For those who prefer mortgages over cash: At what rate would that switch?

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BSA44
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For those who prefer mortgages over cash: At what rate would that switch?

Post by BSA44 » Thu Oct 12, 2017 9:54 am

I know there have been many debates on this forum on whether to pay for a house with a mortgage or cash. This question is targeted to those who generally recommend getting a mortgage over paying cash for reasons such as the mortgage tax deduction, not reducing liquidity, and not minding the extra leverage. Particularly, given the recent rise in mortgage rates and the fact that even with the increase, mortgage rates are still historically low, at what mortgage rate would your preference for buying a house with a mortgage switch to buying one with cash?

In case a specific example might be useful, my personal details are below:

My situation: My wife and I are planning on buying a house at some point in the next 3-7 years. We don't feel the need to buy it right now, but we want our next move to be into a house. We may be buying the house with little advance notice due to various factors (e.g., we may be suddenly moving states at some point and will want to buy when we move). We are in the lucky position that we could pay for the house in cash if needed. However, as noted above, similar to many people on the forum, our preference would generally be to use a mortgage. As part of our planning and as a thought exercise I'm considering at what percent mortgage would that no longer be a worthwhile decision. My view is that it's good to come up with a game plan in advance, so that poor decisions aren't in the heat of the moment (and don't fall prey to falsely trying to evaluate unpredictable market conditions at the time we need to buy). An issue that pushes us even further toward doing a mortgage is that the "cash" we would use for a mortgage is in a brokerage count with an average of about 30% capital gains (thank you bull market) that would need to be realized. Other details are below.

Age: 29
Annual income: $210,000
Annual savings: $84,000 (~$40,000 goes into tax advantaged accounts and the rest into a taxable brokerage account)
Current rent: $1260/month (given our rent is low, our savings rate will go down due to the house mortgage)
Expected house cost: $500,000
Down payment: 20% down payment is in a 5 year CD
Other assets: $1,000,000 (lazy 3 fund portfolio; 85% stock, 15% bond; ~40% in tax advantaged accounts and ~60% in a taxable brokerage account; average capital gains ~30%)

Grt2bOutdoors
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Re: For those who prefer mortgages over cash: At what rate would that switch?

Post by Grt2bOutdoors » Thu Oct 12, 2017 12:34 pm

With current mortgage rates of 3.5-3.75% for 30 years, your after-tax cost would be roughly 2.5%. If you estimate you can earn more than 2.5% safely over the long haul, then it pays to finance a portion of home purchase. If you plan on moving or vacating home before 10 years, would finance part of it - you don't want to tie up all of your liquidity.
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GAAP
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Re: For those who prefer mortgages over cash: At what rate would that switch?

Post by GAAP » Thu Oct 12, 2017 1:57 pm

My semi-random thoughts:

I would ignore direct tax benefits (interest deduction) unless I had sufficient other itemized deductions that exceeded the standard deduction -- the actual tax benefits from a mortgage aren't that significant. In fact, many who qualify for the deduction don't bother to take it.

I would not ignore any effects on my ability to increase/maintain retirement savings.

I would be more likely to put more down, prepay, etc. only if mortgage rates were higher than a reasonable real return expectation from a reasonable portfolio choice. I would consider only that portion of the portfolio that would be affected -- reducing a cash or cash-equivalent without rebalancing is significantly different than trying to maintain a specific asset allocation. You'll note that this says nothing about a specific rate -- a 4% mortgage in a 2% inflation environment is very different from the same mortgage in an 8% inflation environment, or a deflation environment.

I would be more likely to increase equity if I wanted to take advantage of an HECM -- the most notable limitation for you would be the minimum age requirement.

If I had a debt problem, or a history of prior debt problems, then I would be much more likely to pay cash -- some folks just can't handle debt well. Recognizing that -- and acting accordingly -- is essential.

I do not consider the house I live in to be an investment, rather a non-liquid fixed asset that generally tracks inflation values, occasionally exceeds them, and often falls far behind. As such, I prefer liquidity to equity. That is NOT THE SAME as a "leveraged investment". That liquidity may allow more investment, but it also allows for greater emergency savings and flexibility. It is the actual use of the funds that matter.

I track my house value at cost, plus any capital improvements (also at cost). I do not track market value. For the purposes of a HELOC, HECM, or sale, I would investigate market value at the time I wanted to make that move -- the number is meaningless otherwise.

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grabiner
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Re: For those who prefer mortgages over cash: At what rate would that switch?

Post by grabiner » Thu Oct 12, 2017 5:52 pm

My guideline is strictly mathematical. If you can get a better after-tax return on low-risk bonds of the same duration as the loan, then you can come out at the same risk level by investing the money. If you are considering not taking out the loan (paying cash for a house, or making a smaller down payment), or paying off the whole loan, then the correct duration is the duration of the whole loan. If you are considering paying down an existing loan, then the correct duration for comparison is the length of the loan, since that is the future payment you will eliminate.

For example, if you can pay cash for a house, or take out a 15-year loan, you would use the 7-year bond rate for comparison. If your loan is at 3% and you are in the 28% tax bracket, the break-even rate on 7-year municipal bonds is 2.16%.

But suppose that you did take out the mortgage, which now has 10 years left. You do not have enough cash to pay off the whole mortgage, but you could make an extra payment now which would reduce your payment 10 years from now. The fair comparison is now a 10-year bond rate.
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Mainlandjones
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Re: For those who prefer mortgages over cash: At what rate would that switch?

Post by Mainlandjones » Fri Oct 13, 2017 5:43 am

I would think the 30 year safe withdraw rate would be a reasonable benchmark. The SWR studies (Trinity, etc) show that a 4% annual withdraw, even adjusted up annually for inflation, leaves you with nice gains for the vast majority of 30 year scenarios. So I'd say 4% is the simple and conservative answer here... ie the odds of the long term market return on investments beating a mortgage rate of 4% are very high. However, if you factor in tax deductions (to the extent they may apply) and inflation (which will increase returns but not increase your fixed mortgage rate), I could see justifying a higher answer, say max of around 7% for aggressive individuals. Personally, my mortgage is 3.625% and I itemize my tax deductions... so I consider it a no brainer.

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grabiner
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Re: For those who prefer mortgages over cash: At what rate would that switch?

Post by grabiner » Fri Oct 13, 2017 9:31 pm

Mainlandjones wrote:
Fri Oct 13, 2017 5:43 am
I would think the 30 year safe withdraw rate would be a reasonable benchmark. The SWR studies (Trinity, etc) show that a 4% annual withdraw, even adjusted up annually for inflation, leaves you with nice gains for the vast majority of 30 year scenarios.
This is not equivalent to a 4% annual return. For example, a 0% return above inflation allow you to sustain a 4% withdrawal rate increasing with inflation for 25 years; just withdraw 4% of the portfolio every year. For 30 years, you need about 1.2% above inflation.
So I'd say 4% is the simple and conservative answer here... ie the odds of the long term market return on investments beating a mortgage rate of 4% are very high. However, if you factor in tax deductions (to the extent they may apply) and inflation (which will increase returns but not increase your fixed mortgage rate), I could see justifying a higher answer, say max of around 7% for aggressive individuals.
Taxes work both ways; if you have a taxable account and a mortgage, you deduct interest on the mortgage but pay tax on the gains (or accept a lower yield by using municipal bonds rather than taxable bonds.) However, if taxes aren't an issue, it is usually a good deal to contribute more to a 401(k) or IRA than to make extra mortgage payments.
Personally, my mortgage is 3.625% and I itemize my tax deductions... so I consider it a no brainer.
And mine is 2.625% for 11 years (originally 15), but it isn't a no-brainer for me. Paying off the mortgage would give me future savings equivalent to buying a portfolio of bonds maturing in 1-132 months, which would have a duration of 5 years. I can't earn quite as much on actual bonds with a 5-year duration, even with a 1.89% rate after 28% federal tax. Therefore, if I had enough cash to pay off the whole mortgage, I would pay it off, given current bond yields. I don't have enough cash; to raise that much cash, I would have to sell stock for a huge capital gain, which is not worthwhile.
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Re: For those who prefer mortgages over cash: At what rate would that switch?

Post by KlangFool » Fri Oct 13, 2017 9:39 pm

OP,

You plan to buy a 500K house. You have 100K down payment plus 1 million elsewhere.

A) If you take a mortgage, you have a 400K mortgage plus 1 million elsewhere.

B) If you pay cash for the house, you only have 600K elsewhere.

I would not pay cash for the house. There is too much money tied up with the house. I would only pay cash for the house if I have at least 1 million elsewhere besides the house.

KlangFool

itstoomuch
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Re: For those who prefer mortgages over cash: At what rate would that switch?

Post by itstoomuch » Fri Oct 13, 2017 9:47 pm

I would switch to a better mortgage from our 4.75%, 40% down & equity (August 2017). I'd be overjoyed to just to have a 4.33% mortgage :annoyed
My remaining Discretionary $$ (after the purchase) is +10% YTD and has been 20-50% cash for 2017, currently 25%. :wink:
Rev90517; 4 Incm stream buckets: SS+pension; dfr'd GLWB VA & FI anntys, by time & $$ laddered; Discretionary; Rentals. LTCi. Own, not asset. Tax 25%. Early SS. FundRatio (FR) >1.1 67/70yo

itstoomuch
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Re: For those who prefer mortgages over cash: At what rate would that switch?

Post by itstoomuch » Fri Oct 13, 2017 9:59 pm

OP,Depending on where you want to have your SFH, You may be in losing position,at this time, if you hold cash or a balanced portfolio.
viewtopic.php?f=1&t=229515
YMMV
Rev90517; 4 Incm stream buckets: SS+pension; dfr'd GLWB VA & FI anntys, by time & $$ laddered; Discretionary; Rentals. LTCi. Own, not asset. Tax 25%. Early SS. FundRatio (FR) >1.1 67/70yo

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