Investment Workshop 39: Investing With Debt

Wanderer
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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.

We recently received an email from a reader that went something like this:

I know your stance on buying a house, and I agree with your reasoning.  However, I live in the Midwest of the U.S. where it is more financially sensible to buy a house instead of rent. I currently live with family while I am paying off debt, and I will be debt free by the end of next year.  Once my debt is paid, I plan to save more aggressively for retirement, increase my emergency fund from a couple months to a year, and save for a house.

So my question to you: If given the opportunity, would you buy your first house in cash over getting a mortgage?

OK first of all, great job on becoming debt free, you deserve a pat on the back for that.

Now, onto her question.

It’s no secret that we here at the Millennial-Revolution.com have certain…opinions on housing (hint: Not a fan). Housing should be treated as a place to live, not as an investment, and in many high-cost cities it makes much more sense to rent rather than own.

But in certain cities, it might not be the worst idea. Justin McCurry from RootOfGood.com bought his house in North Carolina for just $108k. At that price, you won’t blow up your retirement plan too badly.

So in situations like this, where the housing costs are low enough for it to make sense and you have the cash, does it make more sense to take out a mortgage or just pay cash?

If it were me? I’d always choose to pay cash.

Here’s why.

We’ve all heard the arguments of why it supposedly makes mathematical sense to go into debt (or in this case, deliberately take on a mortgage) to invest. If the interest rate on the debt is only 3-4%, and markets give you gains of 6-7%, it makes sense to do it, right?

Well, not really.

That may have made sense before the financial crisis, when we believed the economy looked something like this.

In the Economy, there are 3 separate yet equally important groups. These are their stories. *chung chung chung*

But as we found out during the Financial Crisis, they’re not separate, are they? In fact, they’re linked like this.

Now we know that when one falls, it can (and will) pull other parts down with it. A housing crash can roil the financial markets, which can spark massive layoffs, which cause housing to crash even more, which makes the financial markets plummet even more, and so on and so on until we have a worldwide recession.

It’s in this situation when using debt to invest gets you into trouble.

Index investing is, I believe, the most reliable and simplest way to generate long term gains for retirement, but a core part of that strategy is that when your allocation drifts from your target you’re supposed to rebalance. This means selling stuff that went up and buying stuff that went down. And crucially, in a financial crisis like the one we experienced in 2008, that means selling bonds and throwing cash at equities as they plummet.

It’s not fun but it does work, as we experienced first hand when we got through the 2008/2009 crisis without losing any money using exactly this strategy.

However, we wouldn’t have been able to do this if we invested with debt. When financial companies run into trouble, it’s entirely in their right to call whatever debt they have and force you to pay it off immediately. If this happens, you’ll be forced to sell your equities to cover the debt, and that’s exactly the worst possible time to sell.

That’s for HELOCs. For mortgages, the risk is similar because if the crisis gets bad enough that you lose your job, you’ll fall behind on your mortgage payments and risk getting your house foreclosed, forcing you into the difficult situation of selling off assets at the worst possible time or losing your house.

But if you had paid for the house with cash (and you had a sufficient emergency fund) you could wait out the storm, not lose your house, and not be forced to sell your retirement portfolio until the job market picks back up.

Now there’s a downside to paying with cash that you’re probably noticing. The higher the home price, the more cash you need, and the more cash you don’t have to invest for your retirement. And that’s kinda the point.

Home equity is dead money. And it will remain dead money that you can’t access until you sell the damned house. So it makes sense to keep the money you spend on your house as low as possible.

So that’s why I’d pay with cash. It avoids debt which would force you to sell your portfolio at a loss if a crisis happens, and it keeps you from buying too much house, which as we’ve written time and time again, is an excellent way to blow up your retirement plan.

What do you guys think? Would you take on a mortgage and invest, or buy the house with cash?

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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.

23 thoughts on “Investment Workshop 39: Investing With Debt”

  1. It all depends on the circumstances, especially on the price to rent ratio and the mortgage offer.
    Personally one of my best financial decision was to buy the right house at the right time with only little down payment.
    Is it always the right choice? Obviously not. You should sit down and calculate for days or weeks with conservative numbers, compare 3-4 possible scenarios and then you will see a clearer picture.
    Considering the current low interest rates, my gut feeling says that IF you find a house with a reasonabe price to rent ratio AND you are planning to stay there for at least 5-6 years, buying with all cash is a bad idea…

  2. It’s all about balancing your risk, right? Theoretically, you’d make more money by having a mortgage and investing rather than having a paid off house (i.e. house poor). In exchange for making this money, you take on the risk outlined above. Is that risk worth it? Math that shit up and see if the difference is worth the risk.

    In a similar vein, whether to refinance is a similar risk analysis. If your house has appreciated, refinancing can be a way to shift that equity out of the house. Maybe turning the dead equity, alive! Or at least, into zombie equity.

  3. Both. Get the mortgage, then work like heck to get the mortgage paid off while still adding to the retirement accounts. It’s important to start the retirement accounts and add to them as early as possible, so they shouldn’t be ignored in favour of mortgage repayment.

    Only if the house price was reasonable would I buy a house.

  4. For some areas, buying is the worst idea on the planet (SF, NYC, London, Perth…) but other areas it can actually help. I believe this because I live in the Midwest. I bought a 2600+ sq ft multi-family unit for $85k with $5k down. My mortgage is $705 a month and I get $1100 from the other units. Now I have next to no housing costs so I can put even more money into the market- regardless of it going up or down.

    1. SF seems like one of the worst places on the planet to buy a home now. And it’s seemed like that for the past 30 years. However, anyone who has bought at any time more than 2 years ago is very glad they did. I calculated how much my home values went up in SF over the past 40 years… 8+% a year, unleveraged, for 40+ years!! Anyone who took out a loan to buy a house in SF (or anywhere in Silicon Valley) made a fortune! Financial Samurai is a perfect example. And renters are getting crushed.

      The 8% does not include all the rent you would have saved every year. Plus when you sell, you get $500k per couple of tax free gains. You don’t get that with stock.

        1. At real estate market peaks, short-term this is true. I was coming from more of a long-term view. I have rentals near SF I purchased for ~100k each five years ago that rent out for 30k each a year today. The rent has almost doubled during that time but my carrying costs are more or less constant.

          When I bought my primary home for 600k 15 years ago, I thought it was a real estate bubble, because the same home sold for 250k 10 years before that and 150k 5 yrs before that. It’s now worth 2M. My childhood home in SF was purchased for 36k back in the 1970s and is worth $1.2M today without any major remodeling; it currently rents for 50+k a year and has a property tax of ~1k. The rental numbers do look bad if you compare vs today’s market price. But in the most expensive areas, there’s been the benefit of appreciation year after year through decades of severe recessions, market crashes, earthquakes, droughts, etc.

          I don’t have a crystal ball to see where SF real estate values will be at 10 years from now, but disagree that SF has been one of the worst places to buy on the planet at any time in its history up to today. Going from over a century of history, I would guess values will probably be significantly higher than today. SF real estate acts like a blue chip stock.

  5. “When financial companies run into trouble, it’s entirely in their right to call whatever debt they have and force you to pay it off immediately”

    This is a very rare occurrence that typically only happens when a person is not meeting their contractual agreement (payments). I’ve never heard of a bank recall a mortgage, loan or HELOC from an individual, even during severe crashes. Why would they? They’d be losing all that interest you’re paying. They MIGHT stop your ability to add more debt by locking your HELOC, for example, but actually demanding the money back would be highly unusual.

    Business loans are a bit of a different playing field and I’ve seen stories of businesses being forced to pay back loans during these times when the bank no longer thinks the business is viable and they worry their loan is at risk. For example, I saw a story of a cow farmer who owned 400 cows being forced to sell all of his cows during a “cow recession” because the bank was worried and wanted their loan back. This is essentially forced bankruptcy as you have no option but to sell your investment at the worst possible time. Even then I imagine it’s a very rare occurrence and probably not a major bank (like all of Canada’s banks) that’s doing it.

    Long story short, I wouldn’t sweat it if you’re a consumer.

    1. I’d assume the same. Also, part of this really depends on your leverage ratios – eg: if you’re leveraged 20:1 on a house, I’d be concerned the bank might want you to top things up a bit if it was looking really bad. If you’re leveraged 1:1, I’d expect that to be a walk in the park in comparison. Not saying it’s impossible, but even in 2007-2009 it took ~1 year for bank preferreds (eg: RY.PR.A) to reach a low point. I doubt the bottom of the down side will happen overnight and if you’re averaging into things you have lots of room for adjustment and reduction of leverage ratios.

  6. As JLCollins says, not all decisions are about the finances, but we should always be aware of the financial consequences of our decisions…I’d also go for cash and ensure you’re the one in charge, not the bank.

    But first I’d run the numbers, and make sure my finances could handle such a large purchase. There’s nothing wrong with renting while you build up your finances. Apparently some people carry on renting even after they’ve become millionaires…;)

  7. I personally prefer to mortgage my houses because it gives me more liquid cash to invest in the markets… or other houses….

    From my perspective, you’re going to pay rent or a mortgage and I’d rather pay the “rent/mortgage” monthly and invest the rest to spread risk. One house can be burnt to the ground (or lose value) or something but many houses/stocks/investments can’t. Kind of like buying an index fund instead of just *insert stock here*.

    But then I was in a similar situation in the midwest. I bought a house that was 1.25x my yearly salary, lived in it for 5 years, and now I rent it out for roughly double the monthly costs. I never worried about pre-paying the mortgage and I’m not worried about it now. Each to his own.

  8. We paid cash for our house. We saved for years by renting. But we couldn’t do the rent thing anymore for a number of reasons that all have to do with other tenants. ; ) Paying cash forced us to stick to the budget when house hunting (under $180,000). So that helped immensely. It is so easy to be tempted into spending more when house hunting especially if you find something you really love. It took almost a year but we found the house we were looking for, without going over our budget. It felt really good too, I still have the photocopy of the cheque used to pay for the house. And suddenly, we were rent free and we were saving a lot more because our living expenses are now lower than rent had been. Yes, we “lost” that money we could have invested but it certainly motivated us to save more to build the savings back up. And now we know we have somewhere to live when we do become FI. And we can sell anytime and use that money to fund our FI.

    1. Running the numbers from your example. If instead of paying cash, you had put 20% down to avoid mortgage insurance and kept the other 144k invested. The returns ($10080/year or $840/month assuming 7% return) would have paid your mortgage of $690/month with a 30 year fix mortgage at 4% with some left over to pay of the mortgage sooner. In this scenario, you get tax deductions for interest paid, you can still maintain the same savings rate because your returns cover the mortgage payments, and you maintain the 144k lump sum in investments. Not to mention you can pay off your house at any time because you have the money available.

      1. We weren’t really investing back then, didn’t have a clue what to do with our savings really. Other than just a high interest savings account. But yes, I’m sure paying all that cash out was not the best choice. However, I really like the fact that we have no debt. But this may not be the most rational thing to do.

  9. Having done both (paid off our house rather than investing those funds, then later took out a mortgage and invested the funds that were in home equity), I think it comes down to two key personal decisions:

    1. What sort of risk tolerance do you have?

    2. What interest rate are we talking about with the debt?

    Everyone will invest borrowed money at some interest rate. (At the extreme end is something approaching 0%). And for most investors, if someone offered you money below 1%, you’d realize the arbitrage opportunity is too good to pass up.

    But you reach a tipping point somewhere along the line. Money borrowed at 5% is perhaps too risky for you in particular, and money borrowed at 10% almost assuredly is way too high for just about everyone.

    Additionally, if mortgage payoff is your goal, you’re actually better off doing as Wanderer says and buying it all at once upfront OR investing the money in a taxable account and paying off a mortgage all at once. Paying it off as you go removes any liquidity during the payoff process: in my opinion, the riskiest approach.

  10. This post has made me “house horny” all over again. I’m going to have to look over my student loan statements and remind myself of how much I hate debt until the feelings passes. 😒

  11. I don’t disagree with you, but as you mentioned it depends on the cost of the house. In some rural Southern, Midwestern and even Northeastern areas you can find a house for $120k to $150k, but that is becoming rarer. That would be my max. I wouldn’t possibly save 200k or more to buy a house. I would just take out a conventional 30 year mortgage. Moreover, if you do it with 20% down you have a little bit of a buffer if the housing market totally tanks. One of the reasons why (and you are right on this) is that so many people got in trouble is because they bought in housing markets where the prices were unsustainable. My brother and sister in-law live in Las Vegas. The house they bought there cost them 250k, but at the top of the market it was 650k (something they could never afford on a teachers salaries). I do love these workshops. I hope you have another Chautauqua next year. I hope to attend then.

  12. Where I live in upstate New York, houses are much nicer to live in than apartments. If you want to live in a nicer abode, it has to be a house. I considered renting, but the vast majority are 2 BR or smaller. There just are not many options when you want 3+ bedrooms. Plus with the house, you get more freedom to decorate, landscape, own pets, architectural sophistication, nicer & safer neighborhoods, and have a garage. All the things that make a house your home. Housing cost is modest here, though property taxes mess that up some.

    In many part of middle America, away from the big cities, I bet housing is similar.

    Waiting until you save the whole cost of the house means you cannot have nice things until years later. No thanks.

  13. I love your website! It’s so helpful for beginners like me! I have a question about rebalancing. You keep saying to rebalance the index funds and sell stocks/bonds if needed to rebalance but what about the taxes you have to pay? Is it worth it to sell a percentage to rebalance vs. just investing significantly more in either stocks or bonds and not sell anything? Won’t the taxes just cut too much into your profits in the long run? Thanks!

    1. Hello Jill,
      I am a newbie to the whole investment scene too. However, I might have an answer for your question. I remember recently reading about this on one of the umpteen blogs that I read. Rebalancing is awesome. Why is it awesome? Coz by rebalancing you’re selling high and buying low. When you rebalance, you sell some of the higher performing stocks/etf’s and buy some of the lower performing stocks/etf’s (this is selling high and buying low). However, as you have correctly stated this can get very messy if not done right with respect to taxes on capital gains. One way to do this is keeping all your rebalancing in tax advantaged accounts. That way you don’t get taxed for the gains (due to the tax advantaged nature of the account – 401k etc.). The other thing to do is to buy index funds which are highly tax efficient and don’t have a high turnover. This means that they provide tax loss harvesting and don’t buy and sell entities very often which is good for a taxable account. Let me know what you think!

  14. When my wife and I got married we had a huge amount of school/professional debt and we took on a mortgage as well. It was definitely tough but despite all of the criticism of home-buying on this blog (most of which I agree with) it has been great for us as an investment but also as a tool for debt consolidation. Our mortgage rate is much lower than the rates on the debt we were carrying which has now been consolidated into our mortgage, significantly reducing our interest costs. We have also been renting out the basement to great tenants.

    On top of that we are using the Smith Manoeuvre to essentially make our mortgage interest tax-deductible (that’s an oversimplification – see https://www.milliondollarjourney.com/the-smith-manoeuvre-resource.htm for more info, may not be right for everyone). That is what has allowed us to start building an investment portfolio (many thanks to this workshop).

    So to summarize, having a mortgage can actually be a good idea in some scenarios, and if you are going to do it, make the most of it!

  15. I think leverage can be used effectively in certain situations, but not all. In regards to real estate it really depends on the type of product you’re buying. If you’re willing to own rental properties in the Midwest or in the South where unlevered rental yields can hover around 6-8% then adding a mortgage becomes really attractive. This can produce levered yields in the mid teens. Leverage also allows you to buy multiple properties, which will actually reduce your risk by creating diversified sources of cash flow. However, this is strictly for rental properties where the cost of a mortgage is being matched with a stable cash flowing asset. If you’re going to buy a house and live in it, then that’s not a productive asset unless you try to add roommates. In most cases an owner-occupied house just ends up becoming a money pit where the owner wants to buy nice appliances and have fancy upgrades. In this case having a mortgage is definitely on the riskier side. Here in San Diego where home prices are astronomical, buying a house is not an efficient use of funds as cap rates are close to zero or even negative. Capital would be better deployed in the stock market, in my humble opinion.

    -Dan, NinjaCapitalist

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