By Dr. James M. Dahle, WCI Founder
There is an idea out there that is very common but needs to be shot down. Because it's stupid. Those who espouse this idea simply have not thought it through. Yet I see it casually considered as an obvious truth when used in real-life conversations; on social media; and in blogs, podcasts, and books. The idea is this:
“Money in your home is being wasted, thrown away, tied up, or doing nothing.”
It is a complete and total falsehood. That money absolutely IS doing something—both before and after the home is paid off. Let's talk about what it is doing and what that is worth.
The ROI on a House Down Payment
First, let's consider a simple down payment. Classically, a down payment is 20% of the value of the home. If you put 20% down, you can get a conventional mortgage. As a general rule, these mortgages are easier to get. They have lower fees, and they have lower interest rates than mortgages where you don't put down 20%. A conventional mortgage also avoids the need for Private Mortgage Insurance (PMI), insurance the borrower must purchase to protect the lender from the borrower potentially defaulting. I know all about physician mortgages and how you can avoid PMI without having to put down 20%. I'm even aware that occasionally you can get an interest rate and terms on a physician mortgage that are comparable or even better than a conventional mortgage despite not putting down 20%. But most of the time, a down payment saves you fees, PMI, and interest.
The typical PMI cost ranges from 0.5%-2% of the original mortgage. Let's say you pay an additional 1% in upfront fees by not getting a conventional mortgage. And perhaps 0.5% more in interest. Adding it all up, let's call it 2% a year. So if you were going to put down 10% and you put down 20% instead, what is the return on that additional 10%? Let's use some real numbers and calculate them.
Let's say it's an $800,000 house. You were going to put down $80,000, but instead, you decide to put down $160,000. What is the return on that additional $80,000? Well, it allows you to save 2% * $720,000 = $14,400 a year. That $14,400/80,000 = an 18% return. Pretty nice GUARANTEED return on that money, huh? You're certainly not going to get that out of any other investment that offers a guaranteed return, like a treasury bond, CD, or insurance product. Heck, you're probably not even going to get that long term out of a non-guaranteed investment, like stocks or real estate.
The Return on Home Equity When the Mortgage Is Paid Off
We talked above about the beginning of the home-owning process. Now let's talk about the end, when you have the mortgage completely paid off. That $800,000 home now has no debt whatsoever. Is that home equity doing nothing? Absolutely not. It is doing one of two things, and we can look at both to try to assign a return to the home equity.
The first thing it is doing is saving you rent money. Since you own the home, you don't have to pay rent. The home provides free rent. To determine the return on that $800,000, you have to determine what comparable rent would be. That's an easy process if you can find comparable homes for rent. The numbers vary by geographic area, but it certainly would not be unusual for monthly rent to cost somewhere in the range of 0.5%-2% of the value of the home. For an $800,000 home, that would suggest a rent between $4,000-$16,000 per month. On an annual basis, that saved rent would be $4,000 x 12 = $48,000 to $16,000 x 12 = $192,000. That would suggest a return on your home equity of 6%-24%. Truthfully, the more expensive the home and the higher the cost of living in the area, the more likely you are to be on the lower end of that scale. So maybe a $100,000 home can rent for $1,500-$2,000 a month, but it's pretty hard to get $12,000-$16,000 a month out of an $800,000 home.
However, that isn't entirely accurate. Remember that there are more expenses to homeownership than just a mortgage. That homeowner is still paying maintenance, repairs, insurance, and property taxes. A useful rule of thumb for real estate investors is that 45% of rent goes toward non-mortgage expenses. Some of those expenses, such as management fees and vacancies, don't really apply. Maybe it would be OK to use 35% or 40%, but we'll just use 45% for simplicity. If you reduce that 6%-24% return by 45%, you bring the range of returns down to 3.3%-13.2%. That money is certainly not “tied up;” it's earning a significant return.
The second way to look at this is simply to compare it to the mortgage that you could have on the property. If you have a paid-off home and the going 30-year fixed mortgage rate is 2.8% (which it is as I write this) , you're earning 2.8% on your money in the home. Guaranteed. That's a whole lot better than other guaranteed investments are paying these days. As I write this, a one-year treasury bond is paying 0.4%, and a one-year CD is paying 0.65%. That 2.8% looks pretty good compared to those other numbers. To be technically accurate, you might have to reduce that 2.8% a bit if you are in a tax situation that allows you to reduce your taxes with a mortgage interest deduction. But if we're going to look at after-tax numbers, you will need to apply taxes to the return of those treasury bonds and CDs, too.
What About as the Mortgage Is Being Paid Off?
In between purchase and pay-off, you have a mortgage. Paying extra toward that mortgage doesn't reduce your monthly payment; it doesn't help your cash flow at all. However, it still provides a return. What is the rate of return? Precisely the same as the mortgage rate. As the principal is paid off, that principal no longer generates interest each month. If you pay extra one month, more of your next payment will go to the principal. That means a 2.8% mortgage = a guaranteed 2.8% return.
Separate the Mortgage from the Value of the House
Why do so many people get so confused about all of that? I think a lot of people forget that the house is completely separate from the mortgage. If you put 20% down on a house, you don't own 20% of the house with the bank owning the other 80%. If the value of the house falls by 20%, you don't lose 4% of your money and the bank loses 16% of its money. You lose all 20%. Likewise, if the house goes up 20% in value, you get to keep the entire increase. You own the whole house. There just happens to be this other liability associated with it—a mortgage. The return from paying down that mortgage has nothing to do with the return on the change in value of your house. The house will go up and down in value the same whether you have a big mortgage, a small mortgage, or no mortgage at all.
Non-Recourse Mortgage States
Some people in non-recourse mortgage states (Alaska, Arizona, Washington, Utah, Idaho, Minnesota, California, North Carolina, Connecticut, North Dakota, Texas, and Oregon) feel like paying down their mortgage is putting their money at risk. Their reasoning is that if the value of their house drops dramatically, they can simply mail their keys to the lender (or better yet, quit paying and squat in the house for a few months until the lender forecloses and boots them out). Then the lender cannot come after them personally. While that is true, it's a pretty rare situation that this really works out well for the borrower. There are two reasons.
The first reason is that most of the time the value of the home doesn't fall enough that it really wipes out all of the borrower/homeowner's equity. If you put 20% down and the home appreciates 20% and you pay off another 10% of the mortgage, you might now have a 50% debt-to-income ratio. The price of the house now has to fall 50% just to wipe out your equity. It would have to fall even more for you to really “come out ahead” with this strategy and stick it to the bank. Housing prices don't fall by 50% very often. So, it's really only available to people who put down less than 20% and haven't been in the house very long at all when a huge housing correction occurs.
The second reason is that, morality and ethics aside, defaulting on your mortgage is going to ruin your credit. That will be on your credit report for the next seven years. Maybe you could get another mortgage in five years, but the point is you can't just turn around and buy another house with a mortgage. You'll be missing out on an opportunity to buy during a major housing correction/buyer's market. By the time you can buy again, it'll likely be a housing boom and a seller's market and you won't get nearly as good of a deal. But what if you are super rich and have tons of money in cash and can just buy your next house with cash? Then, you don't care what your credit score is, right? I suppose so. But consider how rare this situation is. People with that kind of wealth don't typically get that way by screwing over people who lent them money. I've interviewed a lot of millionaires on the Milestones to Millionaire podcast, and none of them got rich this way. In my experience, the same drive that causes people to save and invest enough money to get rich also seems to cause them to pay off their debts rapidly.
Finally, there is a cost to being in a non-recourse state or having a non-recourse mortgage in a state that offers both. Did you really think the lender was going to give you the same rate and fees on a non-recourse mortgage as they would on a recourse mortgage? Bankers aren't stupid. They charge a little more to make up for the occasional non-recourse default. On average, you're not coming out ahead.
Leveraging Up Your Investment Portfolio
Fine. At this point, you admit I am right. You admit that your home equity is providing you a guaranteed return at least equal to your mortgage rate. But, you argue,
“I can beat that rate with my investments. I expect a higher return from my stock index funds and real estate than 2.8%. If I can't beat that over the long term, I will have much bigger problems than my home equity being tied up.”
You may be entirely right. Naturally, once you pay taxes and adjust for risk, the difference will not be as big as you might think. But you are still likely to come out ahead over the long run. As a leveraged portfolio goes, borrowing against your home is a pretty good way to do it. You get long-term, fixed, non-callable debt at a pretty low rate. That will usually beat your credit cards, your broker's margin loans, and even dragging out your student loans. You simply need to decide whether that leverage risk is a risk you need to run (and for how long you need to run it) to meet your financial goals.
You should also take a look at your investment portfolio. If you're deliberately dragging out a 2.8% mortgage to leverage up your portfolio and your portfolio is composed of 40% bonds paying 2%, that's probably not going to work out nearly as well as you think. Paying 2.8% to make 2% is not a winning strategy. The more conservatively you invest, the better off you are paying off that mortgage.
As you can see, your home equity is not “tied up.” It is performing a very useful service, saving you rent and earning you a return. Is there an opportunity cost to only earning a relatively low, but guaranteed return? Of course, but it's probably not nearly as high as you think once you adjust for risk and taxes. We paid our mortgage off in 2017 and have yet to regret it. If we ever did, we could always go out and get another one. Don't even get me started on the psychological benefits of not owing money to anyone; being able to use your cash flow for whatever you want; and knowing that, even in a worst-case scenario, your family will still have a roof over their heads. The fact that almost nobody with a paid-off mortgage ever does that should tell you something.
What do you think? How do you calculate the return on your home equity? How do you decide whether to leave the equity in your home or use it elsewhere? Comment below!