Author Topic: Help me understand something basic  (Read 1540 times)

diesel

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Help me understand something basic
« on: October 23, 2019, 05:49:58 AM »
Hi Everyone,

I have a question about a question that has probably been asked 1,000,000 times.  I am currently a renter and thinking about next steps so obviously the rent vs buy internal debate comes up.

I have read the multiple forums and blog posts and such (beginning of an example attached).  The math is not complicated and it usually boils down to, "Would you rather have $XXX,XXX tied up in a house that tracks inflation or $XXX,XXX tied up in the stock market/index fund/ etc."  That always made sense to me but it seemed like there was something not adding up when I thought about application and I finally figured out what it is.

In all these scenarios, the two people being compared both have that $XXX,XXX somewhere to invest in either a house or the market.  My question is what if you are not starting with that?  Let's say you only have enough money on hand to put down a small down payment on a house and will finance the rest.  Obviously not the most profitable idea but you still have a place to live AND you have $XXX,XXX invested in something (even if it's not a great investment and it just tracks inflation and it costs you money along the way).

So I guess my question boils down to is it better to borrow money and "invest" it in a house or not have that amount of money invested anywhere?  If we are only going by the "Would you rather have $XXX,XXX tied up in a house that tracks inflation or $XXX,XXX tied up in the stock market/index fund/ etc." couldn't you make an argument that we should just find a way to borrow money and invest it all in the market and make payments on the debt out of pocket while the investment grows? - essentially profiting the difference between interest paid and growth?

I'm not sure if that makes sense so I can clarify anything needed but thanks in advance for your help!



habanero

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Re: Help me understand something basic
« Reply #1 on: October 23, 2019, 06:22:37 AM »
couldn't you make an argument that we should just find a way to borrow money and invest it all in the market and make payments on the debt out of pocket while the investment grows? - essentially profiting the difference between interest paid and growth?

Not really. In fact, not at all. If you go to your bank and want to borrow without collateral, you would be looking at an interest rate that way exceeds expected returns from the stock market. You could probably lower the borrowing cost by borrowing against your equity investments, but  the bank would take a haircut (i.e if you had 100.000 in equities you could only borrow say 80.000 against it). And most important: If your investments were to (temporarily) fall in value below some threshold (typically the hiarcut) the bank can/will executed a forced liquidation of your investment and you are screwed unless you can magic up some extra collateral to put in. A mortgage collateralized by a home with a downpayment (20% or so) is the only cheap funding an ordinary person has access to. Without collateral covering almost the entire amount borrowed borrowing costs skyrocket.

If you somehow had access to cheap funding your argument would make more sense, but it would still be a risky strategy. Leveraging multiplies both your gains and your losses and you can effectively get wiped out completely, and then there is no recovery. If the market recovers a year or two later it doesn't help you, because you were forced to sell and you are not in the market anymore. You still have the remaining loan balance to repay, however.
« Last Edit: October 23, 2019, 06:26:19 AM by habaneroNorway »

katekat

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Re: Help me understand something basic
« Reply #2 on: October 23, 2019, 06:25:26 AM »
If it helps you to google, the word you are looking for is "leverage", and yes, it can be part of a financial strategy: https://www.investopedia.com/terms/l/leverage.asp

In business leverage can be used in many ways, but amongst individuals, a mortgage is most likely the main large debt they are able to incur at good rates, and so mortgages (either for a primary residence or becoming a landlord) are the most common way that not-hugely-wealthy individuals use leverage in their financial lives.

The primary risk of leverage is that it can increase losses as well as gains. And if you have to save up for a significant downpayment, remember to include in your calculations the time that you may keep that money out of the market while you do so (most people will be saving up for their downpayment in a savings account, whereas if they planned on renting indefinitely and keeping that money in the market, they would be putting it into the market as they got it -- your 'house investment' only starts at the point you buy the house, rather than in dribs and drabs before that). You also should consider (a) diversification -- you can diversify your money that you put into the market -- one house is still just one house, even if you own 'more' of it, (b) how active you want to be in 'managing' you investment -- owning a house comes with its own chores & worries quite separate from the financial ones, (c) for primary residence, whether you are happy to commit to a specific home that you can afford. People have different opinions on what is 'better' for their lives that can't be reduced down into running the maths with a couple different fixed rates of return :)

habanero

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Re: Help me understand something basic
« Reply #3 on: October 23, 2019, 06:30:00 AM »
The only way this can work is if you already have a home and have spare credit capacity on it. Then you can increase your mortgage and invest the proceeds. This is essentially the flipside of "Don't prepay your mortgage". If you can borrow at say 3.5% for 30 years and invest you are likely to come out way ahead as long as you can make the monthly payments on the increased mortgage.

Malcat

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Re: Help me understand something basic
« Reply #4 on: October 23, 2019, 06:37:04 AM »
Honestly, I never looked at it that way and never would.

There's so much more to choosing to buy than what you've posted. The biggest factors for or against buying aren't even primarily financial ones.

First and foremost, you have to decide to hunker down and stay in one place for the long haul. This isn't a given.
There are huge opportunity costs to owning a home, it dramatically lowers your job flexibility, which is, IMO, the single largest factor to consider.

Second, it's a lifestyle. For some people, their dwelling is an extension of their lifestyle, a place where they can garden, or renovate, or have a work shop, or whatever, and working on/in their home is a major part of their happiness. For others it's essentially a climate controlled box to sleep in.

Only once you hammer out the very critical, lifestyle factors that favour either renting or owning should you look at the numbers, and quantify what you are willing to spend for your preferred lifestyle.

Personally, I dramatically, 100% prefer renting. However, I own because it financially is so beneficial for me to own the exact kind of apartment I would rent. Although I always prioritized being able to move easily, DH's career is very geographically settled, so we're here for the next 13 years at least.

If we both had the kind of careers that benefit from being able to pick up and relocate, we would happily pay a premium to continue renting.

When it comes to financial decisions, don't get too caught up in just comparing numbers because those numbers are meaningless in and of themselves. The only significance money has is the options it gives you, so look closely at what your options are and how much they matter to you.

To be honest, I'm still utterly confused by the "would you rather" question of your initial post because it just seems like the most nonsense way of looking at housing.

Check out the NYT rent vs Buy calculator, it's very helpful in quantifying this type of choice and putting your options into financial perspective.
« Last Edit: October 23, 2019, 08:10:18 AM by Malkynn »

maizefolk

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Re: Help me understand something basic
« Reply #5 on: October 23, 2019, 06:37:44 AM »
In all these scenarios, the two people being compared both have that $XXX,XXX somewhere to invest in either a house or the market.  My question is what if you are not starting with that?  Let's say you only have enough money on hand to put down a small down payment on a house and will finance the rest.  Obviously not the most profitable idea but you still have a place to live AND you have $XXX,XXX invested in something (even if it's not a great investment and it just tracks inflation and it costs you money along the way).

So I guess my question boils down to is it better to borrow money and "invest" it in a house or not have that amount of money invested anywhere?  If we are only going by the "Would you rather have $XXX,XXX tied up in a house that tracks inflation or $XXX,XXX tied up in the stock market/index fund/ etc." couldn't you make an argument that we should just find a way to borrow money and invest it all in the market and make payments on the debt out of pocket while the investment grows? - essentially profiting the difference between interest paid and growth?

As others have said, it (generally) isn't possible to secure a 30 year, uncallable, loan at low and fixed interest rates for reasons other than buying a house (which then serves as collateral for the loan). Outside the USA it isn't even possible to secure these terms when you ARE buying a house.

So if you're starting out with only enough money to make a downpayment, the first thing to do is plug your numbers into a rent vs buy calculator. That decision has nothing to do with whether it makes more sense to invest in the stock market or pay off a mortgage.

If buying a house makes more financial sense than renting, then and only then are you faced with the choice of whether you use surplus money above and beyond your mortgage payment to invest in the stock market, or to make extra payments against your mortgage.

And then you can sift through the countless pages upon pages of debate that has been spilled on this topic on this forum over the last several years.

ctuser1

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Re: Help me understand something basic
« Reply #6 on: October 23, 2019, 07:00:30 AM »
Statistically speaking, expected return on leverage is negative.

Why?

The one scenario where you lose everything, your investments are liquidated and you get no chance to recover. But the opposite melt-up scenario does not force you to liquidate and lock up your gains - hence the probability you will lose it all again.

Over a sufficient long timeline, this is a big problem. Over a long time, itís when, not if, you will hit the 100% loss scenario with leverage. ďWhenĒ that happens, you will lose everything!! I.e. speaking slightly tongue in cheek, with a lot of unstated assumptions, you are guaranteed to lose everything over a long enough time horizon when you use leverage.

Laura33

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Re: Help me understand something basic
« Reply #7 on: October 23, 2019, 07:23:33 AM »
As katekat says, this is about leverage.  And that means the answer will be different depending on how far along you are into the mortgage.  If you have 5% equity and owe 95%, and your house value rises 5%, poof, you have a 100% return on your investment, because you only had to tie up 5% of your assets, and now your equity is twice that.  If it's 30 years later and you have 100% equity, though, a 5% gain in value is a 5% return, because there is no leverage to act as a multiplier.  This is why a number of people argue that you should never pay off your house, and why many real estate investors will often refinance once they get too much equity in any unit so that they can then deploy that money on additional income-producing assets.  The downside, of course, is that those numbers work exactly the same in reverse -- if you have 5% equity, a 5% drop wipes you out, and a 10% drop means you're underwater.

The other thing to keep in mind is that the comparisons are never really apples to apples -- unless you live in the middle of a big city, you're usually comparing a cheaper rental apartment to a more expensive house (huge generalization, of course).  So maybe you're comparing $800 in rent to a $1500 mortgage.  That's an extra $700 out of pocket every month, but some of that goes to principal, which is basically equity that you get back when you sell.  On the other hand, that equity isn't worth jack to you unless you are actually willing to sell; in addition, the house often comes with higher taxes, utilities, maintenance, etc.  There is just no way to generalize, because the options and the relative costs are so highly local.

All of that is why I don't get caught up in this kind of argument.  The reality is that you will need to pay some money to put a roof over your head -- but anything beyond the bare minimum is a consumption choice, pure and simple, regardless of how you choose to pay for it.  The best way to get ahead financially is to keep your "must-haves" in check, focus on what you actually need, and not buy/rent bigger/fancier digs because you've talked yourself into it as a "good investment."  If you want to evaluate the finances of your real options, look at the kind of places you would like to live in that are in your area, and then run all the numbers -- not just difference in rent/mortgage and opportunity costs, but commute time, maintenance costs, upkeep, utilities, taxes, schools if you have kids, etc. 

Malcat

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Re: Help me understand something basic
« Reply #8 on: October 23, 2019, 08:27:00 AM »
All of that is why I don't get caught up in this kind of argument.  The reality is that you will need to pay some money to put a roof over your head -- but anything beyond the bare minimum is a consumption choice, pure and simple, regardless of how you choose to pay for it.  The best way to get ahead financially is to keep your "must-haves" in check, focus on what you actually need, and not buy/rent bigger/fancier digs because you've talked yourself into it as a "good investment."  If you want to evaluate the finances of your real options, look at the kind of places you would like to live in that are in your area, and then run all the numbers -- not just difference in rent/mortgage and opportunity costs, but commute time, maintenance costs, upkeep, utilities, taxes, schools if you have kids, etc.

Spending justification is honestly a HUGE issue with buying.

When buying, it's best to stay put for a good long time. The problem arises that then the buyer starts looking for something perfect that will fit their needs for years to come.

This leads to A LOT of "need" inflation.

You might be at a point in your life where renting a 1 bedroom apartment makes perfect sense, but buying a 1 bedroom feels too limiting for the future.
You might be fine with a cramped kitchen while renting, but buying one would lock it in as a long term lifestyle choice.

Then there are all the finishes.
While renting, it's very easy not to care about what your cabinets and counter tops are made of. Owning can magically somehow make things like backsplash tiles feel oddly important.

Then there's the furniture. When renting, it's easy to not care all that much about high end furniture because you might just move at some point and who knows if that "perfect" sofa will be perfect in the next place. Meanwhile, knowing you are settled makes ideal furniture feel like an "investment".

All in all, home ownership can lead to all sorts of lifestyle creep that can cost you a damn fortune if you don't keep it in check.

Once you factor in the "just in case" extra bedroom (or bathroom! Lol, see the thread!), falling in love with that house that had the bigger back yard, starting to care about stone countertops ("I mean, this laminate is looking pretty worn..."), committing to a leather sectional and love seat because you now have a dog(!) because you're settled, and the commute is a lot longer because you could just get so much more house for less by moving far from work...well, suddenly renting was a lot cheaper.

Jon Bon

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Re: Help me understand something basic
« Reply #9 on: October 23, 2019, 08:32:30 AM »
Important Point:

The leverage you get on a primary residence is heavily subsidized by the government. I dont know what a free market mortgage rate would be, but it would most definitely be above current rates of ~3%

So yes sure if you were just given 100k at 4% rate and you could invest in a house or the market, you should buy the market all things equal. But in reality the rates would be wildly different even if you could get a (unsecured) loan to buy stocks.


Greystache

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Re: Help me understand something basic
« Reply #10 on: October 24, 2019, 08:33:20 AM »
Let's skip all of the hypothetical arguments and use an actual example.  I bought a house in 1994 for $200K with 5% down. This was at or near the bottom of the local market. The price increased rapidly and I was able to cancel PMI after 3 years. Interest rates were falling and I was able to refinance a couple times and reduce the term of the loan without increasing the monthly payment.  After about 10 years the the cost to rent an equivalent property exceeded my monthly principal, interest, and tax payments.  Now the mortgage has been paid off for 5 years. The house is worth $695K according to Zillow. My monthly cost for taxes and utilities and maintenance ( I do almost all maintenance myself) is about $700 per month. The cost to rent an equivalent property is about $3000 per month. Even if we downsized to a one bedroom apartment, the rent would be double our current monthly housing expenses. Granted, this is not typical. I accidentally bought at the perfect time. I live in SoCal so my property taxes are capped, my utilities are very low and rental prices are stupid high. I think the take away from all of this is that buyers don't have to tie up a huge amount of money to purchase a house and they lock in their housing prices while renters see their housing prices increase with inflation. As an early retiree, I am grateful to have low housing costs that are not subject to constant rent hikes. Also, my home equity serves as my safety net in case everything goes wrong.

minimustache1985

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Re: Help me understand something basic
« Reply #11 on: October 24, 2019, 09:04:32 AM »
@Greystache brings up one of the strongest points for buying.  Assuming you plan to stay put for a considerable length of time (at least 5 years or more) and the rent vs buy calculators donít drastically favor renting, buying locks in your housing costs indefinitely.  Sure you have maintenance to consider and need to factor that in calculations, but the apartment I rented 7 years ago for $1100 now rents for $1430 (a complex where I can see their availability online), and thatís for someone new off the street- my renewal offer when I left was like $1215 because they know they can charge current tenants slightly more since moving is a PITA and not free (application at the very least, non refundable deposits and paid movers at the high end).  My mortgage meanwhile has gone up less than $100 as property tax increases are capped (not as low as Cali but like 3%/yr) for a primary residence and insurance rates only increase slightly with inflation if you shop around as needed.

Malcat

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Re: Help me understand something basic
« Reply #12 on: October 24, 2019, 09:15:22 AM »
@Greystache brings up one of the strongest points for buying.  Assuming you plan to stay put for a considerable length of time (at least 5 years or more) and the rent vs buy calculators donít drastically favor renting, buying locks in your housing costs indefinitely.  Sure you have maintenance to consider and need to factor that in calculations, but the apartment I rented 7 years ago for $1100 now rents for $1430 (a complex where I can see their availability online), and thatís for someone new off the street- my renewal offer when I left was like $1215 because they know they can charge current tenants slightly more since moving is a PITA and not free (application at the very least, non refundable deposits and paid movers at the high end).  My mortgage meanwhile has gone up less than $100 as property tax increases are capped (not as low as Cali but like 3%/yr) for a primary residence and insurance rates only increase slightly with inflation if you shop around as needed.

Yeah, that's why buying is primarily a lifestyle decision, with the biggest impact being on career options.

When contemplating buying, the first question shouldn't be "what kind of house do I want to live in and is it affordable to own?" It should be "How okay am I with dramatically limiting my career options?"

havregryn

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Re: Help me understand something basic
« Reply #13 on: October 24, 2019, 09:30:06 AM »
But how does this work in a globalised world?I can walk into my bank today and walk out with 100 000 euro loan with a below 2 percent interest rate tomorrow. I could take it and buy real estate in a poorer European country and it feels like an almost fool proof idea but I don't dare because it can't be that simple. Or it can? The rate of inflation is higher than the current interest rates on loans bank would give to a client like us (high income, secure jobs, respectable net worth) and interest is tax deductible also on personal loans. I honestly don't understand why I am not in debt to my neck, probably because this current economic climate is hard to wrap my head around.

Malcat

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Re: Help me understand something basic
« Reply #14 on: October 24, 2019, 09:46:07 AM »
But how does this work in a globalised world?I can walk into my bank today and walk out with 100 000 euro loan with a below 2 percent interest rate tomorrow. I could take it and buy real estate in a poorer European country and it feels like an almost fool proof idea but I don't dare because it can't be that simple. Or it can? The rate of inflation is higher than the current interest rates on loans bank would give to a client like us (high income, secure jobs, respectable net worth) and interest is tax deductible also on personal loans. I honestly don't understand why I am not in debt to my neck, probably because this current economic climate is hard to wrap my head around.

Well...it is that simple. That's exactly how very wealthy people make a lot of money, by being leveraged up to their eyeballs into profit schemes that involve a certain degree of risk.

It's also how a lot of very rich people lose everything.

maizefolk

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Re: Help me understand something basic
« Reply #15 on: October 24, 2019, 09:52:27 AM »
But how does this work in a globalised world?I can walk into my bank today and walk out with 100 000 euro loan with a below 2 percent interest rate tomorrow. I could take it and buy real estate in a poorer European country and it feels like an almost fool proof idea but I don't dare because it can't be that simple. Or it can? The rate of inflation is higher than the current interest rates on loans bank would give to a client like us (high income, secure jobs, respectable net worth) and interest is tax deductible also on personal loans. I honestly don't understand why I am not in debt to my neck, probably because this current economic climate is hard to wrap my head around.

I suspect it's a combination of long tail risk and your own experience being representative of a lot of potential borrowers.

For the first: the Eurozone seems a lot more stable than it did back in 2010/11, but there is some small risk it could still either break apart or lose members. In that case the resulting exchange rates might make the property in the poorer country (and any rent paid by folks if you're planning to rent it out) worth far less than the loan balance in Euros. It only takes a very small perceived risk of a 40-50% loss to cancel out a lot of the appeal of an otherwise sure thing investment.

For the second: the "animal spirits" of the general public in both the EU and US still seem to be pretty spooked about debt and leverage since the great recession and european debt crisis. So if people aren't that interesting in taking out loans, even at terms that should make financial sense, then loan rates are naturally going to continue to fall.