scenario as a basis to justify keeping a mortgage so that you can invest more aggressively, then why wouldn’t you incorporate the risks associated with indebtedness into the model? It’s only fair because a paid off home is inherently less risky than a mortgaged home. Without a mortgage, there’s less concern for foreclosure, fewer issues with cash flow, significantly more money to invest, etc. Thus, financially speaking, risk matters, so it should be mathematically accounted for (i.e., a risk-adjusted rate of return). That’s certainly how insurance companies do business, and they don’t lose money. It’s a numbers game, while one policy may be “costly,” in aggregate, there are thousands more policies that more than make up for the few times the insurance company pays in excess of the premiums they take in for any given policy. Additionally, this is why companies have risk management divisions (for a great movie example of how important Risk Management is to a business, watch the new movie Margin Call). Properly accounting for risks means that one would have to downwardly adjust the rate of return if he or she chose to keep a mortgage so that he could invest more. This isn’t pessimism as much as it is due diligence. Eighty percent of families WILL have a major financial expenditure within the next 10 years. Now, imagine the risks incurred by keeping that mortgage for 30 years. A plan that only works if everything works out well, is not much of a plan anyway.
I Would Have Paid Off My Mortgage Rather Than Invest More Aggressively Because I Don’t Know the Future
There’s an old saying that if you want to be rich, figure out where everyone is trying to go, and get there first.
Depending on when you run the numbers, the market could have easily been significantly up or down. This lack of reproducibility is perhaps the biggest limitation of using a single case study to substantiate a point, such as using mortgage leverage to invest more aggressively. There’s a preponderance of evidence suggesting decreasing your debt-to-income ratio will improve your overall financial health, but is there solid data supporting short-term speculation in growth stocks? Moreover, any perceived advantage obtained using debt as leverage is often mitigated once risk and taxes are accounted for.
I would also argue the market is getting hard to predict, as the volatility index has increased in recent years. The cyclical and volatile nature of the market are the reasons investments are for the long-term. It’s always easy to say in hindsight that if I would have invested in stock XYZ, I would have tripled my money. That doesn’t mean that it was a mistake to avoid stock XYZ. Your total financial picture is relevant because you don’t know what stock XYZ will do, and it is your responsibility to allocate your resources to the best of your ability. You may suspect outcomes and be armed with your best data, but in the end, there’s no certainty about stock XYZ’s future performance. In contrast, one could say with certainty that nearly all homes that are foreclosed on have a mortgage (or at least a lien).
Being clear about what I do and do not know, my values, and what financial stress I do not want in my life makes paying off the mortgage an easy choice for me.
Other Considerations
- If your cash flow is large enough that you can eliminate a pay off your entire mortgage in less than two years, 1) the mortgage likely represented a small part of your financial world and 2) since the mortgage payoff period is relatively short, you have a long time to financially recover from the alleged “mistake,” assuming your income doesn’t decline. During this recovery period, you can invest mortgage free!
- The “mistake” paying off one’s mortgage is easily rectifiable. If you want a mortgage on a paid off home in a nice area, there are plenty of bankers who would be more than willing to oblige. While you did miss a bull market or two, there’s surely another one coming alone.
- There’s no guarantee that the money used to pay off the mortgage would have gone into investments anyway. While we have the best intentions, sometimes having an unrealistic goal, such as paying off a mortgage in a ridiculously short time, is enough to correct behavior that would otherwise not be as disciplined.
Closing Thoughts
In summation, regardless of whether you are a traditional worker, self-employed, or a business owner, you are in business for yourself. Minding your own business doesn’t just mean investing for growth, it also means controlling risks, including debt. Leveraging yourself for the next 30 years, which for most people represents 25-33% of their income, is a decision that has serious financial implications. In fact, housing expenses of those with mortgages are approximately 3.5 times the expenses of those without mortgages; that affects opportunity too!There’s a reason it’s emotionally difficult to go from a paid off home to a mortgaged home with a volatile portfolio. Your heart is leading you to prosperity and safety. Are you listening?
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Copyright 2012, Roshawn Watson, Pharm.D., Ph.D. All Rights Reserved.
Well said Roshawn! When you pay off a mortgage, you now have that 4 or 5% to do what you please.
Investing on the other hand… if you had invested $100 at the beginning of the lost decade, you'd have made $104 at 0.4% annualized!
Investing is not a given. When you pay off your house, you pay off your house.
Awesome post. For me I would rather pay off my mortgage if I could. Like MC said, your return is so much higher. We don't have any debt apart from our mortgage which is good however if we didn't have to make those payments every month we would definitely be able to seize more opportunities.
Thanks MC! I'm so happy that you brought up the numbers! I was tempted to, and I am glad you did the math 🙂 Your comment demonstrates what common sense would tell you anyway. It's not surprising, yet people treat it like it's revolutionary. That's a poignant example of just important of a financial, not just emotional, decision paying or not paying off one's mortgage is.
Thanks Miss T! I agree not having a mortgage hanging over your head does allow you to capitalize on even more opportunities. So often, this is missed or ignored. I know sometimes discussing this topic is preaching to the choir, but that doesn't mean it shouldn't be said. Cheers!
I think it is a question of opportunity costs. Can I get a better return by investing the money in the market or paying off a X% mortgage. Some people are doing both. I know I am by maxing out my retirement savings and adding a principle payment to accelerate my mortgage.
The opportunity costs issue are definitely big. I think a lot of people should be firing on all cylinders like you, especially if they have gotten rid of consumer debt. I guess sometimes we don't think about the implications of our decisions until after they have already been made, rather than asking the key questions beforehand.
I did read the original post and my impression was that the author was saying that it is a very personal choice. I think that very few decisions in our lives – be these about money – are taken without emotion. For me, feeling secure is important but I do realise that paying off the mortgage doen't always make sense financially.
I absolutely think you nailed it! I can't argue with his opinion about his situation because it's just that. Obviously, no matter what he did, he would have been fine by most people's estimation, likely his too. I guess I wanted to bring to light the thought process behind my decision as a counter perspective.
I like the idea of paying off a mortgage first too 🙂
I'm sure everyone's preferences and situations are different though.
Agreed. It is certainly cool that everyone makes the best decisions for his or her own personal situaitons and risk tolerance. That said, I certainly felt compelled to present the side of the argument that would probably be the "safest" road to wealth for the majority of readers. Cheers!
Amen Brother! "There’s no guarantee that the money used to pay off the mortgage would have gone into investments anyway."
It's all about behavior and we need to know ourselves well enough to be able to make the statement "I would have rather put money in the market". Good intentions never put money in the market, paid off debt, or sent our kids to college – Money you apply towards those things do.
Great insight!!!! I love the statement "good intentions never put money in the market, paid off debt, or sent kids to college." That's critical and often overlooked. Who's to say that things would have worked out perfectly (as intended)? I would love to see that happen, but too often there are missteps, and to assume otherwise just isn't practical. However, the "money you apply towards those things" will certainly be more fruitful than lofty hopes, wishes, and intentions because you're putting action behinds those words. Great comment. Cheers!
I would love to have my mortgage paid off, even though it is at only 3.125 percent. Debt is a bummer at any interest rate in my opinion because it reduces the amount of freedom I can enjoy!
Kris, I love it. I actually thought of your recent refinancing when I wrote this post. I thought of how aggressively you (and Don) have been with respect to reducing your housing expenses/indebtedness compared to your/our contemporaries. I suspect if an investment adviser approached one of you with the option to invest your cash flow instead that you would be unwavering in this regard. You have identified your target AND done your own analysis and decided that reducing your debt burden is the best course of action for you, which I think is FREAKIN' AWESOME!
I will not use a heloc to invest ever!. This is just too risk to me. I think once the mortgage is paid off you should use those funds and invest to your hearts desires. Just keep paying a mortgage payment to your investment account. That's what I plan to do when my mortgage is done in 12 years.
That's a great plan. That's very "Dave Ramsey," even though I do not think you are trying to be! The implication is I think with a strong foundation you can be even more aggressive with respect to your other investments. It's ironic, no? Anyway, I'm bullish on this plan.
I'm too lazy to look now, but I recall a survey showing the difference in risk tolerance before and after catastrophe hit. Everyone is aggressive until things go wrong. I like your perpective on remembering to protect your downside. Paying off debt accomplishes that nicely.
Thanks Average Joe! I haven't seen that particular survey, but other data corroborate its findings. Particularly, studies during the Great Depression and now after the Great Depression show that young people during that time are NOT investing in record numbers. Here's a link to where I discussed it recently. It's a sad and disturbing trend! http://www.roshawnwatson.com/2011/11/young-people…
Shawn, I don't know where to begin. This is just another of your depthful and well analyzed issues. You covered so many facets of investment decision making as well as the personal nature of one's actions. It was quite kind of you to reference my "sunk costs" articles, and a good reminder for me to have a short memory.
Thanks!!! You are very generous. I appreciate your encouragement. You make great comments, and I realize the time-investment involved in keeping up with so many sites. Kind Regards!!!
It's interesting that one could pay off a mortgage too quickly. The common wisdom has always been to pay it off as quickly as possible. Perhaps home mortgage leverage isn't necessarily such a great thing…..
@youngandthrifty – in order to pay off a mortgage that quickly, one must have a large income with respect to the mortgage, as your comment suggests. That's a great situation to be in, regardless of the decision. I still am a fan of the conventional approach, not because of unexamined beliefs, but due the the rationale that I laid out in the post. Great observation!
Our mortgage will be paid off when we move and sell our house, in the not too distant future (say 8-10 years out). Making superior returns with traditional investments should never be an assumption. There are numerous time periods where the markets were down.
That's a great point. Being able to reliably predict when you will get good and less than optimal returns has certainly proven difficult, even among the most gifted. While I suspect this particular investor has done well (it was his job), even amongst the most lauded investors there are problems. Thanks for bring this up!
I'm not sure I get it — home mortgages for low fixes rate for long periods of time are ridiculously cheap in the U.S.. In the 70s millions of homeowners saw their wealth skyrocket in real terms due to heavy inflation, and their low fixed-rate mortgages did not keep up.
If you are aggressively paying down a long-term fixed rate mortgage, you are betting on the fact that inflation will remain low, in spite of massively increasing sovereign debt and spending. That is a form of leverage as well.
Very well written post about a complicated subject. Kudos! All the media coverage on explosive stocks and high flying real estate markets get investors salivating. Greed is good, right? But the ones who really win in the end are investors who look at both sides of the equation, risk and reward. Is risk management unsexy? Happy New Year!
Well if one is aggressively paying down a mortgage, one could be betting on inflation remaining low, despite the fact that it is well-known that it is artificially being kept low. However, one could not be basing the decision to pay off debt on the macroeconomy at all: it could be purely microeconomic decision: 1) Will one personally fair better over the long-term being financially solvent and having limited liabilities, noting that aggressive investing WILL continue once he or she becomes debt free or 2) will one be better off using debt leverage to purchase paper assets. Inflation will do what it does, and the best defense IMO have an good foundation, so that you can aggressively purchase hedges against inflation without damaging your financial position.
Risk management is about as sexy as budgets!
You completely nailed the disposition of investors, and the takeaway, as you succinctly stated is "the ones who really win in the end are investors who look at both sides of the equation, risk and reward."
I like it!
We are paying extra on our primary residence mortgage every month. Sure, I could invest those extra payments instead, but the market is just so volatile lately. I already max out my 401k and paying extra on the mortgage is the next priority after that. There is no guarantee that the stock market will give superior return.
Yeah, if there was a sure thing (guaranteed superior return), then at least the rationalization would be a lot more clear. I think we're along the same line of thinking though: cover your bases by building a solid foundation, and the other stuff is "gravy." Kind Regards!
Roshawn – When I wrote that post referred to here it was meant to prompt people to think and discuss – which it did. The lack of depth and one-sided nature of the discussion also prompted me to realize the need for a follow-up post providing a balanced, definitive guide on the subject instead of the tongue-in-cheek short post your are referring to.
For readers interested my follow up guide is here…
http://financialmentor.com/financial-advice/pay-o…
Hopefully it brings greater understanding to the issues involved. I welcome your comments…