You may know people who gained nicely from homeownership. This article analyzes a critical element for sustaining the high growth: leverage using mortgage loans.
Is This Article for You?
This article assumes that you desire to maximize the growth rate of your investment in your home, at the price of higher short-term risk in the early years. The risk is very real: many people lost their home or went bankrupt by incorrectly analyzing their risks or simply panicking during a downturn in real estate or stocks. To add to the difficulty, real estate cycles are typically longer than stock market cycles, testing the patience of the most disciplined investors.
Note: To make the article tangible, specific cases are provided. Actual numbers can vary wildly depending on the specific home and timing, but the principles should apply to many cases.
No Leverage: Let’s start with non-leveraged returns. Real estate returns with no mortgage loans are typically moderate. For example, you may obtain combined returns + savings of 6.2% on owning your own home instead of renting it, assuming:
- 4% appreciation (U.S. real estate growth in the long run)
- 4% saved rental payments (a common ratio)
- -0.8% property tax of ~1.1% after tax-deduction
- -1% repairs
Such returns are nice relative to bond investments, but are below stock returns.
With Leverage: With a mortgage, the results improve. With the addition of an 80% loan with a 5% interest rate (below the average of the past 20 years), you get an additional gain of (6.2% – 5%) x 4 1 = 1.2% x 4 = 4.8%, for a total of 11%. This is more in line with some stock investments.
Notice that the returns change dramatically depending on the mortgage interest. If you can get today a loan with a 3.5% interest rate, the increased returns thanks to the mortgage, jump to (6.2% – 3.5%) x 4 = 2.7% x 4 = 10.8%, providing a total of 17%, competing with most stock portfolios.
Key point: The returns above are returns on the amount invested. If you bought a $1M home, and put down 20% ($200k), your 17% return is $34k. While this is a great return on the amount invested, taking the loan makes financial sense only if you can invest the rest of your money and expect higher returns than the interest paid when averaged over the life of the loan. This applies to any money you have, whether it is the full remaining home value ($800k), or any smaller amount. If you spent the rest of the money, or invested in bonds with low returns, your financial position will be worse than not taking the loan and keeping the money invested in the house. Here are a few examples for returns depending on the return on the rest of your money:
Year-1 Returns on $1M house with $200k down payment and the remaining $800k invested elsewhere, and 6.2% return on money investment in home
|You spent the remaining $800k
||(34k – 800k) / 1M
|You kept the money in cash
||(34k + 0) / 1M
|You earned 3.5% in bonds (same as loan interest)
||(34k + 3.5% x 800k) / 1M
|You earned 10% in stocks
||(34k + 10% x 800k) / 1M
|Your earned 17% in stocks
||(34k + 17% x 800k) / 1M
While such gains are appealing, they cannot be sustained by taking a 30-year mortgage, and keeping it until it is fully paid off. They assume that the loan as a percentage of the home value (called loan-to-value, loan/value or LTV) stays at a fixed 80%, when in fact the returns drop quickly, as the mortgage is paid off. There are two things working to reduce the loan-to-value:
- Principal paid: A 30-year fixed mortgage is paid off over 30 years, meaning that every year some of the principal is paid off, reducing the loan balance. This decreases the nominator of loan/value.
- Home appreciation: Increases the denominator of loan/value.
The following table shows the decline in returns over the years:
Returns on investment in home with 30-year fixed mortgage, 3.5% interest
Assumptions: 4% appreciation, 4% saved rent, 0.8% after-tax property tax, 1% repairs
||Principal Paid 2
||Home appreciated 3
Problem: Within a few years, most of the leverage benefit is erased
For example, the return after as little as 5 years is much closer to the non-leveraged return than the 80%-loan return (10% vs. 6.2% non-leveraged and 17% leveraged).
Solution 1: Add a second loan: either a mortgage or a HELOC (home equity line of credit)
This is a good solution for a few years, since it increases the leverage (loan/value) without losing the benefit of the low rate on the remaining loan balance. There is a negative to this approach: the rate on a second loan tends to be higher than a primary loan, and the rate on a HELOC is variable, adding to the risk and cost of the HELOC as rates go up. While this negative is moderate in the first few years, when the balances are low, it becomes much more meaningful as the years go by, and the second loan or HELOC become large. At that point, you are typically better off refinancing (Solution 2 below).
Solution 2: Refinance to increase the mortgage
This solves the shortfalls of adding a loan (Solution 1 above), but requires accepting a new interest rate, even if it is much higher.
Key Point: If you are eager to lock a 30-year mortgage at today’s low rates, the benefit is likely to be outweighed by the declining leverage. Solving this problem requires accepting future, potentially higher, rates.
Optimization 1: adjustable-rate mortgage (ARM)
Since you are not likely to benefit from holding the same mortgage for many years, you can consider an adjustable-rate mortgage (ARM). Such a mortgage guarantees a certain rate for a limited period – typically 3, 5, 7 or 10 years, and later adjusts annually. By retaining the risk of rising rates, you are compensated through a lower initial fixed rate.
Choosing the optimal ARM term:
- When rates are high, you can choose a shorter lock, to get the lowest rate, since rates are likely to decline at some point, anyway making a refinance beneficial.
- When rates are low, it can be beneficial to lock the mortgage for longer at the price of a higher fixed rate.
- An important subcase: When rates are low because real estate declined substantially, and in an attempt to help real estate recover, you may choose a shorter fixed period, since (1) rates may keep being reduced while real estate keeps declining, allowing you to refinance with better terms, and (2) once real estate declines stop, the reversal may introduce unusually large gains early on, reducing your leverage quickly, and leading to a quicker refinance.
Optimization 2: interest-only adjustable-rate mortgage (IO ARM)
A variation of the ARM loan is interest-only ARM. With such a loan you pay only interest for the first few years, keeping the loan balance fixed. This has the benefit of slowing down the decline in leverage. The leverage declines only through the appreciation in the home value. An IO ARM typically carries a slightly higher interest rate, and, depending on how you invest the loan proceeds, can make sense.
More potential issues: While keeping a high mortgage balance can help maximize your wealth, it is not advisable or possible for most people, even if they desire to do so:
- Cannot Qualify for Loan: As you seek increasing loan amounts, you may not qualify for the loans based on your income.
- Excessive Risk: Any additional borrowing to invest increases your short-term risk. This is pronounced with rates that may adjust higher. A careful risk analysis is necessary to determine the short-term risk, before focusing on the potential long-term benefit. The risk analysis should address factors such as loss of job, a stock market crash, a deep and long real estate decline, and a spike in interest rates, to name a few.
- Refinance Labor Too Great: The work for a refinance every 1-3 years, to keep the leverage high, may not be appealing to many homeowners.
Once you reach your capacity to borrow, buying additional real estate as an investment would often be inferior to simple investing in a globally diversified stock portfolio, in terms of returns (with no leverage) and in terms of complexity.
Owning a more expensive home will typically cost you money
Once you realize the benefits of leveraged homeownership, you may ask if you can make more money by owning a more expensive home. The answer is “no”. Let’s review the scenario from the top, modified to exclude the saved rent, to calculate the growth in the amount spent on the extra home value. We get: 4% appreciation – 0.8% property tax after tax-deduction – 1% repairs = 2.2%, as the return without leverage. While this is a positive return, it is far worse than other investments, losing you money compared to the alternatives (and even compared to the typical inflation).
As long as mortgage rates are higher than 2.2% over time, leverage would only hurt the returns (for example with an interest rate of 5%, any leveraged returns would be negative, based on: 2.2% growth – 5% cost of borrowing = -2.8%.
From a financial standpoint, you would be best to own the cheapest home that fits your needs.
Homeownership (vs. renting) can turn from a moderate investment to an appealing one with the help of leverage, but the leverage has to be high (80%) to get the benefit. Even a mild reduction in leverage erases most of the appeal. For the few who (1) can qualify for loans to keep the leverage so high, (2) can afford the short-term risks, and (3) have the desire for such a plan, the potential gains can be substantial.
1 6.2% – 5% is the gain in the home value (6.2%) beyond the cost of the loan (5%). 4 is the multiple of the down payment that is borrowed. With an 80% loan, the down payment is 20%, and the multiple is 80%/20% = 4.
2 The principal paid is calculated using a loan amortization formula by a financial calculator.
3 Home appreciation at 4% per year, for example, in year 5, the appreciated home value is: 1.04 raised to the power of 5 = 1.22, and the appreciation is 22%.
4 The initial 80% loan-to-value is adjusted by: (1) multiplying by the reduced loan balance, and (2) dividing by the increased home value. For example, in year 1, the loan-to-value is: 80% * (1 – 1.9%) / 1 + 4%) = 80% * 0.981 / 1.04 = 75%.
5 The returns are calculated similarly to the base case described in the “With Leverage” section above. For example, in year 1, the leverage multiplier is: 75% loan / 25% down payment = 3, and the returns are: 6.2% + (6.2% – 3.5%) * 3 = 6.2% + 2.7% * 3 = 14.3%