A Mortgage can be your friend
It seems as though having a mortgage is a bad thing. Most people you talk to will tell you to pay off your mortgage as soon as possible, or worse yet, to buy property without a mortgage in the first place. But in fact, the financial system is designed for people to use a mortgage to their advantage.
Disadvantages of Buying Real Estate in Cash
- your money is not liquid- any money that you put into a property is no longer liquid, its hard to get it back out should you need it.
- money you put into a piece of real estate is not safe from loss of principle- if the value of your real estate goes down, you lose money, possibly lots of it.
- your income tax liability is higher the smaller your mortgage becomes- a mortgage helps you save on taxes (and taxes are most likely the largest expense you have nowadays- and growing).
- your money generates no cash flow- you don't get payments from your money which leads to the last (at least on my list) and most important disadvantage of putting all your money into a property without a mortgage...
- your money earns a Zero % rate of return- yes, money in a property does not earn any kind of return what so ever.
Advantages of Having a Mortgage
- your money is liquid- by keeping cash out of your property, its very liquid, and easy to access when needed for investing or emergencies (including making payments or paying off your mortgage if you want to).
- protection of principle- if you have money/equity tied up in your house, and the housing market goes down, you lose money. However, if you have your money safely out of your property, and have someone else's money in the house (i.e.- the banks money), your cash is safe, only the property value went down.
- mortgage interest saves you money on taxes- mortgage interest is one of the few deductions that most employees get to take advantage of on their tax returns. Unlike businesses, we don't get the luxury of buying things before we pay tax- the government takes their cut out of our paychecks before we even get paid! Mortgage interest is preferred interest- you can deduct it on your tax return. If you have $10,000 a year in mortgage interest, you can deduct it off the top of your income. If you are in a 30% tax bracket, the real savings will be $3000. That is money that you would have paid to Uncle Sam in the form of income taxes. If you think about it, you can probably spend your own money more wisely than your Uncle Sam!
- money kept out of your property can be used to generate cash flow- you are free to make money with your money (preferably in assets that protect principle and remain liquid, even better if its tax advantaged too).
- as above, your money (some or all depending on what you put down) can earn a return out of your property- remember money in your property earns no return on investment, its basically dead money. Money outside your property can earn a rate of return.
Why does home equity have no rate of return?
Say you have a house that is worth $200,000, and you bought it in cash. The housing market goes up 5%. So now your house is worth $210,000. So it seems as though the money in your house, your equity, gained 5% too. Not exactly. To illustrate, lets say instead, that you bought your house (initially worth $200,000) with a 0 down, $200,000 mortgage (just for illustrative purposes). You put the money ($200,000) you would have used for a down payment (or cash payment to buy the house in full) into another asset class that gains 5% a year. The housing market goes up 5%. How much is your house worth? $210,000. Your $200,000 also gained 5% in your other asset. You just gained $20,000 total! Your cash gained a 5% return, and your house also returned 5%. What if you had the $200,000 in the house? what would the house be worth at the end of the year? just $210,000. So as you can see, whether the house is all paid off, or mortgaged to the max, the money in it (equity) has no rate of return, the house does. The money you keep outside the house however, can have a rate of return.
Arbitrage
But what about the mortgage payments? ah, this is where the risk comes in, and where you need to know your tolerance for risk, both mentally and financially. Its where good risk management comes in, but its also where Arbitrage can get interesting. Lets say you borrow the $200K at 5% interest. That's $10,000 in interest payments a year. Looking back, that cash kept outside the home, was invested in an account that gained 5% for the year, or $10,000. A wash? The trick is, its mortgage interest you were paying, and you get a deduction. So in reality, in a 30% tax bracket, you are really paying only $7000 of that in interest per year. This leaves you with a net gain of $3000, or $13,000 on the house and separated equity. Not bad for money that would have been otherwise dead. You can do whatever you want with the money, spend it, invest it, or even use it to pay down the mortgage.
You are using Arbitrage- borrowing money at a fixed rate of return, and gaining a higher rate of return on that money. Banks do this all day. They borrow money at say 2%, and loan it back out again at 5-6%. Sure they are only making 3-4% return on that money, but hey, it wasn't even their money to begin with! So you can see, banks don't want to keep their money tied up somewhere, they need it to be working for them. They want you to tie up your money with them, so they can then lend it back out again at a higher rate. So they will pay you 2% on your money sitting in a CD, and loan it back out again at 5%, netting 3%. Do this enough times, and that tiny 3% gain turns into millions. The good news is, with Arbitrage, you can also be the bank.
