Monday, December 24, 2007

Bursting Your Bubble - The Investment Fallacy

"Buy a house, it's the best investment you'll ever make"

Half of that is sound advice; buying a house is, in general, a good idea. The second half of that statement though, is completely and utterly false.

Unless you are paying cash, a house isn't an investment; and even then, you can almost always get a better return out of your cash than you would have out of the house.

"Oh you're so right, but if you get a 15 year mortgage, you're paying a little bit more, but THEN you're really building equity so you come out ahead"

Well, actually, you're paying a LOT more; and you come out further behind.

"Well I waited 'til I had the cash to buy, and didn't get into any debt"

Okay, now your house IS an investment; but it's one with a very high risk, a poor return; and most importantly a VERY high opportunity cost. You could have been making a hell of a lot more money with that cash.

All of what I'm saying goes against the conventional wisdom, and even financial advice from some people who should (or who do) know better. In fact, on its face, it seems contradictory to it's own internal logic.... So why am I the super genius saying this, not some financial guru?

Because everyone likes to think of their house as a investment. People get angry and lash out at you if you threaten that idea in their head. Most of the famous type people who should be saying this are trying to sell books to those same people who would burn them at the stake for challenging their idea about their house.

I won't say number don't lie; because of course you CAN lie with numbers; but seriously, run them. When you run the numbers, you will see that not only is a house not an investment, it is almost always a major liability...

But wait a sec, I said that buying a house was good advice... if a house is a major liability, how can it be good advice to buy one? The answer is, once again, in the numbers.

Let me show you what I'm talking about:

My home is worth about $300,000. I am currently in a lease to own deal; which means that at the end of my lease I have the option to buy at an agreed price, with a portion of my lease payments discounted off that price.

I do not have, and cannot easily save, the $60,000 necessary for a 20% down payment... and in fact I don't know anyone who is paying 20% down anymore. That means 5% down mortgages, and PMI for me... and just about everybody else as well.

Most people traditionally opted for a 30 year fixed mortgage. Although other options have proliferated greatly in the last few years, especially interest only, jumbo, and 3/1 or 5/1 adjustable; for most people the 30 year fixed is still by far the best deal... or rather the least bad deal; and I'll explain why as we go.

Now accepting that buying a house is a good idea, and starting with the default 30 year fixed, let's look at why the advice to go to a 15 year mortgage is a bad idea financially.

A 30 year fixed mortgage on my house at 6% interest, no points, and 5% down would result in a payment of $1800 a month, not including property taxes and PMI.

Going from a 30, to a 15 year mortgage on my house would add an additional $1000 a month to the payment; though it would cut $144,000 in interest charges off ($648,000 vs $504,000).

$144,000 saved in interest; that's a great deal right?

Well, saving on interest is good, but the real question there is, would putting the cash towards early payoff, or into a mutual fund instead result in a better return after 15 years?

Presuming your house appreciates 50% in value over 15 years (the average since 1980 rather than the recent bubble rates), including inflation, then that $300,000 house will be worth $450,000; and you will have paid $504,000 for it; a net loss of $54,000.

If you use the extra $1000 per month for early payoff of a 30 year fixed, you end up paying $561,000 total; a net loss of $111,000.

Now, presuming you put all $1000 per month into a fund; and aggregating for annual performance, plus assuming reinvestment of earnings, at an average year over year of 8% (that's average fund performance over the last 30 years for index funds. Some do much better), and capital gains of 15%; you come up with $384,000.

You will have paid $324,000 in mortgage payments, which at the 15 year point will have reduced your principal balance to about $200,000, for a total liability of $524,000. If you then sell the house for $450,000 your net loss would be $74,000.

However, you now have $384,000 in savings and investment income; which offset against that $74,000 net loss, is a $310,000 gain. Even removing your initial capital investment of $180,000 over 15 years, you’re talking about a $130,000 gain.

Or better, don’t sell. Just pay off the loan and take the $1800 a month that was going into your mortgage, and put it into your 8% fund instead. Now you’re starting with $184,000, and your annuals go up to about $34,000. At the end of that second 15 years, you’ve got about 1.6 million in cash, AND a $600,000 house.

I keep trying to explain it to people; houses are not an investment unless you can pay cash.

Paying a house off early may make you more secure, and it may very well be a good idea; the less interest you pay the better; but mortgages are not a good deal for you. Interest almost always accrues faster than value; and most often you would be better off taking that money and investing it.

The only good thing about a mortgage, is that unlike rent, you have an asset to recover value from. I’d rather be paying $1800 a month, and recovering some asset value, than paying $1800 a month in rent, with no asset value. That’s why mortgages make sense at all; because you’d have to be paying rent anyway.

Over a typical 15 year mortgage, you are going to pay around 65% of the original mortgage value as interest, and a house will increase in value about 50%; you come out at a substantial net loss.

Over a 30 year mortgage you pay about 105% as interest. A house will typically double in value over 30 years, so you come out pretty close to even.

Now, if you pay your house off in 15 years, then hold on to it and sell it after 30, you make about $100,000; but 30 years worth of inflation makes $100,000 a pretty small number.

The only way mortgages makes sense, is if you look at them as an alternative to rent. 30 years of rent at $1800 (let’s presume rent is the same as the mortgage payment) is $648,000; and at the end you’ve got nothing but a net loss; whereas with a mortgage, you’ve got a $600,000 asset for a net loss of just $48,000.

Even for a 15 year, it’s a better deal; with a $504,000 net loss, vs a $54,000 net loss.

So don’t look at your house as an investment; what it is, is a stoploss.

Of course this should make it clear why IO loans make no sense whatsoever. They are in fact worse then rent; because not only are you not building asset value (in effect you are paying the bank rent), you are incurring a huge liability and risk at the same time. There is no upside to you, and no downside to the bank when you are in an IO loan.

If you do take an IO, it's because you are going into more house than you can afford; and betting that the houses value will increase fast enough to offset your liability, and build equity for you.

Bad bet.

In order to get value, you need to understand just how much you are losing; and how much less you lose with different mortgage and payment options. This lets you maximize the value of your stoploss, and direct your assets and income into areas where they can best earn for you.