Housing: The leverage bulls return

By Felix Salmon
March 8, 2011
Linda Stern's latest paean to leverage and housing risk, it certainly seems that way.

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I know that memories are short on Wall Street. But are they short on Main Street too? Reading Linda Stern’s latest paean to leverage and housing risk, it certainly seems that way. Saving for a down payment is hard, she says. It can take time!

And that doesn’t seem to pay. If you think about the cost of paying rent for five or more years, you may be better off jumping into a home with a low down payment now. That’s true even if you have to spend more money on fees and mortgage insurance to get one of those low down payment loans.

Well, yes, let’s think about the cost of paying rent for five or more years. In fact, let’s plug all our numbers into a rent-vs-buy calculator and see where we’re at after five years. The problem with Linda’s formulation here is that it helps to reinforce the common fallacy that 100% of rent payments are “wasted,” in a way that mortgage payments are not. But that’s simply not true. In both cases you’re paying money every month for your shelter; in the rental case that money goes to the landlord, while in the ownership case it goes to the bank.

Some small part of your monthly payment may or may not end up helping you build equity in your home, if house prices move up rather than down and depending on how much of your payment goes towards principal. But remember that the alternative here is saving up for a down payment — which is essentially the same thing as building up equity in a future home. If you save up $250 per month for five years and then put down $15,000 as a down payment, then you immediately start off with $15,000 of equity in your home. By contrast, if you buy today with no money down and start making mortgage payments, there’s a good chance your equity will be much less than $15,000 in five years’ time.

But Linda’s on a roll here, and manages to come out with one of the most astonishing pieces of personal-finance advice I’ve seen since the crisis hit:

Even if you have the money for a bigger down payment, there can be good reasons to save your cash. Mortgage rates continue to skirt all-time lows: Why not put your money to work for yourself and borrow as much as you can reasonably afford, on a monthly basis, at today’s rates? You can put the money you’re not paying into a down payment to work elsewhere. If home values rise, you will have done your best to leverage a small down payment into bigger equity. If they fall, you’ll have less skin in the game, and that could put more pressure on your banker to improve your loan terms lest you walk away.

This, in a nutshell, is everything that was wrong with the housing market before the crash — everything that we want to avoid going forward. Can’t Linda look around at the current devastated state of many people who bought with little or no money down, and see the dangers here? Evidently not. Instead, she seems to think it’s a bright idea to borrow more money than you need, to the point at which you’re pushing the envelope of what you can reasonably afford. And then take the cash you’re not using for a down payment, and “put your money to work for yourself.”

I barely know where to start on this. Here’s one way of thinking about it: banks are not charities, and that they expect to make money from their loans. They have a cost of funds which is lower than the mortgage rate that you’re paying; the difference between the two rates is their profit. You, however, if you follow Linda’s advice, have a cost of funds which is your mortgage rate: if you wind up getting a lower return on your savings than you’re paying on your mortgage, you would have been better off just using the money for a down payment. Needless to say, if there was an easy way of getting a higher return on capital than the mortgage rate, the banks would have done it already, rather than lending you the money. And it’s pretty delusional, frankly, to think that you can invest better than say JP Morgan. Yes, there are tax benefits to having lots of mortgage-interest payments. But they’re not sufficient to make the difference here.

Here’s another way: let’s say you own your home outright. Would you take out a mortgage against 95% of your home’s present market value, and then invest that money in the market somehow, trying to “put it to work for yourself “? Of course not: you don’t have remotely that kind of risk appetite. Borrowing money against your house to invest in the market is, always, stupid. But that’s exactly what Linda’s proposing you do.

And here’s one more: shit happens. Sometimes, you end up needing money, in an emergency. If you’re already borrowing as much as you can reasonably afford, that’s a big problem. If you have a bit of fiscal breathing room, you’re much better off. If you end up in a situation where you’re in a position to put pressure on your banker to improve your loan terms lest you walk away, that’s not a good situation to be in. It means you’re broke. It’s something you want to avoid, whereas in Linda World it seems to be something to actively court.

Linda’s also convinced that house prices are going to rise: if you buy now rather than later, she writes, that means you’re buying “while housing prices are low.” That’s debatable — they still seem quite expensive, on some measures: the price-to-rent ratio, for instance, is still well above its historical average. And more generally, buying low doesn’t help you in the slightest if prices just continue to grind lower.

Linda’s conclusion is that “the less you put down, the better off you are.” Which is true so long as you keep on making all your mortgage payments without any problem, and nothing goes very wrong either with your personal economic situation or with the US economy as a whole. That’s the way that leverage works: it makes everything sunny, so long as things go right. And then it plunges you into misery when things go wrong.

The scariest part of Linda’s post, for me, is when she talks about how it’s a good idea to “do your best to leverage a small down payment into bigger equity.” It’s not the dollar amount of the equity she’s talking about here, it’s the leverage used to get there, and the higher the leverage the better off you are. Following that advice got us into our current mess. And taking it now is a recipe for disaster.

21 comments

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Duh, felix, buy silver, short NFLX – you’ll have the house paid off in 3 years, obviously.

great piece, sir.

Posted by KidDynamite | Report as abusive

If you’re going to buy a house in the current environment, it makes perfect sense to use the 3% call option instead of the 15% call option.

This is turning into the never-ending housing disaster…

Posted by mr_a11is | Report as abusive

Is Linda a paid shill for the National Association of Realtors or just completely financial and economically ignorant (or both)?!?!?

My god, Reuters gave this person such a large platform from which to spew-forth one of the most egregious and dangerous pieces of financial “advice” I’ve ever encountered! I seldom call for such things, but Reuters should not just take down that post but apologize profusely for it.

Such ignorant drivel is just as bad, if not worse, than when Jim Cramer told everyone that Bear Stearns would be fine.

In meritocricies where people have to be accountable for their performance, this woman would be censured if not fired for such an unmitigated disaster. Glad you’ve called her out on it, she more than earned it…

Posted by Anal_yst | Report as abusive

I never thought that I would feel lucky to have experienced first hand the rust belt industrial recession of the 70s and 80s, with my adolescent fear magnified greatly by my family’s personal catastrophe arising out of my father’s mental illness. It taught me how quickly things can change, how prudent it is to have a cushion, and how misery rarely seems to visit alone or just once.

That’s a good point about the downpayment–in some markets, you really can’t save enough to offset rising prices. This happened to some friends of mine in Brooklyn, New York, but where prices seem stable (and possibly still going down), this is a stupid reason to buy improvidently. It’s also the case that homeowners consistently underestimate the cost of maintenance and upkeep of their home.

Posted by rb6 | Report as abusive

“It’s pretty delusional, frankly, to think you can invest better than say JP Morgan”

“I know that memories are short on Wall Street. But are they short on Main Street too?”

I wouldn’t have expected those two sentences to show up in the same article.

Posted by awgupta | Report as abusive

As usual I disagree on the point that there is no difference in paying to the landlord or the bank. I saw the wings on my monthly rental payment as I ‘enjoyed’ living in someone else’s home paying her mortgage payments and having to live with her colour choices… That was an impetus to save in a miserly fashion to own my first home in my early twenties.

When you are putting down a solid down payment and keep track of the interest rates and economy, you can refinance in your favour and choose mortgage plans that suit your needs at the time. I have used the all of the options according to my circumstances of life and the economy because i like owning my own home. (and I mean literally owning)

I do agree that her advice was atrocious and makes me doubt she has a handle on your housing market. It hasn’t nearly settled and her discussing walking away as though that is now the norm was rather startling.

rb6 is right. Not everyone has the savvy to understand what they are getting into. Unless you have a decent down payment and intend to stay in a home long term, don’t do it at all. A home mortgage that doesn’t pay down principal to me sounds like … renting, but with a whole lot of risk all round.

Posted by hsvkitty | Report as abusive

I live in an area where the median house (@2,000-2,500 sf) goes for less than $250k. A normal week in the county has no home closings over $500k. A half acre lot, fully developed, typically is available for less than $50k. Few people commute more than 30 minutes to get to work. We have very few foreclsoures because house prices didn’t go up much and didn’t go down much over the past decade.

Local builders put up new houses for these prices. Home resales are at these prices. These are essentially equilibrium prices at replacement cost plus a reasonable margin. Across the country, prices higher than this are essentially a “goodwill” component and are subject to the “greater fool” theory. In other words, if people decide they don’t want to live there as much, house prices will plunge as we have been observing around the country.

If house prices aren’t as low as around where I live, then Linda Stern is simply telling you to make a bet that your house price won’t go much lower even though the replacement value may be much lower.

Posted by ErnieD | Report as abusive

Okay, I’ll say it. It’s not profit unless you can cash out. Few if any real estate markets in the US are liquid enough to let you realize a profit (if in fact you have one), and it doesn’t look like they will be liquid enough for many years.

Posted by Curmudgeon | Report as abusive

Roughly $1k of my mortgage payment each month goes towards principal, the other $500 towards interest. Felix is correct that equity builds slowly in the initial years of a mortgage (unless the home appreciates), but over the course of a 30 year loan you ultimately accumulate 100% equity.

That said, I am horrified at the author’s position. Accumulating a downpayment SHOULD be hard. If you spend five years paying $1800/month rent while saving an additional $1200/month, you’ll have accumulated roughly $75k for a downpayment. That is enough for a 20% downpayment on a $300k house, some $15k left over for emergencies, and you’ll find that you have a really easy time keeping up with your monthly mortgage+taxes+insurance bill of under $2000 (largely tax deductible).

If you don’t have sufficient cash flow to tuck away that kind of savings, then you almost certainly do not have enough cash flow to afford the mortgage safely.

Posted by TFF | Report as abusive

Felix, as Linda is a colleague of yours, are we going to hear from her? Or are we just going to leave it as a hands-off tit-for-tat? Where’s the debate?

Posted by Curmudgeon | Report as abusive

Since everyone is on the same page here, allow me to play devil’s advocate. I agree that this is bad advice for the collective US. But keep in mind that Linda is a personal finance writer, not a macroeconomist.

What we have here is a classic case of the tragedy of the commons. If a few people “work the system” to their advantage (low down payment, max out deductions, in case of fire try to break the bank’s glass, not your own, etc.), no problem. If everyone does it, big problem. System crashes, world ends, that kind of thing.

Linda’s advice should be seen for what it is: proof that the underlying structure to the system remains rotten and untouched. Unless it becomes impossible to do what Linda advocates, it WILL come to pass. Don’t attack her. She is the canary in the coal mine warning of impending doom.

Posted by LadyGodiva | Report as abusive

I agree with LadyGodiva that borrowing standards REMAIN horrifically lax. But that isn’t the audience Linda is writing to.

From the consumer side, if you allow yourself no financial flexibility than you are very likely to end up in default. Unless you have wealthy parents to bail you out of a jam, I would strongly argue in favor of prudence. Live cheaply for a few years while saving money. Use part of the money saved for a downpayment. Live the rest of your life without worrying about calamity. If that doesn’t work for you, then you probably don’t have the stability necessary to buy safely.

I admit that there is some temptation to borrow more and invest rather than paying down the mortgage. And that does make some sense in terms of retaining financial flexibility. But arguing that it is profitable? Somebody needs to give her a lesson on risk/reward balance. That is essentially advocating leveraged investment, which regularly gets PROFESSIONALS in trouble.

Posted by TFF | Report as abusive

Just for the record, equity does not equal principal, paid, plus your down payment, plus (or minus) a change in home values. It is principal paid, plus a significant annual tax benefit, plus the down payment, plus (or minus) a change in home values. In working the numbers one should also factor in the fact that there are costs for maintaining a home and for selling a home. And, by the way, Linda is not entirely wrong in pointing out that mortgage money is some of the cheapest “other people’s money” out there, which is why some business people carry large mortgages and borrow less from business lenders. It all depends on one’s appetite for risk and one’s overall financial situation and needs.

BoulderAgent

Posted by BoulderAgent | Report as abusive

Is the tax benefit really all that significant? When I had a mortgage, the combination of my Schedule A deductions didn’t greatly exceed the standard deduction (maybe by $1K). And that was with much higher interest rates (8.5%); with interest rates the way they are today, unless someone has a large (possibly nonconforming) loan, I can’t see the tax benefit being more than a few hundred bucks.

Of course, your mileage may vary depending on your Schedule A deductions, but for nominal cases I’m not sure how it can add up to a lot. Perhaps someone can enlighten me.

Posted by Curmudgeon | Report as abusive

BoulderAgent, I agere that “equity” and “principal” are very different concepts. Equity is only relevant when you sell. But when the principal on a mortgage is fully paid, you can stop making payments!

Curmudgeon, it depends on your situation. If you have a ~$100k income and tithe to charity, then you are already over the standard deduction BEFORE you add mortgage interest and property taxes. And a 25% writeoff on those is significant — easily a few thousand a year, even for a modest house and mortgage. The mortgage interest deduction is one of the most regressive aspects of the tax code, offering little benefit to a lower-middle-class household.

Posted by TFF | Report as abusive

@TFF, my income is over $100K (and was when I had a mortgage). My charitable deductions were around $1K, and property taxes $5K (my state has no sales tax, so my natural choice is the property tax). My mortgage interest was around $6K. The house is upper middle class for my area, so I’m not talking a first house or fixer-upper. If you look at the mortgage interest as additive to my Schedule A deductions, I was actually only able to deduct about $1500 of it over and above the standard deduction. I suspect that my case is not unusual.

Posted by Curmudgeon | Report as abusive

Generally agree with the post, but a couple of comments in Linda’s defense:
1.) One’s “effective” interest rate is really lower than what the bank is offering due to the mortgage tax deduction, so while the bank is getting 5% on my mortgage, I’m really paying something like 3.5%. So really the question is whether I think that I can beat a risk-free rate of return of 3.5% on my money — not the 5% that JP Morgan would see.

2.) Suppose I have $420K in cash, and I want to buy a house for $400K. I can either (a) put 20% down and invest the remainder, minus a small cash reserve, in a diversified portfolio according to my financial risk profile; or (b) pay for the house in cash, putting my entire nest egg (minus a small cash reserve) in the house. Option b equates to placing a very large financial bet on a single investment vehicle — not only is all of my money tied up in real estate, it’s tied up in a single property.
This would seem to fly in the face of the conventional advice one receives from financial planners.

Thoughts?

Posted by matthew.kromer | Report as abusive

Curmudgeon, your situation might not be unusual but neither is the situation I describe. Charitable donations of $5k and state income taxes of $6k take you up to the standard deduction already.

Conforming mortgages are up to $417k these days. At 5% that comes to over $20k of mortgage interest and (likely) another $5k of property taxes. Even if you had NO other Schedule A deductions, that would still put you $14k over the standard deduction for a tax benefit of $2k to $3.5k.

It sounds like you live in a state with no income taxes and had a small ($100k?) mortgage balance. Either that or you are miscalculating the benefit you received.

MatthewKromer, you owe taxes on your investment returns (unless placed in a retirement account). And the tax benefit only drops your effective tax rate from 5% to 3.5% if you are in a 30% tax bracket *and* can make full use of the mortgage deduction. That is a little unusual.

Your second point runs afoul of some common mistakes. First, a house that you intend to live in is not truly an investment and should be considered separately from your financial portfolio. Second, basing decisions on “a diversified portfolio according to my financial risk profile” is like trying to play tennis in a straitjacket. You begin with an assumption that limits your mode of thought and then don’t think to question if the inevitable conclusion makes any sense. I’ll prepare a more careful response below.

Posted by TFF | Report as abusive

MatthewKromer, your scenario is exceptionally narrow in its focus. Let me flesh it out a little, but feel free to modify my assumptions.

I’m guessing that your hypothetical homebuyer is 35, recently married with kids on the way, and has stable household income of at least $140k. Any less income than that and they shouldn’t be considering a $400k home. And if they are nearer retirement, a $420k nest egg is a woefully inadequate accumulation — again pushing them to consider a cheaper home.

Thus your hypothetical buyer may have just $420k of savings, but they also have a strong income and savings stream. Even discounted heavily, the present value of their future savings stream amounts to at least another $400k-$500k. Consider that as part of the picture?

Now let’s assume your choice is between paying cash for the house and borrowing 80% (no PMI and best rates) on a 30-year loan at 5%. You can either:

(1) Invest $340k in bonds/stocks/tulip bulbs while paying $20k/year in mortgage and adding an additional $30k/year to your investments.
…or…
(2) Keep $20k in emergency cash, no long-term investments, but no mortgage — allowing you to cram savings for the next 30 years at $50k/yr.

Which is financially optimal? Depends on whether your long-term investment returns are greater or less than the 5% you are paying on the loan. And yes, tax games can help quite a bit (recognize losses, defer gains, stash money in tax-sheltered accounts, and so forth). So your plan will PROBABLY leave you better off.

But which is riskier? Dumping that $320k into the market in a lump sum (and committing to a mortgage that you THINK you can afford as long as you don’t lose your job) or spreading out your financial investments over 30 years in what amounts to dollar-cost-averaging?

I have a hard time seeing how DCA investment would be more risky than lump-sum investment. And certainly the financial flexibility of having NO mortgage is greater than the financial flexibility that remains when you are committing half your free cash to the mortgage.

Posted by TFF | Report as abusive

As general advice, Linda has it wrong. But for my part I have a lot of money in dividend paying stocks that I bought during the market meltdown of ’09.

Should I liquidate a portfolio that is yielding over 7% (and growing every year, and compounding) to pay down a loan that costs 4.5%? Of course not. A lot of this depends on whether you have a really firm grasp of the time value of money. In my case borrowing as much as I can possibly get from the bank makes perfect sense. Doing anything else would be financial stupidity.

However, for the average person who thinks a sale price on an LCD TV makes it an “investment” it is dangerous to leave them with spare cash. At worst they will spend it on consumables and at best they will jump in and out of the market and end up not even beating the 5% guaranteed yield they can get paying down principle.

So while i agree Linda gave awful generic advice it isn’t necessarily wrong for financially savvy people.

Posted by MikeURL | Report as abusive

MikeURL, I doubt your portfolio is yielding over 7% based on the present market value. You are almost certainly measuring the yield relative to the price you paid in 2009. While that is an instructive number to consider, it isn’t the relevant comparison today to your mortgage rate.

Back in the fourth quarter of 2008 and first quarter of 2009, I was grabbing every scrap of cash I could get my hands on and dumping it into the stock market. Didn’t quite get to the point of taking out a home equity line of credit on the house (or tapping my margin line), but if the market had dropped another 20% I would have been seriously tempted!

But today? Could make a case either way — that 4.5% rate is very low and you ought to be able to beat that with high-quality dividend stocks, very little risk. I paid down enough to eliminate a balloon payment that was coming due in less than ten years but haven’t been motivated to do more than that.

Posted by TFF | Report as abusive