Wealthtender’s Finance Blog Startups to Watch in 2020
With more than 2,000 personal finance blogs in the U.S. alone, it can be difficult...
Previous Article: Want to squirrel away a little cash? Try a high-yield savings account
Next Article: The unspoken rules of gifting money
We want to be transparent about how we are compensated. Some links in articles are from our sponsors. Learn more about how we make money.
There are some well-known people in the personal finance community that advise people that it makes the most sense to buy a house with 100% cash rather than getting a mortgage.
Setting aside putting 100% down on a home is not an option for 99% of the population, I want to address why I would never put 100% down on a home even if I had the money to do it.
From a financial perspective, having a mortgage can have several advantages.
If you were to buy a house with 100% cash and no mortgage you have just created an opportunity cost for yourself; you could have invested that cash in the stock market and received a higher expected return on your investment.
Let’s illustrate this by comparing two scenarios for buying a $500,000 house
If you bought the house with all cash, your expected return would be 3% of the purchase price of the house or about $15,000.
If you put down $100,000 to buy the house and invested the remaining $400,000 into a globally diversified portfolio your expected return after 1 year would be as follows.
Calculating your opportunity cost
Of course, the expected return is not the guaranteed return but its rational to use expected returns when evaluating financial decisions.
Apart from opportunity cost, there is another reason your mortgage may not be as bad as you think it is.
Or to be more precise, inflation is a “mortgage owners” best friend. To fully understand why this is the case we need to understand three concepts.
Inflation is the rate at which the prices of goods and services in the economy are rising, which reduces the purchasing power (what you can actually buy with a dollar) of local currency.
If we say the inflation rate in the United States is 2% this year, that means the general price of goods and services in the U.S has increased by 2%. Or looking at it the other way, the purchasing power of a U.S dollar to buy local goods has decreased by 2%.
Nominal interest rates are the rates advertised by the bank. If the bank approves you for a mortgage with a 4% interest rate, they are referring to the nominal interest rate on your loan.
The real interest rate is equal to the nominal interest rate minus the rate of inflation. If the inflation rate in the economy is 3% and the nominal interest rate on your mortgage is 4%, your “real” interest rate is 1%.
Suddenly that interest rate isn’t looking too bad!
In a previous article, I wrote about how inflation hurts savers. The opposite is also true, inflation helps those in debt. If your nominal debt is not increasing, inflation will lower the true value of your debt over time.
Consider an extreme example to show how this works.
Let’s say I have a $300,000 mortgage and I make interest-only payments for the next 30 years. Meaning I still owe $300,000 on my mortgage 30 years from now. I have not paid a single penny in principal.
At first glance, this is a very depressing outcome. I still owe the same amount of money as I did 30 years ago. Of course, that is not really true.
While I owe the same amount in “nominal” terms, $300,000 my debt in “real” terms would only be $136,425 if inflation averaged 3% per year over the past 30 years.
I was able to cut the real value of my debt in half without making any payments against the principal. Inflation did all the work for me.
To put it simply, $300,000 in 2049 will be worth less than $300,000 in 2019.
Whenever there is a change in economic conditions there will always be winners and losers. When inflation increases those with money in savings accounts are the losers and those with large levels of debt (homeowners) are the winners.
Even though the real value of our mortgage is declining due to inflation, holding high levels of debt is still presents risks.
Risk 1: Inflation Eats into Wages too
If my wages don’t keep pace with inflation over the next 30 years, my “real” income will be declining and my ability to service any amount of debt will be compromised.
Risk 2: Interest rates rise faster than Inflation
Historically speaking, interest rates are very low in 2019. There is a lot more room for interest rates to increase than decrease in the future. If nominal interest rates rise faster than inflation, that is bad news for people with large debt loads.
Risk 3: Increasing our debt loads
The most significant risk in taking my time to pay off my mortgage would be the temptation to refinance my mortgage and borrow even larger amounts of money.
If I said, “it’s okay if I double my mortgage, inflation will take care of it”, I would be setting myself up for financial disaster.
It’s important to take into account all relevant variables when making financial decisions. Simply adopting a mantra of “all debt is bad under every circumstance” can lead to flawed decision making.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.