Saturday, October 25, 2014

Viewer Mail: Is A Mortgage A Hedge Against Inflation? Huh?

Note:  This is an older draft post that I just got around to editing.

People use a lot of odd self-justifications to justify going into debt.

A reader writes:
"What are your thoughts on this article?   Particularly, what are your thoughts on comment #125 by csdx?  I quote, "By having debt, you’re in effect getting something at today’s price while paying for it with your future dollars which are devalued due to inflation. Thus a mortgage can act as a hedge against high inflation."
Is paying cash for your house always the smartest way to go about it?"
I think I addressed this in my opportunity cost article.  

The opportunity cost argument goes like this:  If you get a mortgage at 5% interest, you could take that money you would have used to buy the home and put it into stocks and earn 10%!!! By paying cash, youa are foregoing the opportunity cost of investing all that money!

There are two flaws in that argument about opportunity cost and hedge against inflation.   Actually three.  Well, really four.

1. Opportunity cost is a great argument for businesses to make, but a lousy one for individuals to use in their personal finances.  Usually people trying to lend you money make this argument.  Don't listen to them.  Why?

2.  Because comparing stock returns, which are very risky, with the guaranteed rate of return of not paying interest, is comparing apples to oranges.  Not paying 4.5% interest on your mortgage is like getting 4.5% interest on a Certificate of Deposit - zero risk involved (ask your bank for a 4.5% CD and when they stop laughing, they will ask you politely to leave).  Stocks CAN have a greater rate or return, or, like my GM stock, they can go down to NOTHING.

3. Let's face it, that mythical money you are going to "invest" doesn't exist anyway.   What you are doing is borrowing - and borrowing more than you need to - and then trying to make yourself feel like a financial genius by tossing around terms like "opportunity cost" and "inflation hedge".  A better idea is to minimize the amount of money you borrow.  Borrow what you need, not what you want.
4.  Because you can end up losing all your money - or a lot of it - in stocks, and at the same time, see your house decrease in value by half, while the mortgage debt remains the same.  Suddenly, you are upside-down on a mortgage, and broke as well.  Whereas you could have had a paid-for house that would be worth something - or at least not be upside-down.  This is why, in the olden days, you had to put down 20% as a down payment.

Is this last flaw a far-fetched scenario?  Not really, it happened to a lot of people in February of 2009. They lost their shirt in the stock market and foolishly sold out, locking in their losses.  They owed more on their houses than they were worth.  So much for a "hedge" against anything.

I could see someone making that argument in 2005.  But today?  We know better.   People use arguments like this to self-justify serially refinancing their home or taking out equity to pay off credit card debt.  Or, more than likely, they are just parroting what some mortgage broker told them.   People selling you debt are the last people you should take advice from!

The "hedge against inflation" argument falls along the same lines as "opportunity cost" arguments.   Yes, for big businesses, such arguments make sense as they are making investments with their cash-flow which in turn generates profits.  For the individual, they make less sense.  When you borrow money to spend you are just spending, not making money.  And no, you don't "make money" on your personal residence - at most you just get your money back.   The average homeowner moves every five years, not every thirty.   As a result, the effects of inflation are not felt by most of us, unless we stay in the same house for at least a decade or more.

And in case you haven't noticed, inflation has been at all-time lows recently - which is one reason interest rates are at all-time lows.   When we had 10% inflation back in 1980, mortgage rates were 14%.   You see, interest rates already factor in inflation.  If banks didn't do this, they'd go broke in a heartbeat.  So I am not sure that a mortgage is a "hedge" against anything.  If anything it is just a risk you take, and risks are not hedging.

Usually, for people who make these "opportunity cost" arguments, the point is moot.  They are in debt up to their eyeballs and have no cash to buy a home.   So they use these types of arguments to make themselves feel better about their situation.

They aren't flat broke - they are hedging for inflation!  Right?  Riiiiiight! 

As people found out in 2009, if you do this, and the stock market tumbles and your home value tumbles, you end up losing all your money AND are now heavily in debt.

Or, you end up with $300,000 in your 401(k) and a $300,000 mortgage.   In theory, you are even-steven, but you can't cash in the 401(k) to pay off the mortgage, without incurring huge penalties.

There are a number of factors involved.  Generally, my thoughts are this:
1.  For self-employed people like me, who never know where the next paycheck is coming from - or indeed if there will be one, signing on to a large debt-train is a bad idea.  That debt has to be serviced, regularly.

2.  For young people starting out, the point is moot - they don't have the money.  They get a  mortgage because they have to, not because of some opportunity cost theory.

3.  If you are approaching retirement, a paid-for house is a safe investment.

4.  Comparing 10% in the stock market (risky investment) with the 5% you save on mortgage interest is comparing apples to oranges.  Stocks fluctuate - they can go down to zero.  Not paying 5% interest is a 100% guaranteed rate of return, like a government bond.

5.  If you pay cash for a house, the $1500 a month you save on interest (for example) can be invested.   So it is not like you will have no savings.  And a paid-for house is one heck of a safe asset.
All I can say is, not having a $3000-a-month albatross around my neck is a great thing.  I can work less now, and not worry if there is no work (a lot of that going around these days).  And as I lurch toward retirement, I am more confident that I will survive.  I can live on a little more than $20,000 a year at this point - if need be.

Granted, few people can afford to pay cash for a house.   That is not my point.  My point is, borrow as little as you can - what you need, not what you want.  Avoid the temptation to serially refinance, but instead, work toward paying down the mortgage over time - with the goal being eventually being debt-free.   Perpetual debt is not a hedge or an advantage.  It grinds on you and limits your options.  It is mortgaging your future, quite literally.

All that being said, mortgage rates are very low right now, and if you qualify for a low, fixed-rate mortgage, it is a good time to do so - if you need to borrow the money.

But the mortgage being a hedge against inflation?  Even at 4-5% interest rates, you will pay twice the purchase price of the house, over time, once for the principal, and once again for the interest.

It is a personal decision, based on your personal circumstances.  My suggestion is to borrow what you need, and avoid the temptation to go heavily into debt for granite countertops and a "look-at-me!" house (or car, or whatever).

I think the fellow who made this argument is really saying that he doesn't have a lot of cash, and "opportunity cost" and "hedge against inflation" arguments are reassuring to him that he is being smart about money.  But he is only deluding himself.

Having money is better than borrowing it - bottom line.