What is your house value/current unpaid principal?

Anonymous wrote:

Anonymous wrote:

House 1: $1.1mm; $850k unpaid
House 2: $575k: $380k unpaid

... cheap debt is the most valuable investment opportunity going today. You can put 4x leverage at sub-4% on an asset that should appreciate at min 3% a year. That means approximately an 8% net return as a base case. ...

Can you please explain your thinking here, because I don't understand your math. I totally get that interest rates are very low right now, not to mention the home mortgage interest deduction, and so it may make lots of sense to invest your income rather than aggressively paying down your mortgage (depending on your risk tolerance of course). I also get that if you can buy and rent out the property, that might be great ROI (but it's highly dependent on the specific situation). But here's where your logic confuses me: You seem to be suggesting that because interest rates are low, it's smart to load up on extra houses and mortgages, as if that's improving your financial picture. That doesn't make sense to me ... or perhaps I'm not understanding you.

Take your 2nd house, for example. If you had $380k in your bank account (the amount of equity in your house #2), why do you think it's better to invest that money in house #2, rather than just put it in the market? By investing $380k in house #2, you're earning just 3% appreciation per year, and you're paying interest on the mortgage amount ($195k in your case). But if you invest that same $380k into the market, you're likely earning 5% or more. So why buy property with that money; why not invest in the market instead? It seems like you're taking on a lower ROI option, simply because it's a good borrowing opportunity. Indeed, unless you're getting rental income from house #2 (or perhaps hedonistic benefit from holding it as a vacation house), it seems you'd be better off selling it to free up more cash to invest in the market.

You claim that as an 8% net return on house #2, but I don't get your math there. I understand you are claiming 3% for the home appreciation, but where do you gain the other 5%? Is that supposed to me a return from investing in the market? If so, I don't think you can claim that extra 5% return on top of the equity you invested in the house, because that house equity is not in the market. For money you invest in the market rather than into house equity, you can get a return of the market ROI (~5%) minus the interest you're paying on the mortgage (~4% before accounting for the home interest mortgage deduction, but likely ~3% after HMID). So in the end, you're definitely better off (by about 2%) to invest your monthly excess income into the market rather than into extra mortgage payments. However, I don't see how taking out additional mortgage (or more mortgage than you need) is a smart move. It seems you're better off buying just the house you need, and putting more money into the market.

And as an aside, your property value appreciation figure is debatable, because many experts suggest home value stays at effectively 0% appreciation, if you take into account taxes, interest on the mortgage, maintenance, etc.

Another thought: I totally get your point if you can somehow extract money from your home equity, and instead invest it in the market. For example, if you could open a HELOC at a favorable rate, and then simply write yourself a check for $100,000 to generate cash which you could invest in equities, that makes total sense to me.

Perhaps I've totally misunderstood your logic. If so, please forgive me, and please make me smarter on how to squeeze more value out of my mortgage! TIA.

Yes, you've missed the key, which is the leverage. Though I appreciate the clearly articulated question ... but it is missing the point. Maybe this example will help:

Assume a $500k home. Purchased with 20% down - $100k and $400k mortgage.
Assume 3% market appreciation per year over next three years. (We can debate this as you note, but I think it's reasonably conservative in this area).
3% per annum appreciation is approx 10% (compounded) over three years.
House is now $550k. Mortgage is probably still close to $400k, call it $390k.

This means that the equity value in the home is now worth $160k, and the equity appreciation has been $60k / 60% over three years ... that's about 18% per annum return. Subtract the 4% you've been paying in interest and you're at 14% return on equity. That leaves a giant margin for transaction fees and miscellaneous expenses before you're down in the 8% return range, which was just back of the envelope math based on 3% annual return times 4:1 leverage minus 4% interest expense ... 3 x 4 = 12 - 4 = 8.

On the other hand, if one is paying off the mortgage s/he is reducing the leverage and thus bringing the expected return closer to the base asset return of 3%.

The reason people say that real estate is a good investment is not because of the modest inflation+ historical return! it's because that return is highly leveraged (ie, the multiplier effect above). That said, leverage works the other way too, and if prices fall, then your equity gets wiped out first ... so, I admit that I have to have a constructive view on the market for this to work. But I do ... definitely more so than I have for equity/bond markets near term. And I work in finance, so I have a somewhat informed opinion on markets.

Does that make sense (the part abt leverage that is)?

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03/08/2014 08:03

Subject: Re:What is your house value/current unpaid principal?

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Anonymous

$500
Was $200
Is $300 took $100k out to pay for private for SN child.

report

03/08/2014 08:05

Subject: Re:What is your house value/current unpaid principal?

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Anonymous

PP here (leverage guy) ... at some point this ceases to make sense of course ... ie, it's probably not smart to invest indefinitely in more mortgaged real estate, and once you've got enough cash sitting around and have met your lifetime savings goals it of course makes sense to pay off debts.

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03/10/2014 15:47

Subject: Re:What is your house value/current unpaid principal?

quote

Anonymous

Anonymous wrote:Yes, you've missed the key, which is the leverage. Though I appreciate the clearly articulated question ... but it is missing the point. Maybe this example will help:

Assume a $500k home. Purchased with 20% down - $100k and $400k mortgage.
Assume 3% market appreciation per year over next three years. (We can debate this as you note, but I think it's reasonably conservative in this area).
3% per annum appreciation is approx 10% (compounded) over three years.
House is now $550k. Mortgage is probably still close to $400k, call it $390k.

This means that the equity value in the home is now worth $160k, and the equity appreciation has been $60k / 60% over three years ... that's about 18% per annum return. Subtract the 4% you've been paying in interest and you're at 14% return on equity. That leaves a giant margin for transaction fees and miscellaneous expenses before you're down in the 8% return range, which was just back of the envelope math based on 3% annual return times 4:1 leverage minus 4% interest expense ... 3 x 4 = 12 - 4 = 8.

On the other hand, if one is paying off the mortgage s/he is reducing the leverage and thus bringing the expected return closer to the base asset return of 3%.

The reason people say that real estate is a good investment is not because of the modest inflation+ historical return! it's because that return is highly leveraged (ie, the multiplier effect above). That said, leverage works the other way too, and if prices fall, then your equity gets wiped out first ... so, I admit that I have to have a constructive view on the market for this to work. But I do ... definitely more so than I have for equity/bond markets near term. And I work in finance, so I have a somewhat informed opinion on markets.

Does that make sense (the part abt leverage that is)?

OK, thanks for your explanation. I understand better your point about using the mortgage to create leverage. That is a good point. I also did a little side research on the issue, and I find many debates among investors about the relative benefits of equities investing vs. real estate investing. All those debates emphasize that being able to rent the property for at least the mortgage amount is pretty critical. I'm not sure how your numbers compare if you're not renting the property. Here's how I see your example:

Option A: Invest in Real Estate
1. Buy a property at $500k. 80% mortgage. $100k equity, $400k mortgage.
2. Interest rate = 4% (which is actually lower than what's available right now).
3. After PMID, you're spending about 3% of $400k on mortgage interest each year ($12k).
4. Assume property value appreciates at 3% of $500k per year ($15k), even though I'm still not sure I agree with that given maintenance and real estate taxes.
5. Your annual return on the $100k you have invested is approximately $3k (property appreciation minus mortgage interest), or 3%.

Option B: Invest in Equities
1. Buy $100k worth of a Vanguard Mutual Fund.
2. Conservative return of 5% per year ($5k).
3. Subtracting taxes of 20% for long-term capital gains, actual annual rate of return for equities is 4%.

I think my math is correct, but perhaps I'm forgetting something. If I got it right, equities beats real estate on a straight ROI comparison. Of course, if you can generate even a small rental stream from the real estate to offset the mortgage interest, then the real estate might gain the upper hand. But in your original example, you seemed to suggest just a simple second home without a renter (although perhaps I misunderstood).

I appreciate the dialogue. Even though I disagree with some of your points, it definitely has caused me to gain a new appreciation for real estate investing. Indeed, it makes me want to withdraw some money from my long-term savings and buy an apartment in my neighborhood to rent.

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03/10/2014 15:52

Subject: Re:What is your house value/current unpaid principal?

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Anonymous

$768,000
0

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03/10/2014 15:53

Subject: Re:What is your house value/current unpaid principal?

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Anonymous

$1.5 million
$200,000