Author Topic: Mortgage vs paying with cash  (Read 618 times)

Stash Man

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Mortgage vs paying with cash
« on: July 03, 2021, 02:51:41 PM »
A friend is debating whether he should buy a house with cash or get a mortgage. He has been told that as long as the effective mortgage rate (after tax deductions) is less than inflation it's a no-brainer. He feels skeptical about this general claim.

I told him that if he buys with cash, after 30 years he'll still have a house. If he gets a mortgage, he can invest the cash and stands a good chance that at the end of 30 years he'll have a house PLUS an investment portfolio with money left over. 

However, the investments must survive the periodic principal & interest payments without ever depleting, despite the fact that the principal payments go into house equity and still belong to him. The situation is actually similar to retirement withdrawals, where sequence of returns matters a lot.

With current 30-year fixed at 3%, annual payments (principal + interest) come to ~5% of the loan. So he's effectively doing a constant 5% withdrawal (payments don't go up with inflation). Simulation shows this has 98%+ chance of success, so getting a mortgage is a good deal.

Questions:
1) Does my explanation make sense?
2) Am I missing anything in my considerations? I want to make sure I'm not giving my friend bad advice.

Financial.Velociraptor

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Re: Mortgage vs paying with cash
« Reply #1 on: July 03, 2021, 03:24:21 PM »
Mathematically, getting a mortgage and investing the cash is a no brainer.  I'd still be tempted to give up some performance for peace of mind.

If friend really wants to optimize and de-risk:

Get 30 year fixed at 3%.  Put cash in closed end municipal bond funds IQI and NEA (paying 4.59% and 4.49%, respectively) federal income tax free.  These montly payers should more or less cover his payment (escrow for tax, insurance etc another matter).  But the core loan becomes self liquidating and kicks off an itemized tax deduction.  Basically, have your cake and eat it too by deploying the cash in a mental bucket towards the house, while making a tax arbitrage play.

Theoretically, you come out 1.5% ahead plus some tax benefits.  Risk is very low and you lock in a small return.

EDIT: The decision doesn't need to be binary either.  Friend can put 20% down, 50% down, 75% down, w/e.  A "large" downpayment might allow for a 15 yr fixed at a substantially lower interest rate.
« Last Edit: July 03, 2021, 03:32:04 PM by Financial.Velociraptor »

bthewalls

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Re: Mortgage vs paying with cash
« Reply #2 on: July 03, 2021, 03:32:33 PM »
The knowledge base in this place is amazing....

Stash Man

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Re: Mortgage vs paying with cash
« Reply #3 on: July 03, 2021, 06:32:07 PM »
Mathematically, getting a mortgage and investing the cash is a no brainer.  I'd still be tempted to give up some performance for peace of mind.

If friend really wants to optimize and de-risk:

Get 30 year fixed at 3%.  Put cash in closed end municipal bond funds IQI and NEA (paying 4.59% and 4.49%, respectively) federal income tax free.  These montly payers should more or less cover his payment (escrow for tax, insurance etc another matter).  But the core loan becomes self liquidating and kicks off an itemized tax deduction.  Basically, have your cake and eat it too by deploying the cash in a mental bucket towards the house, while making a tax arbitrage play.

Theoretically, you come out 1.5% ahead plus some tax benefits.  Risk is very low and you lock in a small return.

EDIT: The decision doesn't need to be binary either.  Friend can put 20% down, 50% down, 75% down, w/e.  A "large" downpayment might allow for a 15 yr fixed at a substantially lower interest rate.

Thanks, this sounds like a safe play. I did a little research and read that muni bonds hold up better than treasuries during rate hikes. What are your thoughts on rate risk as it relates to muni bonds?

Radagast

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Re: Mortgage vs paying with cash
« Reply #4 on: July 03, 2021, 07:02:20 PM »
I have looked at CEF leveraged munis such as IQI and NEA a few times based on @Financial.Velociraptor 's recommendation. However, because of their costs and cost of leverage they have never been on the efficient frontier of different assets. As an example, some blend of Vanguard High Yield Municipal Bond Fund VWALX (actually very safe) and VTSAX would always give a better result with less rick, just bump VTSAX a little if you wanted greater returns. So I'd go with that, but maybe split stocks 50/50 with international in case the next 30 years are different.

Example:
https://www.portfoliovisualizer.com/backtest-portfolio?s=y&timePeriod=2&startYear=1985&firstMonth=1&endYear=2021&lastMonth=12&calendarAligned=true&includeYTD=false&initialAmount=10000&annualOperation=0&annualAdjustment=0&inflationAdjusted=true&annualPercentage=0.0&frequency=4&rebalanceType=1&absoluteDeviation=5.0&relativeDeviation=25.0&reinvestDividends=true&showYield=false&showFactors=false&factorModel=3&benchmark=-1&benchmarkSymbol=VWALX&portfolioNames=false&portfolioName1=Portfolio+1&portfolioName2=Portfolio+2&portfolioName3=Portfolio+3&symbol1=IQI&allocation1_1=100&symbol2=NEA&allocation2_2=100&symbol3=VWALX&allocation3_3=85&symbol4=VTSAX&allocation4_3=15

Maybe add a smattering of EE savings bonds because 3.5% for a 20 year bond is a guaranteed win, even if in tiny amounts.

nereo

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Re: Mortgage vs paying with cash
« Reply #5 on: July 03, 2021, 07:17:11 PM »
Mathematically, getting a mortgage and investing the cash is a no brainer.  I'd still be tempted to give up some performance for peace of mind.

If friend really wants to optimize and de-risk:

Get 30 year fixed at 3%.  Put cash in closed end municipal bond funds IQI and NEA (paying 4.59% and 4.49%, respectively) federal income tax free.  These montly payers should more or less cover his payment (escrow for tax, insurance etc another matter).  But the core loan becomes self liquidating and kicks off an itemized tax deduction.  Basically, have your cake and eat it too by deploying the cash in a mental bucket towards the house, while making a tax arbitrage play.

Theoretically, you come out 1.5% ahead plus some tax benefits.  Risk is very low and you lock in a small return.

EDIT: The decision doesn't need to be binary either.  Friend can put 20% down, 50% down, 75% down, w/e.  A "large" downpayment might allow for a 15 yr fixed at a substantially lower interest rate.

Thanks, this sounds like a safe play. I did a little research and read that muni bonds hold up better than treasuries during rate hikes. What are your thoughts on rate risk as it relates to muni bonds?

I would consider paying cash for a home to be the far more riskier thing to do.

This is particularly true if one a) has tax-advantaged head space they are not filling, b) paying cash would result in a large percentage of one’s NW tied to their home, c) have no other inflationary hedge, d) plan on living there for >> 5 years, e) paying cash would leave the buyer without substantial assets to draw upon should the SHTF (extended job loss, medical expenses, etc).

See:
https://forum.mrmoneymustache.com/throw-down-the-gauntlet/dont-payoff-your-mortgage-club/
https://www.bogleheads.org/wiki/Paying_down_loans_versus_investing
https://forum.mrmoneymustache.com/investor-alley/investment-order/

Dicey

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Re: Mortgage vs paying with cash
« Reply #6 on: July 03, 2021, 07:33:47 PM »
Bless you, @nereo for beating me to it! Everyone is welcome at link #1, aka the DPOYM Clubhouse.

I love reading the "Race" threads and at least lurk on most of them. The people who are making the most impressive progress are mostly not hastening to pay off their mortgages early. There's a good lesson there.

Financial.Velociraptor

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Re: Mortgage vs paying with cash
« Reply #7 on: July 04, 2021, 10:21:31 AM »

Thanks, this sounds like a safe play. I did a little research and read that muni bonds hold up better than treasuries during rate hikes. What are your thoughts on rate risk as it relates to muni bonds?

Interest rate risk for bonds only exist for those who intend to sell before maturity.  As the maturity date draws closer, the price of the bond moves back towards par.  At maturity, it pays exactly par.  If you take IQI and NEA as "forever positions", you want rates to rise.  As the shortest duration bonds mature, they are replaced by higher yielding munis.  Thus, your distribution starts to climb.  Else, you collect over 4% till the end of time.  Assuming the 4% rule, that is a pretty good deal for your bond allocation in my opinion. 

I also think there is a lot to be said for PDI, if you can catch it when it trades below NAV (infrequent).  Great yield, long history of strong performance.  Taxable, but at current yield of 9.12%, I'll gladly pay the tax.

Stash Man

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Re: Mortgage vs paying with cash
« Reply #8 on: July 04, 2021, 05:01:44 PM »

Thanks, this sounds like a safe play. I did a little research and read that muni bonds hold up better than treasuries during rate hikes. What are your thoughts on rate risk as it relates to muni bonds?

Interest rate risk for bonds only exist for those who intend to sell before maturity.  As the maturity date draws closer, the price of the bond moves back towards par.  At maturity, it pays exactly par.  If you take IQI and NEA as "forever positions", you want rates to rise.  As the shortest duration bonds mature, they are replaced by higher yielding munis.  Thus, your distribution starts to climb.  Else, you collect over 4% till the end of time.  Assuming the 4% rule, that is a pretty good deal for your bond allocation in my opinion. 

I also think there is a lot to be said for PDI, if you can catch it when it trades below NAV (infrequent).  Great yield, long history of strong performance.  Taxable, but at current yield of 9.12%, I'll gladly pay the tax.

Thanks for the explanation, this is very interesting. Does that mean it's necessary to have an idea of IQI/NEA's mix of maturities and pars, since they have a direct effect on the NAV?  I suppose if a large portion of the fund has pars below their current prices, the NAV will drift lower as they mature, all else being equal.