Real Estate/Mortgage Loan/Stock Market

[squiffy]

In a recent post, which I cannot locate, one poster was saving up to buy a home. And he wanted to know some of the pros and cons of either paying for the home in cash or making a small downpayment and borrowing most of the money at 6%.

I thought the responses were excellent, but wanted to add two more points, which I don't recall being mentioned.

First, I believe you also need to consider inflation. If you borrow 100K today in 2005 dollars and pay it back slowly over 30 years, you will be repaying the loan in dollars that are worth less then the dollars you borrowed.

Assuming inflation at a typical historical rate of 2-3%, the borrower benefits from inflation and wants to delay repayment so that he is paying back in dollars that are worth less, due to inflation.

Note, according to some CPI calculators, $100 in 1975 is the equivalent of say $600 in 2005, 30 years later, due to inflation.

And, in the event of a major war or economic or political problems, there is a chance we could face major inflation as we did during the 1970s after the inflationary effects of the Arab oil embargo and the Vietnam War. I believe inflation was running at about 10-15% or more, which again, hugely favors borrowers. You borrow money today which has great value, and hopefully repay it with inflation-ravaged dollars that have less value.

In other words, if you know we will have 50% inflation for the next 30 years, starting tomorrow, then you would want to borrow as much money as you can today, buy assets which will hopefully hold their value despite inflation (say gold, commodities, or real estate)and laugh at the bank or creditor who was foolish enough to lend you $100 K and let you repay him with the equivalent of 50K or less in tomorrow's dollars.

My second point, is merely to illustrate a point which was already made in one of the other responses. If you borrow money at 6% and inflation is at 2%, you are really only paying a real interest rate of 4%. And after tax benefits of say 2%-3%, you are really only borrowing the money at a true cost of about 1-2%.

So, instead of paying 100K for the home in cash, if you can invest the 100K in other real estate or in stocks which reliably earn a real investment return of more than 2% after taxes, WITHOUT LOSING THE MONEY, then you are better off NOT PAYING CASH, but keeping the cash and investing it.

The magic of the American economy is that if you put down only 5% of the purchase price and sign a contract promising to pay the rest over 30 years, you have the legal right to call yourself the owner of the land and to profit from any gain in equity over that 30 year period, even if you havn't paid for the land yet.

So, if you can pay $5000, control the land, and invest your remaining cash in the stock market, why would you pay cash and drain your investment portfolio and forgo those POTENTIAL stock market returns.

For example, the leader of the stock investing competition made 45% in one month. I would like to know what investments the top 10 participants selected.

But clearly, if you can borrow money at 6% and invest it and make 20% a year on the stock market WITHOUT LOSING YOUR PRINCIPAL, then over 30 years, you should be better off investing.

Remember, society recognizes your ownership of the land, just based on the down payment and the promise to pay. So if the home goes up in price from 200K to 400K, then you have the right to sell it and pocket the 200K equity gain, even if you only put $5000 down, and even if you still owe 195K to the bank or mortgage co.

Last year, in July 2004, I had about 107K in my retirement account. It was in an IRA rollover account with an online discount broker. So tax deferred.

I bought about 9,400 shares of NOK at prices ranging from 11 to 15 or so, and sold them at about 16.5 a year later. After dividends etc. the balance a year later was about 160K. So the return was 49% or so.

Remember this is tax-deferred. And in a sense, I can keep that money there because I did not need it to pay for the home I live in. And the stock returns, assuming I don't lose everything, will grow tax-deferred for 30 years.

I bought a home in California in May 2002 for 200K. This week it was appraised at 420K. In theory, I have 220K equity in the home. I doubt the price will stay that high, as I believe CA property is way overvalued. In any event, I bought the home with no money down. So I didn't have to borrow any money from my retirement account or cash account to buy the home.

I just signed a piece of paper promising to pay for the home over 30 years and the bank loaned me 200K. Just like that at 6%.

These rates are some of the lowest rates Americans have seen in 37-40 years, since the 1960s.

In other words, money is a commodity, like filet mignon steak.

When banks are loaning money cheaply, you should borrow as much as you can safely afford to borrow, assuming you know how to invest it wisely and profitably.

If high quality filet mignon steak is on special sale today at $1 a pound, instead of at its normal price of $20 a pound, why not buy a lot while it's cheap.

Borrowing money at a real interest rate of 2% is a bargain we may never see again in our lifetimes.

[Dan Mezick]

[ QUOTE ]
My second point, is merely to illustrate a point which was already made in one of the other responses. If you borrow money at 6% and inflation is at 2%, you are really only paying a real interest rate of 4%. And after tax benefits of say 2%-3%, you are really only borrowing the money at a true cost of about 1-2%.


[/ QUOTE ]

One can argue that money had a negative cost when rates bottomed. They were literally paying you to take it away.

[imported_bingobazza]

Cheap money (low interest rates) have the effect of inflating the prices of the assets of choice...in this case....real estate. This ploy has commonly been used by central banks with monotonour regularity to depreciate debt....mostly with the same outcome...a bust with a credit crunch, or a deflationary boom. The point we are at now is a game of 'greater fool' where everyone tries to find a bigger fool to pay more than he paid for the inflated asset...we're getting close to the end now.

I read recently that the real estate bubble is currently hndreds of times bigger than the dot com bubble and that the world has never seen a bubble so large when measured in USD. It isnt just in the US, but almost every major financial centre in the world has ridiculously overvalued property, fuelled by cheap money...(but its different this time...is the cry of the masses).

How about this scenario....the property market starts to level off, people have made a lot of money and are starting to take some profits, then interest rates creep up, smart money leaves inflated areas and find new investment themes that arent on the publics radar yet (Nikkei anyone?)(Donald Trump has starting to sell), fewer buyers for houses as they are too expensive, prices slip, a few inexperienced developers go bust very publically, more sellers in the market, prices fall, interest rates continue upwards, people liquidate stocks to pay mortgages on investment property, the stock market also slips, people feel less wealthy, decide to cash in property investments and retire, prices fall faster now. No one is buying, interest rates go up again...landlords feel the pain, liquidate more stock, stock markets fall heavily, new saving money is diverted from stocks to mortgage payments as higher interest rates bite...no one can sell. Prices are in freefall.....people start handing the property keys back to the banks, and accepting credit blacklisting as they slip into negative equity (the mortgage is larger than the property value) and cannot pay.

Things calm down after a year or two and smart money sells Nikkei stocks and picks up the bargains you left behind, as interest rates begin to fall again.

Heres another scenario...property will continue to increase and cheap money is here to stay. The boom and bust in property is dead, thanks to Alan Greenspan printing money, and everyone grows wealthy as interest rates stay around their 35 year lows for ever....the 'new era' in interest rates. New average university graduates get jobs that pay 3 times more than normal and are able to afford to buy a home to get then onto the housing ladder. Because of this shift, the housing market is fuelled with a new stream of endless buyers each year, enabling the market to keep going up.

You cannot fix one bubble (dotcom) with another (realestate), and they generally all look the same. Be careful if you get involved at this point.

Good luck.

Bingo

[MonarchDon]

Would you consider obtaining a 40 year mortgage ? Many banks are starting to offer 40 year terms. And what about when they come up with 50 terms would you go for that ?

I'm not being a smartA.. I'm seriously asking for your opinion.

[adios]

[ QUOTE ]
I read recently that the real estate bubble is currently hndreds of times bigger than the dot com bubble and that the world has never seen a bubble so large when measured in USD.

[/ QUOTE ]

I don't have a link handy but compare real estate prices in Tennessee and Southern California then tell me there's a real estate bubble in Tennessee. Mentioned many times on this forum real estate markets are localized and not ubiquotous. There was a blurb in the WSJ about rental prices. To pick on Tennessee and California again, California markets occupied 5 of the highest rental price markets while Tennessee had two of the lowest. I'd also point out that in the Mortgage Backed Secuirty (MBS) area (securitization of real estate loans) there are all kinds of bonds with various ratings and the MBS market is bigger than the U.S. treasury market. I trust the agency ratings of MBS more than I do for corporates. In other words a AAA rated MBS is more secure to me than a AAA rated corporate. IMO if the real estate market slumps in SoCal, we'll see the speculators take a bath but so what?

[adios]

Hey squiffy did you notice my recent post about my predicting a bear market for bonds especially on the long end? You and Ray were just a little early [img]/images/graemlins/smile.gif[/img].

[laserboy]

What you just described is what I call a credit bubble.

Only you forgot the part about the banking system collapsing and the deflationary Depression (with a capital D).

Periods of prolonged credit expansion and inflation are followed by periods of credit contraction and deflation.

Total Credit Market Debt as % of GDP

Bingobazza does a good job explaining it.

To play devil's advocate, if borrowing money to chase 20% returns is so easy, then why is the most successful investor of all time Warren Buffett sitting on 50 Billion in cash?

Of course, I could be mistaken. You may have discovered the perpetual money making machine.

[laserboy]

Fannie Mae is completely collapsing right now. They have flat out stated that it will take them til the end of NEXT YEAR to finish cooking their books, and they face a possible delisting from the NYSE.

From my perspective the only reason their MBSs still carry an investment grade rating is fear of roiling the markets. Why rationale is there to trust the agency ratings of these securities?

The whole thing is like reading Smartest Guys in the Room in slow motion.

[adios]

Fannie Mae isn't the only entity issuing MBS securities, please. Also the rating isn't based on who issued the security and also there are all kinds of MBS debt securities. Also your definition of a collapse and mine are two different things apparently.

[laserboy]

I am suggesting their financial difficulties are symptomatic of a systematic problem with current mortgage lending standards and the current state of the mortgage lending industry. If Fannie Mae is having problems securitizing mortgages, is it not logical to surmise that other institutions might as well?

Look at the financials of the subprime lending institutions such as Irwin Financial and New Century Financial, it is apparent that they are propping up their earnings and balance sheets through creative financial means. Why are they doing this? Fannie Mae is refusing to even show their books. Every other financial institution is required to report their earnings every quarter, why does it take them 3 years? What are they using, an aabacus?