I am going to contradict what I have said in the past about my views on mortgage debt to articulate why mortgages can be leveraged as wealth creation tools through simple arbitrage.
What is arbitrage? In the simplest terms it is the shuffling of resources from a less favorable outcome to a more favorable income. For example, buying candy for .50 cents and selling it for $1, or borrowing money at a 4% interest rate and then lending it for 6%. Sounds like what the banks do?
For a long time I believed and preached not carrying any mortgage debt on a personal residential property – in other words your home that you live in. This is still true, but that message is mainly for those who lack discipline or the financial literacy to be able to leverage alternative arbitrage opportunities.
While paying off your mortgage has its benefits, not paying it off also has a significant amount of benefits which I will discuss in this post. The reason why I am specifying the home you live in is because I have been and still am favorable toward good debt incurred to purchase investment property that you can financially benefit from over the long haul. Investing in real estate is one of my favorite ways to generate passive income and build long term wealth.
Mortgages totally make sense if you have alternative investment opportunities. What stops many from considering the alternatives is the risk element involved, or potential loss of capital. While to each their own, this approach in my opinion ends up costing the homeowner not only the opportunity to make exponentially more money on their equity, but also money out of pocket when income taxes and inflation are factored into the equation.
So while many people would rather have their homes paid off and be debt free, the wealthy on the other hand consider themselves debt free based on liquidity on their balance sheets and cash flow to pay off large loans such as a mortgage anytime they wish. They understand that mortgages are one of the best wealth creation mechanisms and one that can get them to their goal of liquidity the quickest.
Think about it, why would you tie up your cash and eliminate potential tax benefits, often yielding zero net return on equity, when you can invest your money elsewhere?
Another benefit of many mortgages is that one can simply walk away from a mortgage at anytime. Sure you will take a hit on your credit, but who cares when you have loads of liquidity? Need a house next time? No problem, just pay cash. The cash you save on a home purchase today can be invested in instruments yielding higher return on equity.
Can the authorities come after you for the mortgage debt default? Not in most cases. Most mortgage loans are fee simple loans. The lender can ding your credit, but cannot come after you personally and liquidate your assets. The credit can be repaired in seven years if I am not mistaken. I am not suggesting you draw up your life plan based on these facts, but they are good to know.
Even corporations understand this is the right way to do it. Many large companies have the cash to pay off debt but they do not. They understand the power of leverage. In fact, most companies are highly leveraged! Why? They raise public debt in the form of bonds at 8% and turn around to make 15% on that money. They have it figured out.
Why can’t individuals do the same? They can. Those who have invested in their financial literacy can by using mortgages as wealth creation tools. A mortgage is not necessarily a bad thing. It can be used as arbitrage to leverage what you don’t have and yet benefit from compounding returns on equity and tax savings.
I like to visualize specific scenarios when I am learning so let’s consider the following:
Let’s say you bought an investment property worth $250,000 with a 20% down payment of $50,000. By putting down 20%, you have full control over 100% of the asset valued at $250,000. Highly leveraged? Yes I think. You cannot do this in the stock market as you can trade of a 50% margin at best.
You can depreciate investment property over 27 years, in this case resulting in a $9,259 deduction per year. If you are in the 25% tax bracket, the depreciation deduction alone would save you $2,315 in taxes, or roughly 4.6% return on $50,000 of equity.
Assuming a modest 3% appreciation of the property, you will have made an additional $7,500 or roughly 15%, which now puts you at about 19.6% return on $50,000 equity. Say you paid off $1,500 in principal payments and generated another $2,400 ($200/month) from positive cash flow from rent, you now have an extra $3,900, roughly 7.8%, which brings the total return on equity to a nice 27.4%.
These numbers could be “bloomier” but I have maintained a relative conservative approach for demonstration purposes.
Let’s walk through another scenario in a slightly different example. Let’s assume you get a $200,000 interest only mortgage at 7% on a $250,000 property. Assuming you are in the 25% tax bracket, your effective borrowing rate is 5.25%. Your annual interest expense therefore is $10,500 or $315,000 total cost of borrowing over a 30 year span.
Can you do better by investing the $200,000 in cash elsewhere assuming you had it instead of paying off the mortgage? Let’s have a look.
$200,000 invested at 8% compounded over 30 years yields a total interest income of $1,812,531. Assuming the same 25% tax bracket, you will have $1,359,398 in your pocket. I know I know I am assuming an 8% compounded rate which you may have an opinion on despite what all the historical charts say.
I understand that the bitter reality can state otherwise. That said, there are alternative opportunities for those who have invested in their financial education, such as investing in equity indexed annuities that can realistically yield 8% fixed interest on $200,000 of parked cash or investing overseas at higher risk free interest rates with the understanding there is forex and geopolitical risk.
I purposely did not factor in appreciation of property because this would equally apply to both scenarios. So what is the rush in paying off your mortgage? Would you rather pay it off early or have a few extra million in your bank account down the road?
Let’s look at this in a slightly different way. If Person A is interested in a interest only mortgage and person B doesn’t believe in mortgages, assuming they have the same net worth today, who will come out ahead financially if both were to purchase a $250,000 property?
Let’s make the following assumptions:
Let’s have a look at where each Person stands at the end of 30 years.
Person A is better off by $844,398, or almost a $1 million dollars over a 30 year horizon.
Arbitrage can be so powerful that sometimes you can borrow at a higher interest rate than what you earn and still make money in the long term. Why? Because of the power of compounding. Let’s have a look how.
Say you borrowed $100,000 at 8% interest rate. Assuming you are in the 25% tax bracket, your effective borrowing cost is only 6%. Your annual interest is therefore $6,000 or $180,000 over 30 years.
Say you are able to earn 6% return on the $100,000, this amounts to a total return of $474,349 over 30 years. Assuming the same 25% tax bracket, you will keep $355,762 in your pocket after paying uncle Sam. Take out the interest payments of $180,000 and you will have benefited by $175,762 from this simple investment arbitrage.
WOW ? ? ?
Yes I know. The problem is that many just do not view mortgages a wealth creation tool, therefore many financial planners simply don’t include mortgages in their client’s financial strategy. I personally think it is one of the best tax advantaged strategy to create wealth.
I understand this information can take some time to digest and accept, especially if you have never been exposed to this type of an analysis. We are just not accustomed to view mortgages under this light. Are we missing out?
You can arbitrage your way into tons of opportunities in real estate yesterday, today and tomorrow. It is my opinion that one can make money in real estate in any type of economy or era. Majority of our Nation’s wealthiest have created more wealth from real estate than any other type of endeavor.
We currently have over 300 million Americans, and this number is projected to surpass 400 million by 2050, which is “just around the corner”. The demand for real estate is likely to only increase and just like our historical past, real estate will AGAIN be the underlying basis for a heavy bulk of the wealth creation that will take place in the coming years.
I personally love real estate because of the leverage factor, the tax advantages through depreciation and what have you, potential capital gains through property value appreciation and short term cash flow resulting from rents collected.
How do I personally create wealth in real estate? Arbitrage, arbitrage, arbitrage. You can read my approach to value investing in real estate here.
When the $hit hits the fan you are actually safer if you have a large mortgage balance relative to someone who has paid a lot into their property. Why? Banks foreclose on those who have the most equity in their properties first because that is where they can recoup the most amount of their money.
How sad but true. Those who are fully leveraged (i.e. zero down mortgages) essentially shift all the risk from their personal balance sheets to the banks. With that said why would one put equity in their home? Think about it, if you lose your job and don’t have the cash flow coming in any more, no bank will lend to you no matter what kind of equity you have in your home. So what good is all that equity after all? Why are you rushing to pay so fast?
Most people view paying off mortgages as the more conservative approach, but ironically it’s just the other way around. Having the cash, or liquidity to cover emergencies is what sounds more conservative to me. I’d rather have that cash liquid.
If you are interested in running some numbers, and particularly if you are interested in real estate investing either now or later, I highly recommend two effective tools that will help you crunch the numbers such as ROI return on investment, cap rates, pro forma financials, sensitivity analysis (if/then and “what if” analysis).
These are software packages that are very reasonable in cost and ones which I highly recommend. They are well worth their nominal cost.
Readers: Do you agree or disagree with me? Why? What are some of the pros and cons involved in this kind of arbitrage? Is the risk worth the return in your opinion?Previous: My Top Effective Blog SEO Marketing Strategies