Some thoughts on debt

Discussion in 'Business & Economics' started by DubStyle, Mar 20, 2007.

  1. DubStyle I may be wrong, but I doubt it Registered Senior Member

    I was in one of my finance classes today and while we were talking about interest rates, one of the students asked a question about how when you finance a house for example, you end up paying 2-3 times the value of the house and how f'd up that is.

    What was interesting is that professor went on a tangent how the entire argument to pay off a house early is neutral advice at best. I dont know if I can recreate his argument on here, but at the very least it was an interesting discussion.

    Some of his points were that ultimately the present value of the house now, and then in 30 years is going to be exactly the same. For example, you're buying a house that has a $500,000 price tag. If for example you bought the house outright with cash, you would have to have to discipline to reinvest all the money you're saving on interest payments into new investment to realize the same gains you would if had just taken the mortgage. I think the point he was trying to make is that theoretically, paying for a home outright could end up be a negative decision because most ppl are going to take that extra money they save each month and just consume it on new golf clubs or some other garbage.

    I'm probably not doing the idea justice but maybe someone on here understands the premise behind it and has some thoughts. I mean this guy was a pretty smart dude, phd in finance and whatnot. He had this idea pretty well thought out and was shutting down all the counter arguments with ease.

    Anyone have any further thoughts. Also, this is pretty much pure theory that takes into account certain assumptions so I'd rather not see BillyT post about how the dollar is going to tank in April and all this is moot

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  3. quadraphonics Bloodthirsty Barbarian Valued Senior Member

    There's also tax benefits to having a mortage (i.e., you can write off the interest). Many people get into a position where they could pay off their houses tomorrow, but don't do it because it's better to have the write-off. Whether this is a good idea or not depends on your income, the value of your house and what rate your loan was at; adjusting for these factors is what people are doing when they refinance mortgages.

    Your professor's point makes sense, though: unless the buyer invests the difference between the sticker price of the house and the total cost of the mortgage into something with higher returns than the house, he comes out worse off than if he'd taken the mortgage. The figures about paying 2-3 times the original price may sound shocking, but you have to remember that it's spread out over decades. On that time scale, inflation alone will cause the sticker price of your house to double, so any real appreciation is still money in your pocket. People wouldn't buy houses if they expected to lose hundreds of thousands of dollars on them, so you can be assured that most mortgages are, in the long run, financially sound decisions for buyers to take.
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  5. paulfr Registered Senior Member

    A mortgage allows you to LEVERAGE your money and since you are in the beginning of your career, you need this advantage as much as possible.
    As long as you can keep employed so you can make the payments [even if you can't, then you can rent it out], you will be fine.

    Two more ideas for you ....
    1/ If I were your age, I would try to buy as many condos as I could and rent them out. The dollar is weak and there will almost certainly be an inflation soon which will be a windfall for those holding real estate. I had friends back in the 70's who made it big this way and retired early due to their luck in stumbling on to this strategy.

    2/ If you go thru the numbers, paying an extra 10% over your monthly morgage bill will cause you to payoff the home in 15 years, not 30 years. This is another golden tip I missed out on when young. That extra 2/3 of the total payment over the mortgage lifetime drops to 1/3 and you are now rent free in 15 years. That is a big first step to financial freedom .... don't miss it.

    Be sure to have a lawyer read the mortgage agreement before you sign so you are sure the bank gave you what you asked for in terms of a fixed term, no early prepay penalties, fixed rate, etc. Not all agents are honest.

    Good luck
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  7. Fraggle Rocker Staff Member

    This is an utterly absurd argument. Either your professor is out of touch with reality or his words have lost something in the translation. The reason mortgages exist is that nobody has enough money to pay cash for a house. This discussion about where you would put your money if you don't put it into a house is meaningless.

    A pathetic little townhouse here in suburban Maryland, 20 miles from the D.C. civic center, costs $350,000. That's six years salary (before tax) for a college graduate in his late 30s with a good job in I.T. or something similar. There is no way anybody can raise $350,000 cash until they're in their 50s and have made some good investments. The reason so many families are either renting or else buying homes 30 miles further north in the next county where they're cheaper is that they have difficulty just raising the $35,000 to $70,000 for the down payment.

    The reason that real estate is a good investment is that the supply is fixed but the demand will continue to rise as long as the population keeps increasing. It isn't the house you're paying for so much as the land. Homes that sold for $30,000 in 1965 sold for $120,000 in 1985 and are selling for $450,000 today. That is much steeper than the increase in the cost of living; housing takes a much bigger portion of the family budget than it did in the past.

    The advantage of a mortgage is that you are getting appreciation on the entire value of the house, not just the amount you put into your down payment. You put $70,000 down on a $350,000 townhouse and in 20 years it will be worth $1,400,000. Even if you don't pay down your mortgage you will then have $1,330,000 in equity. You haven't made 400% appreciation, you have multiplied your investment by 2000%.

    Of course you will pay three times the amount of your loan principal over thirty years. But if you don't understand why that is perfectly reasonable, you weren't paying attention in finance class. Thirty years is a long long time. That's somebody else's money you're hanging onto for all that time. You have to pay him enough to be willing to let you sit on it instead of him using it to start a business, or put his two kids through Harvard, or just buy himself a yacht. If you want, you can get a fifteen year mortgage for only a couple hundred bucks a month more, and you'll end up paying less than double the amount of your principal.

    With respect to Paul, condos are a risky investment because in their case you pretty much just have the building, which depreciates (and damn do condos ever depreciate, most of them are made out of toothpicks and toilet paper), and only a tiny sliver of land, which is where the real value should be in real estate. Sure there's money to be made in condos but it's more speculative than even townhouses, which at least have a modest size parcel of land sitting under their foundation with a tiny yard attached.

    You have to know a lot about properties and markets and demographics to be really safe with condos. If you're in your 20s you could probably pull it off because risks tend to level out in the long run. But still you're better off if you own three or four of them in widely separate regions so they're not all subject to the same market forces. And the problem with that is that it's tough being a landlord under the best of circumstances, but condos tend to have more problems than houses or apartments, and if on top of that you've got a condo in another city that you can't manage personally you've got yourself some trouble.
  8. 15ofthe19 35 year old virgin Registered Senior Member

    Your professor may have been trying to explain to you the concept financial leverage, which I would hope you already get. If not, you might want to change majors.

    In a nutshell, just because you have the cash to buy something outright, doesn't necessarily mean that's the best use of your cash. In a market that offers low interest rates, it's often the case that the best investment is to use financial leverage to increase your overall internal rate of return on investment. If you have $500K, and you can borrow 90% against a $500K property, and your interest rate is say 6.25% and you can invest the remaining $450K at 9.25%, then you're going to make 3% on $450K plus whatever the increase in equity over the life of the project. Additionally, you can use the interest costs from your loan to offset income.

    This is the norm for commercial properties, not exactly sure I would say that it applies as much in residential in cases where a homebuyer might have the ability to buy their home outright. Even if they could (and very few could), it probably would be better not to tie up all their cash in the home, considering current interest rate levels are still about as low as they have ever been.

    Of course, if you intend to just hide your money in your mattress and not invest, then you should always buy the home outright, as it will almost surely appreciate in value, and you wont have all the nasty interest to pay.
  9. DubStyle I may be wrong, but I doubt it Registered Senior Member

    Oh boy. Dont worry people. I understand the concepts of leverage, inflation, appreciation, etc. And I didn't get the impression that the whole discussion had anything to do with the lesson because it was a pretty big tangent from what we were doing. Whatever. It seemed more like a pet peeve of his that he wanted to get across.

    Whatever. The whole discussion was more about the fact that paying off a mortgage early was neutral at best advice. That tax point that quadraphonics brought up was also part of it. Just for the sake of argument. Say you're buying a new house and you have the cash for it up front. Wouldn't it wise to take out a 30 year mortgage, get the tax deductions, and invest that principle you would have paid into the house upfront?

    I just found the whole idea that paying off a mortgage early is only good advice if you have the discipline to reinvest the the money you are saving into something that will yield equal to or greater returns than a house.

    One of the points he made as I understood it was that in the end, you would be paying the exact same amount. The present value of both cash flows are identical. I mean, maybe this was all a ruse to teach us something about PV concepts. But I dont see why we would take 10 min out of an upper level finance course to rehash some Principles of Finance concepts.
  10. Syzygys As a mother, I am telling you Valued Senior Member

    Maybe you remember wrong. If it was true, people wouldn't invest in real estate.

    In the long run RE is considered one of the best investment for preserving or increasing the value of your capital. That said, there are lots of factors that can effect the value of your RE:

    1. Mortgage interest rates. When it is low (past few years) people have easy access to capital and they buy, thus RE prices go up.

    2. General health of the economy. In a recession nobody buys anything.

    3. Additions to your house during the years. You can greatly improve your RE with a few extra. Also if you just preserve it correctly and don't let it rundown...

    4. The neighbourhood. If you accidentally bought a decent house in the Silicon valley before 1990, the value of it could have easily quadruplied in the next 10 years, due to the tech boom and the need for housing and offices...

    5. Location,location,location....

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    Not to mention people need to live somewhere, so instead of paying rent, you might just pay your mortgages. At the end you will own a house, compared to renting, when you have nothing at the end...
  11. DubStyle I may be wrong, but I doubt it Registered Senior Member


    Yeah, I made a mistake. The PV of the payments. Not the PV of the house. Nice post tho. haha
  12. Billy T Use Sugar Cane Alcohol car Fuel Valued Senior Member

    I want to pick up on what Fraggle Rocker said:

    In real terms, the cost of building a house has gone down for decades. (what change that has occurred is mainly the house got bigger). This is because, tree still grow to make wood (if any thing more rapidly and with greater yield /acre) insulation is better and cheaper, nail guns and dry wall have replace a guy with hammer and 6 nails in his mouth and the plaster man with his crew nailing up lath and mixing plaster etc.

    It is the price of the land that has go thru the clouds, for reasons Fraggle stated. I fortunately understood this while still young. I did not buy a house when I could, but continued to rent apartment, in relatively poor school area. (Only when I had kid ready to go to school did I move to Columbia, Md, as one of the first to do so. (It was just Bryant Woods then - Fraggle seems to be of or at least know the area.)

    The money I could have been putting into a mortgage I put into land -16 acres in Howard county. I had only been able to save $5,000. Then, perhaps still, hard to borrow on land, so I talked the owner in to granting me a "purchase money mortgage" and taking my 5K. - It was the best investment I ever made.

    I first sold one acre piece to Howard County (for their largest water pumping station) - and with the proceeds paid off the prior owner. Then, after about five years, I subdivided off 3, roughly 1.5 acre, lots, each of which sold for twice my original purchase cost. Then I let it sit for about 16 years as Howard county and my 2 kids grew. Finally sold the remaining ~10 acres for about 20 times the original purchase price. - profits paid for their college, one at Cornell and other at Wake Forest.

    None of this would have happened if I had been "normal" and bought a house when I could handle the mortgage, instead of continuing to rent a modest 2 BR apartment in a sea of them in Laurel, MD. (Rt 197, Fraggle if you know the area too.)

    If you are young, don't really need a house, rent and buy relative rural land, soon to be urban land. - That is what appreciates. (but study the population trends, taxes, topography the sewer lines must use, etc.) - Keep its "farm tax” status as long as you can. - I raised bees to do so, but hardly sold any honey. - It was more for the fun of learning about them and the tax angle than a real farm business.
  13. Billy T Use Sugar Cane Alcohol car Fuel Valued Senior Member

    Ohio's "thoughts" (not very well thought out IMHO - sort of "spread the pain to all thinking."):

    March 23 (Bloomberg) -- "Ohio, which had the highest foreclosure rate among the 50 U.S. states at the end of 2006, plans to issue $100 million in taxable municipal bonds next month to help homeowners refinance mortgages they can't afford.

    Proceeds of the bond issue by the Ohio Housing Finance Agency will provide financing for about 1,000 loans with a fixed rate of about 6.75 percent, said Robert Connell, the agency's director of debt management.

    ``We believe that it is incumbent on this agency to do something to assist these folks to enable them to keep their homes,'' Connell said. ``A $100 million bond from this agency is not going to solve Ohio's foreclosure problem. We hope to at least make a dent.'' ..."
  14. zanket Human Valued Senior Member

    I think someone who buys a house outright with cash is likely going to have the discipline to invest their "saving on interest payments". The people who don't have such discipline are more likely nowadays to never pay off their house; instead they do cash-out refi's or get home equity loans, blowing the money on vacations, granite countertops and the like.

    There's no guarantee that house prices will appreciate even at the rate of inflation. They can become overpriced to the point where their price wouldn't keep up with inflation for years or even decades. That's true for raw land too.
  15. psikeyhackr Live Long and Suffer Valued Senior Member

    The curious thing about real estate is to wonder how the prices are manipulated and why the people that make up the market allow it.

    Look at the population density of England. Look at the population density of the United States. Why isn't housing dirt cheap in the United States relative to England? The market is a bunch of dummies being manipulated into competing with each other.

    Now if we actually controlled our governments why aren't our tax dollars going to make excellent inexpensive housing to drive the prices down? I suppose the banks wouldn't want that.

  16. zanket Human Valued Senior Member

    It's because in places most people want to live, namely cities, where there's lots of good-paying jobs and lots of entertainment choices, there's a limited supply of single-family residences with a decent commute, same as in England.
  17. swivel Sci-Fi Author Valued Senior Member

    There's no conspiracy, there is just supply and demand.

    And governments are horribly wasteful. Anything they do with our tax dollars can be done better and cheaper with private firms. Look at J.J. Hill's transcontinental railroad for a classic example. Or the first road systems. The idea that the government could provide cheap housing that people would enjoy living in is just laughable. Go visit the East Side in NYC. Or South Philadelphia. Government-built housing is harmful in every way conceivable. Exactly ZERO benefits.

    As Zanket said, housing is all about people's desire to live in or close to big cities. You know, the demand side. And since supply can't keep up, prices go up. If you want to come live out in the boondocks, with me, you can buy a 2,000 sq. ft. home on 10 acres of land for less than $200,000. There is not a nightclub within an hour of my house. BestBuy is over an hour away. My grocery store has all of 6 aisles.

    OR, you could go spend $500,000 on a townhouse in congested D.C., have a swank high-paying job, go to bars every night and chase the opposite sex, and sit in traffic for a third of your waking life.

    Oddly, most people choose the latter.
  18. psikeyhackr Live Long and Suffer Valued Senior Member

    That's funny. So you control supply and manipulate demand. That is why I said , Why don't we control our government to use our tax money to alter the supply of housing? Does the real estate industry have more influence with the government then the masses. How many people in government are rich on the basis of real estate. I think we can forget this idea of the government as some objective, indifferent entity.

  19. zanket Human Valued Senior Member

    Communist Russia did that in a big way. Every Joe Blow got a "free" dinky apartment. Some there still wish that was the case now. Others like capitalism, even though they now have to pay for those apartments.

    Government entities in the US do affect the supply of housing, through zoning laws, subsidies etc.

    Do you want the government to give you a free place to live? You'd still have to pay for it in some hidden way.
  20. psikeyhackr Live Long and Suffer Valued Senior Member

    The existence of the US is built on genocide and stolen land.

    The difference between White Russian Communist NAZIs and White American Capitalist NAZIs is about as important to me as the difference between IBM and Xerox. I have been involved with both corporations.

    The ownership of land is a social and legal delusion so the government influences land prices. Economics and politics cannot be separated.

  21. zanket Human Valued Senior Member

    So is the existence of every other country.

    Non-ownership of land has its own set of problems that you may well find to be worse. So why piss and moan about the way things are? Especially when there's almost zero chance of it changing in your lifetime.
  22. TruthSeeker Fancy Virtual Reality Monkey Valued Senior Member

    Hello DubStyle,

    Interest payments measures the expected valorization of a currency. Essentially, the interest payments are simply adjustments to the actual value of the asset. For instance, you buy a house at $50,000 and you expect the value to increase by 6%. Then, the interest rate you pay will also be 6%. Of course, that's just an expected value, so the value il often actually be higher, or possibly lower in a recession.

    The interest is just adjusting the value of the house, because you don't really own the entire house yet, you only own the portion that you have paid to date. This is why at the beginning, most of the payments are interest, while the principal part of the payment is very small. As you pay the principal portion, the balance of the principal will increase, thus proportionally decreasing the portion that you have to pay for interest.

    Errr... huumm... do ya understand what I'm saying?

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  23. ubermich amnesiac . . . Registered Senior Member

    paying off a mortgage is always weakly optimal to paying upfront, all else equal.

    assuming you have the value of the house in assets now, that money either earns no interest and you receive only positive cashflows (e.g. paychecks, dividend returns, capital gains) in the future in perpetuity, OR you earn all of that PLUS the difference in between your interest rate and the rate at which you invested your equity for the life of the loan multiplied by the value of your equity.

    finance always assumes rational choice (maximizing the net present value of your investments or utility), BUT it doesn't seem like your professor's argument hinges on this criterion. the degree of your patience and rationality should be equal under both scenarios; the only difference is the structure of your assets and liabilities.

    the only case in which the weak inequality turns into an equality (for the net present value of both cash flows) is when you save nothing.
    assume you consume 100% of your budget in all future periods. then you earn 0% return on any outside income you receive in both scenarios (with or without loan). you do not invest your equity at a higher return than your interest rate. then in that case the net present value of your mortgage payments should equal the amount you paid out today, ignoring interest. but perhaps you want to pay the interest so you can have a higher degree of liquidity in future periods. then your utility is maximized even if the npv of payments is higher.

    of course, this argument is highly stylized and with financial innovations like ARMs it seems unlikely that you could lock-in a higher return than your interest rate for the life of the loan. if your lender knows that elsewhere in the market interest rates are higher, why would they not charge you extra too? these financial innovations that allow people to purchase homes with less equity, higher interest (or at least interest rates subject to more risk) and lower monthly payments are part of the reason for the housing bubble that has recently burst...

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