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Author: Weathermay One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 127815  
Subject: Two modes of thinking Date: 1/24/2002 10:16 AM
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Looking at the battle that developed over the mortgage issue, I thought I would offer this:

The first view is that of the leverager: borrow at a low rate to invest at a higher one. With the tax breaks a mortgage offers, money can be obtained "cheaply". A more compelling argument is that you should not tie your equity up in an "investment" (which it is not) that only appreciates at the rate of inflation (or is expected to). Obtain a large mortgage (put down only 5% or so) and invest the money you would otherwise put towards and downpayment. Therefore, you would "earn" a higher rate of return on your money. If you don't plan to hold onto the property, avoid paying points -and even consider a ARM or balloon mortgage (although I wouldn't go that route).

This is a sound argument. However, doing this has its disadvantages as well. A home is a tangible asset, while something like a stock is a "piece of paper." We get a secondary gain from our home, and that is we get to live in it -even grow crops on the land. In times of economic crisis -recessions, depressions, stock-market crashes, the home is a source of security. If your portolio exists almost entirely of stocks and bonds, and you have almost no equity in your home (especially if you put down only 5% or even did an 80/10/10 or 80/20), you will need cash precisely when your investments are failing. As one author puts it:

"you are less likely to need to spend your accrued investment wealth when the economy is strong and stocks are doing well. You will need to cash in your investments when there is a crisis, which is when stocks and bonds often lose their value." (Thomas Schweich)

Getting a home equity loan when there is a crisis, is difficult when you have no equity in your home.

The other argument, is defensive: Pay off your mortgage early through extra payments. Take out a 15 year mortgage, which will double your equity building time. Use your home as potential leverage in and of itself because you have equity in it -you can take out a loan if needed. Keep payments low in order to free up future income for other investments. Sacrifice some liquidity for security (although not too much).

As far as rental property goes, realize that it is expected that there will be 25% vacancy on rental property, so plan accordingly. Over-leveraging, especially with rental property can be a disaster. Ric Edelman's book "The Truth About Money" will show the pitfalls involved with borrowing to invest in real estate.

Which view is correct? They both are. Option A works great in bull markets, when real estate values increase, and when interest rates are low. Option B works ok in good times, and great in bad times (like now). I see people like Dave and elizabeth rooting for A, while Veronique leans towards B. It really depends on macro-economic factors (the overall economy, interest rates, etc.) and discipline. Remember that a mortgage is a loan against your income, not your property -your house is collateral which "secures" the loan. I would disagree with the contention that "anyone can buy a home." I would also disagree with always paying cash.

One last note -20 years ago, the minimum percentage of income mortgage payments could take up was around 20%. Now banks will loan you up to 36%. This is because of the increase in property values that has happened in the last 15 years. Just because the bank will give you that much, doesn't mean you should take it.
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