When To Payoff Mortgage: Housing Myths Part 13

Previous: Payoff Mortgage v. Invest Stocks: Housing Myths Part 12

Do not simply compare nominal interest rates, even tax-adjusted rates (which many people miscalculate). Where you are in the mortgage repayment amortization schedule is only one of the additional factors that determine your cost-benefit analysis.

Tony asked, "I have a current home loan of 50,000 and I have 70,000 in a money market. My current interest per month is 260.00. My gian on my money market is only 53.00 in interested per month [less than %1 APR]. Should I pay off my mortgage or keep paying it and saving in my money market? I also have 100k in a cd that yields 4% at this time."

Where are you in the mortgage repayment amortization schedule?

Mortgages front-load the repayment of interest so paying down extra early in the mortgage saves much more money than does paying down extra late in the mortgage.

Compare two people who owe $50k @ %5 interest:

• Person #1 started a $50k mortgage today and owes almost another $50k in interest, $46,627.89 to be exact, which we will round to $47k. Paying off the $50k mortgage today saves $47k.
• Person #2 has about $50k left on a $500k mortgage, in the last 2 years of a 30-year mortgage. He/she already has paid $466k in interest and the last 20 months contain only about $2k in interest (and only $855 of interest in the last year) so paying off the remaining $50k mortgage today saves $2k.

Two people each owe $50k @ %5 nominal interest rate but one person saves $47k by paying it off today and the other person saves only $2k by paying it off today.

The effective annualized interest rate is lower for Person #2 (in the last year or two of a mortgage) than for Person #1 (in the first year of a mortgage).

What is your tax-filing marital status, top federal/state/local top marginal tax rate, and total itemizable deductions?

Calculate both taxes and tax deductions correctly.

A $100k %4 APY CD yields $4k gross but a 10% top marginal tax rate cuts your effective net interest income to $3.6k after federal income tax while a 35% top marginal tax rate slashes your effective net interest income to only $2.6k after federal income tax--and maybe even less after state/local income taxes.

Parting with $50k savings to payoff a $50k mortgage depends partly on your top marginal tax rate that reduces your income from savings:

4 Percent APY Savings Rate:

• $2.0k gross interest income ($50k at %4 APY)
• $1.8k after 10% tax rate
• $1.3k after 35% tax rate

1 Percent APY Savings Rate:

• $500 gross interest income ($50k at %1 APY)
• $450 after 10% tax rate
• $325 after 35% tax rate

A new $50k %5 30yr mortgage costs $2.5k of interest in the first year so a single person with about another $3.5k of other itemizable deductions (property tax, etc., considering the new IRS property-tax deduction) sees ZERO tax advantage or tax reduction from the mortgage interest costs, when compared to being debt-free with a standard deduction.

New IRS Tax Deductions Worsen Mortgage Debt Deal

The new IRS property tax deductions make mortgage debt an even worse deal than it already was.

2008 and 2009 tax years allow you to take the standard deduction but also deduct $1,000 in property taxes (if married filing jointly, or $500 if single) simply by checking box 39c on Form 1040.

IRS Standard Tax Deductions for 2008 Tax Return
(ie, no "itemized" Schedule A needed)

$ 5,450 (single)
$ 5,950 (single, property tax deduction)
$10,900 (couple, married filing jointly)
$11,900 (couple, married filing jointly, property tax deduction)
$14,000 (senior couple, age 65 or older, married filing jointly, property tax deduction)

Non-senior singles can deduct almost $6k without itemizing and without paying a penny in mortgage interest.

Non-senior couples can deduct almost $12k without itemizing and without paying a penny in mortgage interest.

Senior-citizen couples can deduct $14k without itemizing and without paying a penny in mortgage interest.

These deductions are in addition to the $3.5k per person deductions ("personal exemption") for yourself and dependents.

The IRS tax changes are another reason on top of recent market declines as to why debt does not pay.

I warned about such issues before the market crash:

Prepay Mortgage V. Invest in Stock Market
Myth of Mortgage-Interest Income-Tax Deduction
Myth of the Stock Market (Leveraged Borrow-To-Invest Dangers)

Savers Are from Mars. Debtors Are from Venus. Episode 5

Turning Gold into Lead:
How To Lose $100k, and Your House, and Your Family

"Wendy's home had appreciated in value by about $100,000, only months after she and her husband bought it. So, they took out a second mortgage for almost $80,000 to enhance their new home. It was at 8% interest. When the housing bubble burst, that $100,000 in equity evaporated. But, the interest on that second adjustable rate mortgage by now had climbed from 8% to almost 16%, creating a monster of a monthly payment they couldn't handle. 'Then, it just gets pulled from right out underneath you.' Wendy says her marriage even broke-up over this. Now the couple faces possible foreclosure on the house" (KVOA).

Debtors often display this unfortunate tendency to turn even a $100k windfall into more debt, to eliminate increases in net worth, to eradicate any trace of even accidental equity.

Remember that the $100k was only a paper profit, not real wealth, because they did not sell the home at the high price (they ignored the basic, old "sell high" truism).

They ignored the chance to increase their income and instead increased their outgo (spending)--the opposite of basic financial advice to increase income and decrease outgo.

Payoff Mortgage v. Invest Stocks: Housing Myths Part 12

Previous: Home Decorating Costs: Housing Myths Part 11

Hock Your House?
Beware Over-Hyped Benefits of Leveraged Stock-Market Investments

Free Money Finance (FMF) responded to a pro-debt, pro-leverage Ben Stein article. Stein and some FMF commenters unfortunately repeated a number of false assumptions about stock market returns and dubious expectations about arbitrage net returns.

Sustained real returns near double-digit rates prove elusive.

People trick themselves into believing that low inflation (officially) under 3% is normal, that mortgage interest rates under 6% are normal, and that long-term, indexed stock market annual returns on investment (ROI) of 9-12% are normal. None of that is true.

Real (inflation/price-adjusted) stock/mutual fund ROI can be flat or negative over most of a decade. (Update 6/25/08: Remember that you are bleeding your mortgage interest even if your stock is "flat" and remember what a flat or negative first decade means for the long run in the world of compound interest.)

Hyped nominal stock returns near double digits often include periods of high inflation such as when consumer prices rose over 13% in 1979 (little real stock growth). (Update 6/25/08:...and the real growth can become real LOSSES when you remember your borrowing costs (see next paragraph).)

The periods of high nominal stock returns often coincide with high nominal debt costs (little arbitrage room): One measure records average mortgage rates of over 9% in most of 1991 and over 15% for about a year 1981-1982 (US Federal Housing Finance Board’s Monthly Interest Rate Survey (MIRS) National Average Contract Rate for purchase of previously occupied non-farm single-family homes, by combined lenders). The common apples-oranges mistake is comparing a recent short-term snapshot of low mortgage rates to past long-term inflation-contaminated stock returns, which is just as misleading as comparing a short-term stock-market crash returns to high long-term mortgage rates. The pro-leverage cheerleaders parrot the past 30-year S&P500 historical average but rarely mention the concurrently high 30-year fixed-rate mortgage average that leveraged people paid--because the 2nd half of the reality undermines their "easy money" sales pitch. (Update 6/25/08: Note the hypocrisy of people who drone on about decades-old "historical performance" until you remind them that they are leaving out the historical performance of COSTS, at which point they insist that old data is irrelevant because "that was then, this is now": Fine, then never mention past performance again, start with a clean slate on BOTH gains and costs, and we are left with a future, guaranteed mortgage loss compensated by nothing guaranteed on the plus side, and even a 5% mortgage could result in a double loss, as described later.)

Those hyped stock returns are sometimes intentionally inflated using a misleading method (arithmetic average annual return) in another improper apples-oranges comparison to mortgage rates: Use the proper annualized return (geometric mean) to compare directly to compounded mortgage-interest negative returns.

The popular major-market indicator Vanguard 500 S&P500 index fund (VFINX) cost about $30 in 1987 (20 years ago) and $140 today (late 2007), which is an annualized return of not 9-12% but only 8.01%--before taxes (Update 11/12/07: A VFINX $30 purchase and current $133 price puts the 20-year annualized return at 7.73%) (Update 7/13/08: A VFINX $30 purchase in 1987 and the current $114 price puts the 20-year annualized return at 6.90%. There are many other pluses and minuses such as dividends which might add 1.6% to the 6.90% for 8.50% BEFORE COSTS but a 0.15% expense ratio reduces that to 8.35% and a possible 0.5% mortgage PMI (often overlooked on the leveraged cost side) reduces that to 7.85%, plus possible mortgage points, dividend taxes, etc., before we even get to subtracting the main "mortgage rate").

The S&P500 20-year average performed about the same as an 8.xx% bond (before tax differences), and the US 30-year Treasury bond's yield was about 8% for most of the first decade after 1987 and peaked over 10% in 1987.

Borrow at 11% to earn 8%?

Anyone who in 1987 had cash to buy a house in full but decided instead to take an average 30-year fixed-rate mortgage (FRM) to invest the cash in an S&P500 index fund might have crucified him/herself on a (July) 10.5% mortgage interest rate to earn 8% in stocks/mutual funds, for a clear loss.

The poor sap could pay more in additional fees to refinance when mortgage rates decreased but average rates fluctuated near 8% for most of the 2 decades (finally breaking below 6.5% about 2002). Even a small negative arbitrage percentage can cost you tens of thousands of dollars. (Update 6/27/08: You could get a 5.xx% mortgage in 2005 but VFINX price since 2005 performed about 3.2% (5% with dividends) so your 2005-2008 leveraged investment gave about a 0% net return. VFINX price since 1998 performed about 1.8% (3.xx% with dividends) but 1998 mortgages cost about 7% so your 1998-2008 leveraged investment bled a LOSS of NEGATIVE 3.xx% per year for a decade. Pro-leverage cheerleaders say things such as "up 20% since 1998" to conceal the dismal 1.8% annualized returns but remember that negative 7% compounded for a decade results in a 50% loss (DOWN 50% since 1998).)

(Update 6/28/08: The borrow-to-invest plan to lock in a low mortgage rate for 30 years often fails in the real world for a number of reasons: (1) the average American mortgage lasts for an average of only 7 years (according to ING) due to moving or other reason, so the average person does not keep a low rate for 30 years; (2) banks advertise ideal rates that apply to few people but the more realistic rate is the report of average rates actually obtained by borrowers (6.62% for 30yr fixed-rate $165k mortgage according to Bankrate.com's 6/25/08 weekly national survey of large lenders, or 6.45% plus 0.6 points for 30yr fixed-rate mortgage according to Freddie Mac's 6/26/08 Primary Mortgage Market Survey (PMMS)); (3) people like to quote their rate but forget total costs such as points yet 0.6 @ $200k is an instant $12,000 loss before you earn a penny in the stock market; (4) people like to quote their mortgage RATE but their actual, annual debt cost is the APY (Annual Percentage Yield, which is higher than the rate because APY accounts for compounding during the year); (5) internet forum users claim to have a 5.xx% or even 4.xx% mortgage but best credit in ideal market conditions is rare so telling the average person, "Leverage your house in the stock market. First, get a 4.xx% fixed-rate 30yr loan," is like saying, "Make a million dollars. First, get $900k.")

The Iron Rule of Debt

Borrowing usually costs more than investing earns, given equivalent risk (with borrowing, you pay inflation + risk + someone’s salary/bank’s overhead; with investing, you (hopefully) earn inflation + risk – fees - taxes; therefore, with borrowing-to-invest, inflation and risk cancel out and you are left with transaction costs at both ends). Even the abnormally low mortgage rates of recent past coincided with the stock market crash of negative annual returns, so someone could have borrowed at 5% to lose 20% in the stock crash (-5-20), for a net 25% loss.

Investing in income-generating enterprises rather than attempting pure price speculation might help your odds but leveraged investments remain risky even with income-generating investments.

Hope Springs Eternal: Everyone Wants To Be above Average

Even people who know that the average active stock/mutual fund picker will underperform the market by a percent or 2 (e.g. 6-7% instead of 8%) think that they will be the ones who will outperform the iron rule of debt, by both picking and timing both debt and investment correctly, and therefore earning more than their debt costs. Every leveraged investor believes that he/she brilliantly will borrow at 8% to earn 11% when we know that quite a few people will be like the poor sap in 1987 who borrowed at 11% to earn 8%.

Those who beat the odds will be the "poster children" to recruit an army of saps. Even many of the saps will recruit more saps by falsely thinking they earned 11% when they actually earned 8% and by falsely thinking they had a positive net return when they actually had a negative net return. Take the cheerleading leverage/arbitrage hype with a grain of salt and learn the true risk and math before you act.

Good luck to all.

Home Decorating Costs: Housing Myths Part 11

Previous: Homeownership Cost Cliches: Housing Myths Part 10

The Million-Dollar Paint Job
Peculiar Priorities To Justify Spending a Million Dollars

Those who concede that homebuying is not always financially better than renting often switch the argument from financial bottom lines to unquantifiable personal preferences that cannot be tested by Excel spreadsheets.

One of the favorite intangibles that you “can’t put a price on” is the “freedom” to do no end of unpaid labor, such as painting walls.

Bone Is Freedom. Eggshell Is Slavery.

This obsession with painting houses is very strange:

• Others consider painting to be a chore, on par with having to empty the chamber pot if there was no indoor plumbing ("But if I rented I wouldn't be able to empty my chamber pot and the landlord would get to do it every time.").
• Few people confess to jealously resenting the landlord’s “freedom” to repair the plumbing or shovel the driveway yet we hear people eagerly protest the cruel fate that denies them the right to spend their free time spreading liquid on a wall.
• These color-minded people must be very highly accomplished in life to be able to say, “Darn it, I spend way too much time playing with my children. Spreading liquid on a wall is a much higher priority.”
• Few people express the same compulsion to change the color of their car yet we see people shake their fist against the tyranny that denies them the right to spread liquid on a wall.
• Few people express the same compulsion to trim the hedges in particular shapes yet we can imagine people pacing their floor while seething with burning resentment at the anti-artistic conspiracy that denies them the right to spread liquid on a wall.

Oh, the repressed self-actualization.
Oh, the humanity.

A House Is the World's Most Expensive Canvas

Customizing your home, whether rented or not, is understandable.

Less Expensive Solutions for Frustrated Artists:

• Even extremely customized/specialized decoration does not require paint at all: Most people would guess that a room with beige walls and pink drapes, pink sheets, a pink dresser, and a pink telephone is a girl's room.
• The fixation with hammering holes in walls, instead of the “tyranny” of placing your pictures on a mantel or bookcase, is equally perplexing. Given that houses often cost several times their “sticker price” (initial value) by the time they’re paid off, how many thousands of dollars per hole is that (more expensive than wildcat oil drilling?)?
• Compulsive painters could rent while changing professions to become house painters/remodelers to get paid for their hobby, or volunteer to paint walls at homeless shelters or Habitat for Humanity.
• Even if a landlord does not allow temporary color changes, the color-obsessed occupant might find that forfeiting the renter's security deposit is much cheaper than the million-dollar paint job of buying a house.

(Even a non-"jumbo loan" house can cost a million dollars after you add the mortage interest costs to the initial price: $400k @ 8% 30yr = over $1 million.)

Cheaper than a House:
Landscape painter Bob Ross' The Joy of Painting Basic Paint Set

The Myth of Landlord Color Tyranny

Some landlords let you paint and add picture holes. Some landlords let you repaint to a weird color as long as you return to a neutral color before you leave.

Homeowners Do Not Escape Color Tyranny

The irony is that homeowning is no different from renting and experts recommend that you the homeowner behave exactly like a landlord and repaint your purple kitchen to a neutral “landlord-approved” color if you wall to sell your home. This expert recommendation exposes the basic economic fact that color was never a landlord tyranny and always has been a customer tyranny.

Yes, the tyrant was YOU when you were the customer.

The homeseller is slave to the homebuyer.

The average American moves every 7 years (according to the real estate industry). The housing karma is that you were the tyrant when you were buying so you get to be on the receiving end when you try to sell.

Next: Payoff Mortgage v. Invest Stocks: Housing Myths Part 12

Did this Couple Do Everything Wrong or Everything Right?

Two Wise Acres wrote about an older couple who succeeded in the real estate investment rental business by doing "everything wrong" by violating these "rules":

• 1. "Leverage Your Investments to Maximize Growth" (instead, they paid off a property before they bought another).
• 2. "Always Make Sure You Have Well-Drafted Leases with Tenants" (instead, they rented month to month with no lease).
• 3. "Maximize Rental Income" (instead, they charged 30% under conventionally-accepted "market rates").
• 4. "In Your Lease, Make Sure that You Contain Appropriate Restrictions on Tenant Alterations to the Property" (instead, they allowed renters to paint even the exterior of the building).

However, the couple followed these rules instead:

• 1.Minimize costs (debt)--and pass the savings to the customer without lowering your profit (low producer costs=low consumer prices).
• 2.Serve the customer, find a niche, and build loyalty--the biggest cost/effort/risk is spending for the initial setup and then (tick-tock-tick-tock) eating your costs while waiting for a 1st-time customer to "walk in the door" (this why companies spend so much to advertise and to track and profile customers) so the holy grail for renting is "finding your market" (flexible leases) and no vacancies (less turnover, less frictional losses, maximum utilization of your infrastructure, on the edge of your economic "production possibilities curve"), provided by tenants' loyalty and tenant-provided free word-of-mouth advertising/recruiting.
• 3.Undersell the competition--#1 leads to #2. Low price also increases the landlord's applicant pool so he/she can select and keep the cream of the renter crop.
• 4.Build/allow customer identity/community with your product--customers will lower your costs by doing free maintenance (paint the rental house) or will create new content or products for you (free R&D). A recent book argued that most innovation comes from the bottom up, from users who invent something new for their own use first (necessity is the mother of invention, and the customer/user knows his/her own needs better than existing companies know his/her needs) and then the big companies mass-produce what the customers invented for them.

Real-life example: Another landlord (not Two Wise Acres' couple) offered low rent with no lease, let a renter nail/drill holes, and even added a major amenity without being asked or raising the rent. The renter returned the favors, paid to fix the apartment's (landlord's) refrigerator without bothering the landlord, and paid professional cleaners to clean the apartment when he moved out.

(I will write more about renter modifications in a future installment of my "Housing Myths" series.)

Did these Landlords Do Everything Wrong or Everything Right?

Homeownership Cost Cliches: Housing Myths Part 10

Previous: House Depreciation-Maintenance: Housing Myths Part 9

Housing Clichés Can Cost You Dearly

The last article mentioned that counting just 2 factors (inflation and maintenance/repairs) can cancel any supposed real-estate “investment” appreciation but there are many more costs that can turn home ownership into a loss: mortgage interest, taxes/insurance/fees, and opportunity costs of missed investments.

Your mortgage costs DO increase every year and these increases disprove the "payments never go up," "payback with cheaper money," and "good debt" cliches.

“Your rent goes up but my mortgage payment does not” is just another way of saying that the "fixed" mortgage payment starts too high, in real (inflation-adjusted) terms (plus, rents DO NOT always go up). The mortgage-holder tends to assume that the first mortgage payment is the “just right” size and everything later is discounted (by inflation) but rarely considers that the last payment might be the “just right” size and everything earlier is at a penalty rate.

“I get to pay back my mortgage later in cheaper money” is another common cliché that undermines the first cliche: If postponing repayment is so lucrative, then you would want to pay little at first and more later, so mortgage payments that do not increase over time would be bad. The “cheaper money” slogan argues for the ultimate balloon-payment plan of paying $0 for 29 years and paying everything (several times the purchase price) in the last year.

Both of these common quotes misread the mortgage situation:

All mortgages have annual cost increases built-in but people overlook the increases by looking at the nominal payment rather than the accrued cost. If your mortgage rate is 5%, each year your new, extra cost is an additional 5% of the year’s debt. The mistaken belief of no payment increases is an illusion simply because the bank has pre-calculated your 30 years of cost increases and front-loaded your money-up-in-smoke interest costs.

You are repaying your mortgage with more expensive money (not cheaper money) because the interest rate is almost certain to increase the debt cost at a rate faster than the official inflation rate. The repayment would be "cheaper" only if the mortgage had no interest rate (or one less than inflation), but I have not seen any mortgages like that, so I think the banks have figured out that loophole. Unless you find a bank that is so stupid that it lends for less than its costs decade after decade, you are losing more money each year that you keep a mortgage.

A $225k 5% fixed-rate mortgage is about the same as taking 30 years to pay off a $225k 5% credit card debt. Debt is debt. Compound interest compounds.

Pre-paying principal is so powerful at lowering your costs because it reduces the compound-interest increases.

The only escape from annual mortgage-cost increases is to end the mortgage.

Non-debt home-ownership costs increase too and these costs disprove the "but eventually I'll have free housing" cliche.

Owning has many costs such as taxes and insurance that can increase faster than the inflation rate and faster than rent increases. Experiences vary from person to person but consider these real-life examples: One person rented for 7 years without a penny increase in rent while another person during the same period bought a house and saw property taxes skyrocket 50% in 5 years. Even with no mortgage, a homeowner’s costs can increase faster than a renter’s costs.

Opportunity costs of missed investments disprove the "renters end up with nothing," "at least I have home equity," and "mortgages are forced savings" cliches.

Neither borrowing 100% nor paying 100% cash to buy a house necessarily beats renting:

Borrowing $225k at 5% costs $11,250 in interest in the first year ($937.50/mo), not counting loan origination “points,” closing costs, taxes, repairs, and other fees/costs--none of which creates a penny of equity.

Anyone who likes to pay principal on top of the consumption costs can just as well save/invest on top of paying rent, so "owning" and renting offer similar equity opportunities.

Building equity depends primarily on the individual. Spendthrifts can find a way to stay in debt whether they rent or "own."

0% downpayments, interest-only loans, HELOCs, reverse mortgages, and other house-as-ATM "equity harvesting" all prove that home-"owning" is no guarantee of "forced" savings. An automatic payroll deduction into a money-market account might be a cheaper "forced" savings plan. A renter's security deposit has more equity than some no-money-down homebuyers do.

Renters might beat homeowners in the equity-building race because renters are more likely to have lower early payments and therefore benefit from the renown compounding magic of saving early (contrary to "mortgage payments do not increase" and its backward logic of high costs/low equity-building now and low costs/high equity-building late in the game).

Paying $225k cash for a house will avoid paying interest but then you have nearly a quarter-million dollars tied up in an illiquid asset that might appreciate nominally at 5% but can have zero or negative real “appreciation” after all input/carrying costs are considered.

You instead could invest the $225k cash in stock or other investments to earn net 5% ($937.50/mo) and keep your $225k stock equity while the interest/dividends/appreciation income pays your rent, maybe in perpetuity (depending upon exact rent, inflation, etc.).

The Good Cliche: There Is No Such Thing as a Free Lunch in Housing

Housing is consumption when you own as well as when you rent so do not be surprised by the possibility that homeowner’s net costs might be similar to renter’s net costs.

More Misleading Housing Cliches (Parts 1-9, in reverse order):
"Renting doesn't build equity like my house payments do!"
"I'm debt-free! . . . with a $500,000 mortgage."
"My mortgage rate is really 1/3 less and I want to get as big a tax deduction as possible!"
"Buy as much house as you can afford!"
"My mortgage is free because I'm renting to myself!"
"My mortgage doesn't count as an expense because you have to live somewhere!"
"I really increased my ROI by leveraging as much as possible with no-money-down!"
"Never prepay your mortgage!"
"I borrow against my house to invest in the stock market!"

Next: Home Decorating Costs: Housing Myths Part 11

House Depreciation-Maintenance: Housing Myths Part 9

Previous: The "Debt-Free" Deception: Housing Myths Part 8

The Accidental Money Pit:

Do you have a few hundred thousand dollars lying around to sink into a 0% investment?

Real Estate marketing hype is that you sit back and smoke a cigar while your home value goes up, up, up--but the reality often is that you drag yourself home from work to find that you have to bail water out of your basement before black mold takes root.

The repair problem is not limited to the current housing-bubble price crash. Even “normal” maintenance and repairs of 1-2% of home value total $2k-$5 for a $225k median-price home and thousands more for more expensive homes.

Repair=Rent

Consider these 2 real-life examples:

• A condo buyer in the first year suffered water damage costs (a problem that damaged a neighbor’s unit), re-roofing costs, and fencing costs to add on top of the regular condo fees, mortgages, and taxes (regular condo fees cover frequent, small expenses such as lawn-mowing but large repairs often require extra “assessments”).
• A home buyer suffered a single structural problem that cost $9,000—an entire year’s rent for many people—to add on top of all the normal maintenance, mortgage, and taxes.

No Escape from Housing Consumption (not Investment)

You can see the false assumptions:

• A condo buyer thought that he/she would escape surprise maintenance bills by paying regular condo fees but then finds that he/she must pay the condo fees and then still pay big maintenance bills too.
• A home buyer thought that he/she would escape paying thousands of dollars of consumption housing expenditures that do not build equity but then finds that he/she must pay hundreds of thousands for the house “sticker price,” plus taxes and fees, plus (usually) mortgage interest, and then still pay more thousands in housing consumption to counter depreciation.

Imagine if people used real finance rules to calculate their housing “investment”?

Repair=Input: Repairs Increase Your “Cost Basis.”

Repairs are input costs, similar to a delayed addition to the purchase price. People like to stop counting their costs after “closing day” and pretend that years of additional costs never happened.

Tax rules recognize that repairs lower return on investment (ROI), i.e. eat away your "profits," which is why people keep repair records for tax returns, to prove that they did not make that much money after subtracting expenses.

I suppose that theoretically you could prevent your car from depreciating if you poured enough extra cash into it but those infusions would lower your return on investment (ROI), not increase it.

Houses Are a Depreciating Asset?

Try this: Buy a house and then abandon it completely for 30-50 years (no heat, no lawn-mowing, no re-roofing, no sump pump, no security, no insurance, etc.). Go find it when you are ready to claim/sell your nest egg to retire. Is that a winning investment?

(Anyone can be a Monday-morning quarterback and name past performance of a particular location, like saying, "If you bought Stock X in 1930 . . .," but it is harder to predict which markets will be hot a half-century in the future.)

The long-term US residential real estate nominal appreciation has averaged 3-6% per year but inflation plus regular, boring maintenance/repairs means that your house might return 0% real growth after 30 years—and that is before considering mortgage interest cost.

Next: All costs combined can make homeownership a negative investment and possibly worse than renting: Homeownership Cost Cliches: Housing Myths Part 10

The "Debt-Free" Deception: Housing Myths Part 8

Previous: Home Mortgage Tax Deduction Snake Oil: Housing Myths Part 7

The entire rent/own/mortgage debate is thoroughly confused, misguided, and backwards.

You are NOT debt-free if you have a mortgage. Mortgage is debt.

The love of mortgage debt is so bizarre that some people try to deny that mortgage is debt--and then accuse debt-free people of being in debt.

Have you ever had anyone tell you that they are "debt-free" only to learn that he/she carries tens or even hundreds of thousands of dollars of mortgage debt? The person might be justly proud of reaching some milestone in debt reduction but it is quite a feat of denial to pretend that the largest debt of his/her life does not count as debt.

RENT is debt-free for the tenant.

Someone once doubled the "up is down" mistake by asserting not only that mortgages did not count as debt but that rent did count as debt.

The person confused houses with housing, confused consumption with debt, and confused purchasing with financing.

• Housing is consumption, an ongoing necessity like food, but recognition of a future necessary consumption is not "debt" unless you want to tell everyone that you are heavily in debt to the grocery store because you will need to eat lunch 50 years from now.
• Debt is when you consume/take-title before you pay (becoming a debtor to the seller/provider), as opposed to pay-as-you-go (provider and consumer walk away even), or paying in advance (becoming a creditor to the provider).

The rent v. own debate is a false "opposite" and crippled by a logical flaw.

Renting and buying housing with cash are 2 forms of paying in advance. The question is if it is cheaper to pre-pay for 30 days or 30 years.

Renting and buying with cash are similar to each other and it is the mortgage that is the complete opposite. Too many people make a leap of logic of confusing paying-in-advance with spending money that they do not have, which is an entirely different kettle of fish.

The landlord is debtor to the tenant.

The tenant pays in advance by paying on the first of the month for housing in the coming month, which puts the landlord in debt to the tenant. The tenant is the creditor and the landlord owes a month of housing.

Semantics

A lease is a mutual obligation on both parties. Technically, you might argue that you are in debt to the electric company because the company does not bill you until after you consumed the electricity, but by that logic you are in debt when you are eating at a restaurant before the waitress brings the bill. The distinction with restaurants, electric bills, and credit cards is that they provide a grace period with no interest charge (treating the transaction as pay-as-you-go).

The practical test for "debt-free": You are in debt if you are paying interest. You are debt-free if you do not pay interest.

Next: The Accidental Money Pit - House Depreciation-Maintenance: Housing Myths Part 9

Home Mortgage Tax Deduction Snake Oil: Housing Myths Part 7

Previous: Hidden Burden of Overbuying: Housing Myths Part 6

The Home Mortgage Income Tax Deduction NEVER Saved ANYone ANY Money

Taking the Mortgage Deduction Always LOSES You Money

Mortgage Tax "Savings" Are Always Losses

Taxes are losses. "Tax savings" are NOT real savings. Tax reductions reduce tax losses of your initial "pile" of income from, say, negative 10% to negative 9%--but still negative (still a loss). In most tax cases, the best you can do is break even by keeping what you started with (0% loss). There is almost never a chance of real gain or real savings.

The mortgage-interest tax deduction is worse than many tax deductions.

Mortgage-interest "tax savings" are NOT savings. Mortgage-interest "tax savings" are losses because you pay more to qualify for the "benefit" than you get in return. The economic illogic is stark. Would you start a business to make a widget that costs you $10 to make and sell it at $1? Would you borrow money at 10% interest to put it in a bank account that earns 1%? The simplest example of the mortgage-interest tax deduction is that you must pay $10 to "earn" $1 (at a 10% marginal tax rate) for a net loss of $9.

That is a return on investment (ROI) of negative 90%, a 90% loss. A 25% tax rate would return a loss of negative 75% ROI. Does working to "get" or "keep my mortgage deduction" sound like the road to wealth?

Even the "net loss of $9"/"90% loss" way of thinking is too optimistic (for the following reasons):

The standard deduction makes a mortgage an even worse deal.

Tax Deduction Cancellations: The government giveth with one hand and taketh with another.

Assuming for a moment that mortgage interest is the only itemized deduction:

• A 2006 single person could pay $5,150 in mortgage interest and not save a single penny in income tax.
• A 2006 married couple could pay $10,300 in mortgage interest and not save a single penny in income tax.

Everyone gets these $5k-$10k tax-deduction amounts regardless of housing situation.

• A couple who paid $10,300 rent gets a $10,300 tax deduction (standard deduction) without having to pay a penny of interest.
• A couple who paid cash for a house gets a $10,300 tax deduction (standard deduction) without having to pay a penny of interest.

Update 5/6/09: The new 2008 IRS property tax deduction without itemizing means that a couple under 65 years old gets a $12k standard deduction and a senior-citizen couple age 65 or older gets a $14k standard deduction.

"Estimates suggest that approximately 40% of homeowners do not itemize" (Congressman Baron Hill D-IN).

The mortgage holder can deduct mortgage interest instead of taking the standard deduction. A mortgage holder only gets an extra discount on the extra marginal amount of itemizations that exceed the standard deduction.

(The total itemized amount can include other items such as property tax but I will refer only to mortgage interest for simplicity. If a couple already has $10k of itemizable spending even without a mortgage, that level of spending might explain the lack of savings--and perhaps a reduction of spending would help more than the addition of debt.)

The mortgage-interest tax-deduction effective rate is NOT your top marginal tax rate.

The effective rate accounts for the trade-off of losing the standard deduction to take the itemized mortgage deduction instead.

If a couple with a 10% top tax-bracket paid $20,300 in interest, the relative income-tax reduction (compared to not taking a mortgage) would be only the marginal rate of the marginal amount, 10% of the $10,000 ($20,300 paid - $10,300 standard deduction), a relative tax reduction of $1,000.

The so-called "tax saving" is:

• NOT at the full, top, marginal rate. It is less than half of the top rate, not a 10% discount but a 4.9% discount ($20,300/$1,000).
• NOT a net saving. The couple has saved nothing and in fact lost at least net $19,300 ($1,000 - $20,300).
• NOT a real gain. It is only a tax-drain shift from negative $1k to $0 (vis-a-vis the IRS) so the real loss of wealth is the full $20,300 ($0 - $20,3000).

Households at the highest marginal rates, who might think that they would merit the biggest tax reduction, might find their deductions canceled by the Alternative Minimum Tax (AMT) at $42,500 income levels for singles and $62,550 for married couples in 2006.

Any way you slice it, the borrowing cost always overwhelms the tax reduction.

Net Loss: Mortgages Harm Net Worth

Consider 2 couples facing the earlier scenario who start the year with $20k cash:

• The one who denied $1k to the IRS by paying $20k interest to the bank lost all $20k and has $0.
• The one who paid the extra $1k taxes to avoid paying $20k interest lost $1k and still has $19k.

What a difference a year can make.

Would you rather be negative 5% (lose 1k of 20k) or negative 100% (lose 20k of 20k)?

The mortgage tax deduction is 20 times worse than borrowing from Peter to pay Paul.

Borrowing $1k from Peter to pay $1k to Paul is a classic example of going nowhere fast.

However, the mortgage deduction is much worse and actually puts your finances in reverse because you are avoiding paying $1k to Peter only by paying $20k to Paul.

"Hey, what happened to my $1k tax-deduction money that I wanted to keep in my pocket?"

Sorry, your mortgage-interest deduction goes in the bank's pocket, not yours.

IRS "Teaser" Rates:
The evaporating tax discount races to zero.

The effective tax discount, if it existed at all at first, diminishes each year as the amount of mortgage interest paid decreases each year (the "mortgage payment" is mostly interest at the beginning and mostly principal at the end of the loan--and the principal is not deductible).

Therefore, not only might you not get an advantage on the full amount of interest paid in each year that you do itemize, the diminishing interest payments mean that you might not itemize for the full 30 years (not in later years).

If you itemize only for the first 20 of 30 years (because the diminishing interest eliminates the itemization advantage in later years), and during the 20 years your average itemizations exceed the standard deduction only slightly, you get very little tax advantage.

You can pay tens of thousands of dollars of mortgage interest with no itemized deduction for the costs.

Deduct half a million dollars without paying a penny of interest.

The biggest mistake that a person can make is to multiply his/her lifetime total of mortgage interest by his/her top tax bracket, which can grossly overestimate the tax advantage and underestimate the costs (as explained above). Do not make the mistake of assuming that you get a tax advantage on 100% of all mortgage-interest paid when you might get a relative advantage on, say, only 20% of all the interest you paid.

Compare the dollar amount from itemized deductions to $300k of a couple's standard deduction over 30 years or $500k over 50 years.

Why not take the $500k of deductions without paying interest?

Next: The "Debt-Free" Deception: Housing Myths Part 8

Hidden Burden of Overbuying: Housing Myths Part 6

Previous: Do Not Confuse Houses with Housing: Housing Myths Part 5

Would You Pay $250,000 for a Room?

The Housing Bubble: Historical Growth in Houses Square Feet per Person

4 Reasons People Overbuy Housing--and How To Avoid It

1. Expected Duration of Use: People who borrow, say, a lawnmower are not inclined to scour the city to borrow from the person who has a mower with all the exact, ideal features of the borrower's tastes. However, a decision to purchase often launches people on the slippery slope of pursued perfection to find a mower with the highest horspower and best cup-holder.
2. Timing of Use (Now V. Future): People who make small, instant-total-consumption purchases, such as buying lunch, are likely to buy just enough to do the job. That sizing job gets harder with longer time horizons and increasing risk or uncertainty of how much you will need years in the future. Imagine if you had to buy all your food for the next 30 years today.
3. Uncertainty and Insurance Premium: People tend to pay extra to overbuy as insurance against future unknowns, which is why long-term, fixed interest rates usually are higher than short-term adjustable interest rates over time (overpaying as insurance against future unknowns).
4. Infrequency and Information/Experience Deficit: People also tend to overpay when they do not buy an item frequently and therefore lack cost-benefit knowledge, so they overestimate both their needs and the value of the product, such as the case with choosing a college and buying a college degree.

House purchases are both infrequent and long-term (or at least many buyers treat them as such) and so people are prone to overbuy to compensate against future unknowns. Mission creep adds dens, offices, exercise rooms, decks, and saunas. House size doubles from 1,500 to 3,000 square feet—“just in case.”

Upsizing the house is like buying the $50k camper or boat that you use once every few years. People tend to imagine the temporary time of maximum needed space and then go into decades of debt for infrastructure that is rarely used.

Know Your Life-Cycle Needs

A newlywed couple might go 5 years with no children and even a baby does not require a new bedroom. It is not historically unusual for several children to share 1 bedroom (even boys and girls together). Teenagers tend to need more room but that is why they get drivers licenses and go away to work or college. Long life spans indicate decades of life as “empty nesters.” So, people tend to overbuy the largest purchase of their lifetime based on a brief 5-10 years of peak usage.

The Marginal Cost of an Extra Bedroom

The price difference between 1 house and another house with an extra bedroom might be $50-100k, which costs $100-250k for that 1 room after today's typical finance charges of a 30-year mortgage to pay for it (ballpark figures). If you only truly need the room for 10 years, you are paying maybe $10-25k per needed year for that 1 room (not counting the luxury use of the spare room before and after the peak).

Basic finance rules say that it might make sense to buy what you need daily for 50 years but to rent what you need briefly and occasionally. Another option is the pay-as-you-go method to add-on to a house as needed. Buying and selling houses is problematic both because of the high transaction costs and because of government regulations about public-school districts which can prevent families' smart housing choices.

Do Not Buy Too Early

Why borrow and pay interest for extra space over a decade before you need it? Why not save for over a decade and then pay cash for extra space exactly when the need arises? Do you borrow to finance an extra car when your baby is born because the baby will be driving age 16 years later?

The best financial choice is the opposite of what most people do.

The best financial choice for a lifetime house purchase would be a smaller house geared to the minimum points in the lifecycle (because you will have smaller needs many more years than you will have larger needs), with temporary conversions within the original house dimensions (no additions) to accommodate temporary needs for “increased” space. The Brady Bunch’s Greg Brady made an attic room for himself and today’s smaller families average only about 3 persons each (either 1 child or 1 parent) so that fleeting teenage bubble of demand for space will not require much change.

If you want to live in the “perfect”-size home at each stage in your lifecycle, renting might be the best choice for many of the years.

Your Choice Makes a Big Difference:

How much health insurance could you buy by not spending an extra quarter-million dollars for 1 extra room?

Next: Home Mortgage Tax Deduction Snake Oil: Housing Myths Part 7

Do Not Confuse Houses with Housing: Housing Myths Part 5

Why Housing Is NOT an Investment
Why Home Mortgages are BAD Debts

Previous: Homeowner Profits Ignore Huge Costs: Housing Myths Part 4

“You Have To Live Somewhere” and Getting Rich by Eating Twinkies

Some people try to close their eyes to the bad investment of a home mortgage by asserting that the bulk of the borrowing costs “don’t really count.”

The common “You have to live somewhere” argument confuses opportunity costs/benefits and confuses houses (durable goods) with housing (the use of the durable goods).

(UPDATE: Economists recognize the distinction between house (asset) and housing (consumption) by referring to housing as a "shelter" "service"--although government's misuse of this valid distinction in its statistics and policies is another matter; see the Bureau of Labor Statistics (BLS) Consumer Price Index's (CPI) Owner's Equivalent Rent (OER) controversy.)

Rental Opportunity Costs/Benefits Negate Each Other

If the house was an income-generating investment, you could offset your borrowing cost with rental income. Living there yourself instead of renting to others (“renting to yourself”) means that you save writing a rent check to a landlord only by foregoing the receipt of a rent from a potential tenant of your own.

Imagine if you rented a house from someone but you bought an identical house next door and collected rent from your new house next door; the rents would cancel each other and net zero (paying rent to a landlord, collecting rent from a tenant). Owning and occupying a single house has the same result, net zero (not paying rent, not collecting rent). Therefore, the entire cost of the house including purchase/interest/maintenace/etc. is still an extra cost and not defrayed by anything. In other words, your savings are “not paying rent” but your costs are “not collecting rent” so you have not avoided one cent of the additional cost of house price and mortgage interest and insurance and maintenance and taxes.

Housing Is Consumption, Not Investment

You do have to live somewhere. That is exactly why housing is consumption, not investment. Do not confuse the house with housing; housing is the use of the house (shelter service). Housing is the consumption of time in a place (the house). When you "rent to yourself," instead of selling the consumption to a renter, you are consuming your own inventory.

No Such Thing as a Free Lunch: You Cannot Have Your Cake and Eat It Too

“Renting to yourself” means that housing is consumption (not investment) because time is money and the value of living in your house yesterday is gone with yesterday, not saved for tomorrow. Further, only one person can use a particular space at any one time and even renting one of your house's rooms to someone or other "shared space" is a reduction in your own consumption of housing, a reduction in your use of your own house (zero-sum game). Do not double-count.

Get Rich by Eating Twinkies?

You constantly consume housing like you constantly consume food.

Buy and eat a Hostess cake without trying to claim that paying to eat the cake is making you wealthy. Likewise, pay to consume housing (time in space) without trying to claim that paying to sleep in a room is making you wealthy.

Borrowing for Consumption Is Bad Debt

A typical rule of thumb is that so-called “good debt” (actually, less bad) increases productivity or generates income more than it costs (e.g. a tractor increases crop yield). “Bad debt” is everything else. Most people would see danger in taking loans to pay rent yet borrowing for instantly-consumed housing via a mortgage is essentially the same type of debt.

A 30-year mortgage is (in principle) no better than taking a 30-year loan to borrow 3 decades of rent in advance.

Think about that. In the first year of a 30-year rent loan, you could invest 29 years of rent in the stock market (a stock asset instead of a real estate asset).

(In practice, the securitzed mortgage and tax subsidies make a mortgage loan cheaper than a rent loan, but the principle is the same.)

The marginal asset value of a house, over and above the consumption cost of housing, is a separate factor that you can treat as a distinct investment.

You can try to use the historically minimal real appreciation of real estate as an investment but the appreciation is often small potatoes compared to the consumption cost/value of the house-for-housing--and the appreciation often is largely cancelled by costs (taxes, insurance, inflation, and especially borrowing costs if leveraged).

Satisfy your housing consumption and then choose the best investment for your surplus money (real estate? stocks?).

Before you borrow a quarter-million or half-million dollars, know if you are borrowing for investment or consumption.

Next: Hidden Burden of Overbuying: Housing Myths Part 6

Negative 11% Home-Value "Appreciation" Rate Is Considered Good Now?

Negative 11% is one of the best "appreciation" rates in the nation.

The Real Estate Bloggers posted a list of the top 20 real estate markets over last year.

Look at Detroit (below).

If the "top" 20 home-value "appreciation" rates include double-digit negative rates, what do the worst 20 markets look like?

Top 20 Markets: Real Estate Property-Value Appreciation Rates over Last Year

Seattle 9.10%
Charlotte 7.00%
Portland 5.70%
Dallas 1.80%
Atlanta: 1.70%
Denver -1.40%
New York -2.30%
Chicago -2.80%
Cleveland -2.80%
Los Angeles -3.30%
Miami -3.30%
San Francisco -3.40%
Minneapolis -3.50%
Las Vegas -4.10%
Boston -4.30%
Phoenix -5.50%
Washington, D.C. -6.30%
Tampa -6.70%
San Diego -7.00%
Detroit -11.10%

Savers Are from Mars. Debtors Are from Venus. Episode 4

Is Renting So Bad that You Would Steal?

You find a wallet. What do you do?

If you are Elizabeth Cabrera-Rivera, you steal Jose Lara's identity to commit loan fraud by getting a no-documentation mortgage ("no-doc mortgage") for a $419,000 townhouse in his name. Mr. Lara only discovered the plot when he received a $2,800 refund for closing costs and the jig was up for Cabrera-Rivera.

It gets even stranger.

Elizabeth Cabrera-Rivera committed the crime because she could not get a mortgage in her own name. However, she did not abscond with the cash. Nor did she try to get free housing by defaulting on the mortgage and stretching out the eviction. No, our heroine dutifully paid the monthly mortgage payments on time.

Yes, she was buying a townhouse for Jose Lara. Sadly, it sounds like she could have been very successful building equity/savings in her own name while renting. Instead, decades of her toil gets her to that magic moment when the mortgage is paid off . . . for someone else.*

How is that better than renting?

How brainwashed must you be that you "have to" have a mortgage, even if it is to build someone else's home equity?*

* Update 11/12/07: Cabrera-Rivera later transferred the deed to her name (see comments).

Inflating Leveraged ROI Can Ruin You

Previous: Leveraged Investments: High ROI Is Not Always Best

The previous leverage article covered how the common method for measuring leveraged Return on Investment (ROI) can mislead you by underestimating the work and risk. Add overly-optimistic “magic” numbers to inflate ROI and this article shows how the combination of rosy estimates and ignored risk can trick you into a bad investment.

We will start with the same example as last time:
$250k: invest 100% cash (unleveraged) or 10% cash with 90% loan (leveraged)?

$250,000 [100%] paid in full in cash:
--$26,400 in rents - $3300 expense = $23,100 NOI
--$23,100 / $250,000 = 9.2% ROI

$25,000 [10%] cash down payment [plus $225,000 mortgage]:
--$18,879 in mortgage payments + $3300 expense = $22,179
--$26,400 in rents - $22,179 = $4221 NOI
--$4221 / $25,000 cash in front = 16.9% ROI

example from: Using Financing for Real Estate Leverage

Debt makes you 80% richer?

The example author concluded:

“As you can see, even though your risk increases with leverage, it might be a wise choice when you can increase your ROI by as much as 80% (16.9% is 84% increase over 9.2%) over the full cash in front option.”

The promised 7.7% spread (16.9 over 9.2) was not impressive enough so the author used a percentage of a percentage to make the pro-leverage number 10-times bigger (80%--Who doesn't want to earn 80%?). Almost doubling your ROI would be a good thing but let’s not get carried away too soon.

The pro-leverage conclusion depends on magic numbers.

How many rental markets have perfect 100% occupancy rates, i.e. no vacancies at all between tenants, and no missed payments? Here are some real-world rental occupancy rates/vacancy rates that I quickly found to see how the examples perform with real-life inefficiencies:

(Sorry if a long space appears before the table)

© 2007 HFF Market	Occupancy Rate (%)	Gross Rent Annual ($)	ROI Unleveraged (%)	ROI Leveraged (%)
Hypothetical	100.0	26,400	9.2	16.9
2001 Northeast	94.7	25,001	8.7	11.3
2001 US urban (inside MSA)	92.0	24,288	8.4	8.4
2001 US non-urban	89.6	23,654	8.1	5.9
2004-Sep. Texas 6 major markets	78.0	20,592	6.9	(6.3)
2003-Oct. Texas 6 major markets	77.5	20,460	6.9	(6.9)

Sources: Statistical Abstract of the United States, 2002, Community Connections

• In only one real-world occupancy rate did the leveraged ROI beat the unleveraged ROI.
• In one other case, leveraged ROI broke even with unleveraged ROI.
• In most cases, the leveraged ROI was worse than the unleveraged ROI.
• In 2 cases, the leveraged ROI is losing your money while the unleveraged ROI is still providing almost 7%.
• In the last case, the margin spread (+6.9% v. -6.9%) shows that it is the unleveraged ROI that is 13.8% points higher than the leveraged choice.

Can you feel that $225k of debt making you 80% richer yet?

Leveraged Investments: High ROI Is Not Always Best

A recent leveraged-investment discussion revealed that people can calculate a high Return on Investment (ROI) from borrowing by not counting the debt principal as a cost and (in one case) not counting the debt interest as a cost.

Consider a choice to invest $250 cash v. $250 debt:

Investing cash to earn 10% earns 10%.
Investing debt at 5% interest-cost to earn 10% earns net 5%.

However, it is common to claim that debt gives the higher ROI.

Free money, for the asking, no strings attached, no debits

Financial analysts can claim that debt gives the higher ROI by not counting the debt principal as part of the investment, yet counting the net returns from debt (your ROI sprouts from "nothing"). The argument is that the debt is "not your money," although a credit check of your name would not agree completely and at the very least the argument ignores the legal liability, risk, insurance requirements, effect on credit score, credit score's effect on other loan rates, etc.

Infinite ROI, infinite profits

Excluding the debt principal from the initial value of an investment certainly can raise the apparent ROI. However, that argument suggests that 0% downpayment gives you infinite ROI when we all know that, for any given dollar amount of investment, you would be poorer by borrowing more of it and richer by borrowing less of it (as in the "Consider a choice" above, and the example below).

Wait, there is no such thing as a free lunch after all

While a high ROI seems efficient, at some point you want to maximize your profits in dollars rather than percentage points. You cannot buy lunch with percentage points. You need dollars.

Look at your real estate profits here in Net Operating Income (NOI):

$250,000 [100%] paid in full in cash:
--$26,400 in rents - $3300 expense = $23,100 NOI
--$23,100 / $250,000 = 9.2% ROI

$25,000 [10%] cash down payment [plus $225,000 mortgage]:
--$18,879 in mortgage payments + $3300 expense = $22,179
--$26,400 in rents - $22,179 = $4221 NOI
--$4221 / $25,000 cash in front = 16.9% ROI

example from: Using Financing for Real Estate Leverage

The NOI trend gives you an idea of your hard-earned money that you keep by putting a larger downpayment on your mortgage (although this is a rental example).

These types of examples are very common to extol leveraging but you can see the trend that the more you pump up the ROI, the less money you make.

Cocktail-party bragging rights to the higher but leveraged ROI will cost you $18,879.

How high an ROI do you want?

(PS: The NOI informs you that the leveraged ROI is inflated because it ignores that you left $225k cash idle and (apples to apples) the actual leveraged ROI here is only 1.7% ($4221/$250k), or 0.9% ($4221/$475k) if you include the $225k mortgage to discount for debt risk.--Note added 7/25/07, last updated 7/30/07)

-

Leveraging multiplies scale, volume, and risk but I will leave that for a future article. Alternate uses for the same money (opportunity costs) such as stocks or arbitrage are separate choices and each can be leveraged or not leveraged.

Next: Inflating Leveraged ROI Can Ruin You

See also:
Never Prepay Mortgage? Housing Myths Part 1
The $200,000 Blunder: Housing Myths Part 2
Home Mortgages Are Bad Investment Tools? Housing Myths Part 3
Homeowner Profits Ignore Huge Costs: Housing Myths Part 4

Homeowner Profits Ignore Huge Costs: Housing Myths Part 4

"You have to live somewhere"="Pay no attention to that man behind the curtain"
It is an incantation to evade close scrutiny of real estate accounting.

Part of a series of articles on housing myths.

Previous:
Home Mortgages Are Bad Investment Tools? Housing Myths Part 3

Some people make the “you have to live somewhere” argument to ignore most mortgage costs and make the home-as-investment accounting look better (hiding liabilities "off-book" a la Social Security). However, that argument backfires and incurs additional costs that still invalidate the arbitrage game of borrowing to invest in a home as an investment.

"You have to live somewhere" cuts both ways.

The Replacement House Cost: “You have to live somewhere” means that you cannot sell your house without buying a replacement house--or other accomodation, but the "housing ladder" ideal is to "trade-up" and most people do not transfer to a lesser market, smaller house, or rental (although if you had tried to rationalize by subtracting rent value from your house purchase, be consistent and add rent cost to your home-sale costs if you do not buy a replacement house). Therefore, the cost of your replacement house is part of your transaction costs to realize your gain on your first house—and many people would find the result to be a net loss if they accounted correctly.

The Deflator Negates the Appreciation: “You have to live somewhere” negates most or all house appreciation because most people will replace a house with another house that appreciated by a similar amount. The key to “real” appreciation or “beating inflation” is a differential price rate between 2 different classes of commodities (say, real estate v. the CPI’s non-house basket of general goods) or 2 different markets. i.e. when your item increased more than the item that you want to buy, you can trade at a favorable exchange rate (a basic idea most associated with, but not limited to, currency trades). By re-investing in the same asset class and market, you eliminate the arbitrage possibility; you eliminate the possibility of beating inflation. In other words, when you calculate your real appreciation from your house-sale as investment, the proper deflator for the first house is the replacement house’s appreciation over the time period that you lived in the first house (do not use a CPI deflator). Many people will learn that trading keys is like getting a 10% raise to buy items which cost 10% more--they realize no real net gain from appreciation. The profit truism is “Buy low. Sell high” but sell-high-then-buy-high makes no money. You are running yourself ragged on your hamster wheel.

$XX,XXX Transaction Costs to Middlemen: “You have to live somewhere” requires the transaction cost of buying replacement housing and can lower your house-sale net gains by tens of thousands of dollars (compared to the $10 transaction fee that you pay to Ameritrade to realize your stock gains). You (the re-buyer) pay the realtor costs, new loan origination costs (points), closing costs, moving costs, and any other costs plus the value of time and inconvenience to move. The seller pays the realtor with the buyer’s (your) money. The old joke is that the buyer is the only one bringing money to the table and everyone else is a taker. Various “cash-back” games or other incentives usually amount to additional debt heaped onto the buyer (such as your “free” granite countertops at $10,000 plus 6% interest).

No net appreciation + high transaction costs = real net loss

Certainly some people make money and you could avoid a replacement-house purchase by moving back in with your parents--but then you could have lived with parents all along and worked as landlord to your mortgaged property--but then you did not need a mortgaged property at all and your money could have earned more elsewhere debt-free.

Many happy "housing ladder" key-traders stay happy only by not looking too closely behind the accounting curtain.

Next: Why rent and the “You have to live somewhere” argument proves that your housing is NOT an investment: Do Not Confuse Houses with Housing: Housing Myths Part 5

Home Mortgages Are Bad Investment Tools? Housing Myths Part 3

The Lure of the No-Brainer Get Rich Quick Scheme

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.

Next: Homeowner Profits Ignore Huge Costs: Housing Myths Part 4

The $200,000 Blunder: Housing Myths Part 2

Part of a series of articles on housing myths.

Some people will make a $200,000 blunder but think that they are making money.

Chasing Unicorns

Never Prepay Mortgage? Housing Myths Part 1 covered how would-be moguls fail to assess different risk levels when keeping mortgage debt to chase possible investment profits. Some people (real people, not hypothetical people) think that a money market (unlikely to go below 0%) might be the solution to avoid stock volatility. However, less risk means lower possible returns, plus money markets fluctuate too (some crashed below 1% a few years ago). Unfortunately, some people think that they can make money even when their investment rate is lower than their borrowing rate.

Avoid Major Math Mistakes

The first problem is that people apply income tax modifiers essentially backwards, doubling the error. People vastly overestimate their tax reductions by (for instance) applying a 28% discount to every penny of mortgage interest (more on this in a coming article) and then compound the error and also overestimate their investment growth by not applying 28% taxes to their money-market interest. The first step is to estimate a realistic, after-tax return on investment (ROI).

An easy way to account for taxes on compounding interest is to discount the interest rate by your tax bracket (a 28% tax on 5.05% interest is 5.05 x 0.72 = 3.636% effective interest rate). This method is imperfect (it assumes that tax payments/withholdings and compounding occur almost simultaneously) but is much less wrong than ignoring taxes entirely. One blogger who thought that he would have $134k actually would have closer to $119k, a $15k error.

The even bigger mistake is when people make a false comparison at the 15-year mark, which ignores half the costs of the unpaid 30-year mortgage, or they mix up a 15yr scenario with a 30yr scenario. A proper comparison must be at the 30-year mark for both altertnatives.

Our Example (from a real person)

• $200k 30yr 5.875% mortgage (at bankrate.com calculator).
• $1,183.08/mo minimum mortgage payment.
• $500/mo extra available in budget.
• 5.05% money market investment opportunity (annual interest compounded monthly at planningtips.com).
• 28% federal marginal tax bracket (no state tax included here).

Keeping mortgage to invest loses over $100k

Minimum mortgage payments total $426k ($200k loan + $226k interest), offset by $325k after 30 years of money market for a net loss of $101k.

Paying mortgage early gains over $100k

Paying an extra $500/mo on the mortgage principal would pay off the mortgage after 15 years, for a total cost of $300k ($200k loan + $100k interest).

What people forget to count is that if you pay off your mortgage after 15 years, you then can invest your old mortgage-payment amount ($1,183.08/mo) plus your over-payment amount ($500/mo) for the next 15 years (remember that you paid both these amounts for the whole 30 years in the investment scenario too). In our example, $1,683.08 @ 3.636% for 15 years is $402k, or a net gain of +$102k more than the mortgage cost.

The $200k blunder

So, borrow to invest for a net loss of $101k, or eliminate debt and then invest for a net gain of $102k. That is a difference in fortunes of $203k, the difference between buying a second house or paying twice for one house.

A future article in this series will cover why the vaunted mortgage deduction would not fundamentally change these conclusions.

Next:
Home Mortgages Are Bad Investment Tools? Housing Myths Part 3

Never Prepay Mortgage? Housing Myths Part 1

This is the first in a series of articles on housing myths.

Should You Prepay Your Mortgage?

“Rule #1” of personal finance is to pay off debts because killing anti-savings is the best savings in terms of real, after-tax, return on investment (ROI). Unfortunately, the complexity of comparing relative interest rates with differing tax rules can confuse people into breaking this rule in the wrong circumstances.

Risk: A Bird in the Hand Beats Two in the Bush

The first problem is that people treat assumptions as if they were measurements. The second problem is that uncertainty is greater on your income side of the equation: The odds of you losing your job or seeing your stocks drop is greater than the odds that the bank will forget to collect its monthly mortgage payment.

You need to consider the risk or likelihood of an ROI. A fixed-rate mortgage has a fairly certain negative ROI. You might compare a 10-year fixed-rate mortgage to 10-years of CDs to compare contractually-guaranteed rates. Bond yields fluctuate but without anywhere near the principal-loss-risk of stocks so you might compare a 30-year mortgage to a 30-year Treasury bond.

Trade-Offs: There Is No Such Thing as a Free Lunch

You will notice that ROIs decrease as they approach the certainty of mortgage debt and it is very difficult to find similar-to-mortgage-certainty investments that pay more than mortgages cost. Risk being equal, debt will cost more than savings will earn (hence Rule #1). This must be so for a bank to make a profit (in a simplified business model).

Investments that appear to pay better than paying-off-debt usually offer possible profits in exchange for more risk, or offer short-term “teaser” rates.

Testing the "Never Pay Off Your Mortgage" Advice

Chazzman2000's comment at The Simple Dollar mentioned this Fool.com article as an exception to Rule #1, because the Fool.com article argued that you can make a bundle by investing in the stock market instead of paying your mortgage early. Fortunately, that article was written in 2001 so let’s see what would have happened to someone who read the article, closed on the exact same suggested mortgage that same day, and poured the extra money into an S&P500 index fund ever since (I randomly chose SWPIX, which did its intended job of tracking the S&P500, labeled GSPC in the chart):

The 2001 article claimed that it would estimate only a “mediocre” 12% annual return but SWPIX’s actual 5yr average is now 8.23% and its 10yr average is 7.70%, which is less than the 8% mortgage rate. If you had put the extra $300/mo. on the mortgage for the last 6+ years, by now you would have paid $6,569.45 less interest and have built $29,069.46 more equity than if you had made the minimum payments, for a combined benefit of $35,638.91, which is about the same as and probably better than the SWPIX alternative (if we counted every last detail).

Tax deductions probably would not rescue the SWPIX choice but I will cover tax-deduction myths in a coming article.

Update 6/19/07: My comments to The Simple Dollar did not always get published but his latest post seems to echo what I and others have been trying to say.

Update 6/22/07: The questionable 12% S&P500 promise resurfaced in a June 12 MSN/Money Central article that Mighty Bargain Hunter questioned.

Update 10/28/07: Note that I generously assumed the fictitious 8% S&P500 rate but the actual nominal growth from 3/01 was little above 0% and the real "growth" after several years probably was a negative loss.

Next: The $200,000 Blunder: Housing Myths Part 2