Part of a series of articles on housing myths.
Previous: The $200,000 Blunder: Housing Myths Part 2
Home Mortgages Are Leveraged Investments
. . . Just Like Our Greatest Financial Scandals
The greatest financial scandals of the past century were caused not by the specific financial product purchased but by the method of purchase—leveraging, i.e. borrowing to invest on a gamble that the investment would win the race against the loan interest (1920s stock market, 1980s junk bonds, 1990s derivatives, 2000s day-trading). People borrow because they see a high-margin arbitrage opportunity (an arbitrage opportunity is a disequilibrium in asset prices, a profit potential, which invites trading until supply and demand correct the gap). A low arbitrage margin that is below borrowing costs means that it only pays to invest cash and therefore your total profits (or losses) are limited by your amount of cash. For a house investment, you would choose a house price that did not exceed your cash, or you would find co-investors to pool cash to meet the house price.
If, however, expected profit exceeds the cost of borrowing, it seems as if you can make money far beyond your ordinary means by borrowing as much as possible--but this belief has ruined many people. It is one thing to take $100 from your wallet and lose it in the casino. It is quite another to borrow $10,000 and lose someone else’s money in the casino—and then have to pay back $30,000 after interest. Derivatives are not “bad” (they are a useful tool) but they got a bad name when the real culprit was foolish leveraging. Home mortgages are leveraging.
A Home Is an Especially Poor Choice for a Leveraged Investment
Leveraging to invest is risky but at least makes some sense when the investment appreciates faster than the debt (borrow at 5% if the asset grows at 10%)--and there is no guarantee on that. Moreover, owner-occupied, non-rented, residential real estate is one of the worst candidates for leveraging because the odds of such real estate netting more than the real borrowing costs is very low. In fact, you are almost certain to lose money.
Price Volatility with Sticky Ownership Is a Bad Combination
The Risk of Short-Term Market Timing
Volatile prices require proper timing of the market, which requires agility to buy and sell at the proper time. A home (primary residence) has volatile pricing but is very illiquid and fails miserably at these investment requirements. Some experts such as Ben Stein actually tell people not to bother timing and instead to buy what you want when you want it--and many do just that. You will hear examples of some people who, often by accident rather than plan, bought and sold at the optimum times and made a killing on price fluctuations but you also can find people who won the lottery yet that does not mean that buying lottery tickets is a good financial plan. Houses can take months to sell and most people sell for non-investment reasons (change jobs, divorce, etc.), so sales are rarely timed to maximize investment profit and might even result in the dreaded buy-high-sell-low.
Arbitrage Doesn't Live Here Anymore:
The Long-Term Investment Return Is Too Low To Pay for a Loan
The real (inflation adjusted) long-term appreciation of US residential real estate has averaged about 1% annually (or less) since 1890 while the real, after-tax, net mortgage cost can be 2-4 times the home appreciation rate. Borrowing at 3% to earn 1% is a loss. Borrowing at 2% to earn 1% is a loss. Nominal-dollar borrowing at 5% to earn 4% is a loss. There is no leveraged arbitrage profit possible in the long term, absent a quirk of timing. Saying that the debt is for a home does not change the laws of mathematics. In other words, a house bought with cash might tread water and barely hold its value over the long haul but a loan cost easily can put a house investment in the red. Even if you live in the house for 60 years (twice the common mortgage term), when all the carrying costs are factored, you probably are losing money by borrowing to invest in a home.
Pay interest if you must but do not deceive yourself that spending more than you are earning is a road to fabulous riches.
A basic investing rule is not to risk more than you can afford to lose. An easy way to follow this rule is to risk savings and not borrowings, i.e. do not leverage investments.
Avoiding “rent” does not save the investment model, as I will cover in 1 or 2 coming articles.