Investment Workshop 21: Investing With Debt

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 Millennial Revolution 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 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.

Onto the next section!

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For Canadians:

1) Questrade

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For Americans:

1) Vanguard

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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.

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