Your house is your castle but it shouldn't be your retirement. Over the long term, gains on housing have generally been lower than stock market gains. Home ownership is a good thing. But it’s not a substitute for building wealth through investment in a diversified pool of financial assets.
Avoid risky loans (i.e., the ones that let you delay repayment). The real estate boom of the 2000s was spurred on by loans such as interest only mortgages and option ARMs that, in effect, allowed you to delay repayment. That’s why initially making the monthly payments was so easy—you weren’t fully repaying the loan. But no lender lets you delay repayment indefinitely, and all lenders impose a price for delaying repayment. The price of delay for these loans was to increase the monthly payments. These increases generally came within two or three years, and were painful.
Avoid taking out a second mortgage. If you have a second mortgage, pay it off as soon as you can. With housing values flat or dropping in many markets, using a second mortgage in lieu of a downpayment is a bad idea. You can't build wealth paying more interest charges, especially with real estate values mostly flat or dropping. Save up a downpayment instead. If you have a second mortgage, it will have a higher interest rate than your first mortgage. So pay it off as soon as you can. Some home buyers take out second mortgages to avoid paying for mortgage insurance. That's a poor substitute for a downpayment. Having a downpayment means you have some wealth. Having a second mortgage, or mortgage insurance, means you have another debt or expense.
Don’t borrow against your home to buy other real estate or other types of investments. Own your home outright, if you can. Don’t place the risks of other investments on the roof over your head.
Your house is a combination of consumption and investment. You live in it, and pay a variety of expenses to use it, including heating, cooling, upkeep (like cleaning, yard work and shoveling snow), maintenance, and insurance. The house is likely to increase in value over the long term (unless you’re in an economically depressed area), so it has investment potential as well. Like other investment assets, its price can swing up and down.
Housing isn’t the ideal investment for building wealth. Over the long term, gains on housing have run around 1% to 2% per year above the rate of inflation. By contrast, long term gains in the stock market have run around 3% or more above the rate of inflation. Over the years, this difference in returns becomes significant. It’s not wise to put the bulk of your wealth into your house. Granted, some real estate developers who take swamp land and turn it into an upscale community or an office park can make bundles of dough. And some do-it-yourself individual investors who buy distressed properties and put a lot of sweat equity into improving and renting them can do quite well. But the average person with a 9-to-5 job and kids to care for, and not much time to unclog the toilets in a rental property, should not see real estate as a goose that will lay golden eggs.
Since we all need shelter, buying a house is generally a good idea. Some people try to time the real estate market by selling their homes when they think it’s hit a peak, and renting until the market drops back. Then, they’ll buy again. This can be profitable if successful—you could end up with an equally nice home and some cash to invest for the future. But it also includes risk. You may misjudge the peaks and valleys of the real estate market, and could end up paying more to buy another home than you got from selling your earlier home. It’s better to buy a house when you need one for shelter, and sell when you want to move. That way you are at least making sensible consumption decisions. If the house appreciates in value, all the better.
Buy as much house as you need. If you want to buy more, make sure you can afford it without seriously reducing your ability to build wealth in financial assets. Just as you wouldn't put all your retirement savings into one company's stock, you shouldn't put all your money into real estate. Owning le château au cul-de-sac and little else concentrates your investments. It’s wiser to diversify them. For the typical person, having a nice pot of financial assets is an easier way to build wealth. No mutual fund account needs to be mowed, air conditioned or re-roofed.
Sometimes, people pay a high price for a house, not because they want a mansion, but because they want to live in a high-quality school district. The parental urge is understandable. But be careful of over-extending. If you spend a lot on the house, how will you fund the little one’s college education? Or save for your retirement? If you can’t afford to move into the best school district, lobby your board of education to improve the schools where you are. Many school systems improve over time, and some improve dramatically. That's usually because the parents demand it.
Avoid Risky Loans (i.e., the ones that let you delay repayment, like option ARMs and interest only loans)
Most people who buy homes have to borrow, especially those who are buying a home for the first time. Using debt to buy a home is, generally speaking, a good idea that has proven its value. But that doesn’t mean any loan is a good idea.
The problem with debt is that you are expected to repay the money you borrow. If you have the means to repay the debt, life will be good. But if you don’t have the means to repay, you will enter a nasty world inhabited by debt collectors and other trolls. You will get belligerent voicemails on your phone, and your credit rating will swirl around and disappear into the sewage system.
Fixed rate mortgages, where the monthly payment doesn’t change, are relatively easy to repay. You know how much you have to pay each month, and all you have to do is find enough money for that payment. That isn’t always a piece of cake. But most people see their incomes grow as their careers progress and find that meeting the monthly payment on a fixed mortgage gets easier over time.
Adjustable rate mortgages (“ARMs”) are a different breed of animal. The interest rates on these loans can change over time, and the payment may, depending on the terms of the loan, increase within a matter of months or a few years. Many ARMS are “interest only” at first, meaning that you need to pay only the interest on the loan for the first one, two or perhaps three years. After that, you have to start paying down the principal amount of the loan as well as the interest. Even if the interest rate doesn’t change on these loans, the monthly payment will inevitably increase because, sooner or later, you’ll have to start repaying the principal.
Another type of ARM is the “option ARM,” where the borrower does not even have to pay all of the interest for the early months. Instead, the borrower has the option of rolling some of the interest into the principal of the loan (which increases as a result; this is called “negative amortization”). Later on, you have to repay the interest that was rolled into the principal. The interest rolled into the principal bears interest itself, so you end up paying interest on interest. This is, in effect, negative compounding. Just as the compounding of investment earnings has a positive leveraging effect on the growth of your wealth, negative compounding of interest expenses has an adverse leveraging effect. Eventually, you’ll have to start paying down the principal on an option ARM, so its payments, too, will increase even if interest rates do not increase. The increase in payment size would be even greater if you’ve had negative amortization.
ARMs are sometimes depicted as a benefit to borrowers, by allowing them to qualify for a larger mortgage and buy a more expensive home. However, ARMs are also a way for banks and other mortgage lenders to pass financial risk onto the borrower. When a bank or other lender makes a fixed rate loan, it makes a profit only if it can borrow money to fund that loan at a rate lower than the loan rate. For example, a bank may pay 2.0% on money market accounts for deposits that it can re-lend at 6.5% in a 30-year mortgage. So far, so good for the bank, since 6.5% is higher than 2% and it makes a profit. But what if interest rates rise and the bank needs to pay 8% on its money market accounts? Then, it will lose money. (This may sound strange, but it actually happened back at the late 1970’s and the early 1980’s; and some banks and savings and loan associations found themselves living in a world of hurt.) Because the bank is stuck with the fixed rate on the mortgage, it bears the risk of changes in interest rates. (You may have heard that the bank would sell your mortgage; they often do, but then the purchaser of a fixed rate mortgage bears the risk of changes in interest rates.)
When a bank makes an ARM loan, it passes a lot of the risk of interest rate changes onto the homeowner (i.e., you). If interest rates rise, the bank’s cost of getting money via deposits or other borrowings rises. But the bank, in turn, raises interest rates on the ARM and the homeowner (meaning, you) has to come up with more money to pay the increased monthly payments. The bank is better off and the homeowner (again, you) is worse off.
But consider what happens if interest rates drop. How often have you heard of ARM monthly payments being lowered? ARMs often have floors on the interest rate you pay, which keep the rate close to its initial level even if market interest rates drop. So the lender gets a break if interest rates drop, as well as getting a break if interest rates rise.
Some ARMs have provisions that cap the increase in the interest rate at any single time. If the new interest rate on the ARM would have been higher except for the cap, the extra rate increase is set aside for later and may be charged to you when the monthly payments change again. (For example, if the ARM can be adjusted every year, has a rate cap of 2% and rates increase by 3%, the extra 1% that can't be imposed now is saved for later and imposed next year if possible.) This is called "carryover."
Some ARMs also have provisions that limit the amount your monthly payment can increase at any single time, with the extra amount being added to your principal (which you'll have to pay eventually). If your payment cannot increase by more than $250 at a time, and the increase would have been $300 except for this limit, the extra $50 per month is added to your loan principal and bears interest. This is another form of negative amortization.
So even if interest rates later drop, your payment may not drop and could go even higher. (The complexity of many ARMs, with confusing provisions that never seem to miss a chance to extract more money from you, is another reason to stay away from these loans.)
Sure, you can try to refinance, assuming (a) you’ve got the cash to cover any prepayment penalty and the refi closing costs, (b) your house hasn't dropped in value or you have enough cash pay the lender to compensate for any drop in value, (c) your current income is enough to support the payments required by the new loan, and (d) your credit rating and employment status are still good. The prepayment penalty can be very large for relatively new loans--up to six months interest if the loan is less than three years old. Six months interest on larger mortgages can be more than $10,000. And that amount doesn't include refi closing costs or any cash you'd have to pump into the transaction to cover a drop in the value of your home. In other words, to refinance, you need a lot of cash when you probably don't have much.
As you can see, the ARM is often a case of heads the lender wins, tails the lender wins. (Did you really think it would be otherwise? Do you really think mortgage brokers and banks spend all day looking for ways to do you favors?)
Can a homeowner win with an ARM? Yes, if interest rates go down, you can refinance and get the benefit of interest rate drops. That happened for much of the late 1990’s and early 2000’s. This rosy history probably lulled many home buyers into complacency, and they were too willing to take on adjustable rate debt. But interest rates have generally been rising since mid-2004. Many people who bought houses with ARMs are having trouble meeting the increases in monthly payments, and could lose their homes. Interest rate risk is real, and it can be very painful.
ARMs might be a reasonable loan for people who have substantial financial assets already. In other words, if you have a large quantity of cash, stocks and bonds just sitting around looking beautiful, they can serve as a safety net in case interest rates bite your bottom. Or, if you have a significant amount of income that you don’t spend, which is just waiting for the opportunity to cover increased mortgage payments from your ARM, then you’ll be okay. It’s even possible that, if interest rates move down and stay down for many years, your total borrowing costs with ARMs could be less than with a fixed rate loan.
But a lot of people without many financial resources used ARMs to qualify for larger loans than they would have otherwise been able to get (i.e., on a fixed-rate basis). The banks and other mortgage lenders made things worse by offering “teaser” or initial rates that required initial monthly payments far lower than the real payments the ARM would impose after a short grace period. In 2006 or 2007, the monthly payments increased on them. Someone who is tapped out at the time he or she takes out an ARM will probably have no means to handle an increase in monthly payments.
If you try to sell, you need to find a buyer willing to pay a price higher than what you paid, enough to cover the amount of your mortgage(s), the real estate brokers’ commissions, closing costs and any prepayment penalty on your mortgage(s). That is more easily said than done today, with real estate prices falling in much of the country. You may not get enough money to pay off the ARM alone, and might have to find additional cash to cover the unpaid portion of the mortgage debt and the other costs. If you’re lucky, your bank may work out a deal with you where you sell the house for what you can get and are released from the mortgage. Otherwise, you might have to make a trip to bankruptcy court.
An ARM is ultimately speculative—a speculation in the direction of interest rates and the health of the real estate market. Speculators are sometimes clobbered because they take a lot of risk. Avoid speculating with the roof over your head, because it's uncomfortable to sleep in a car. In a rising real estate market, one might look at mortgage debt as a way to leverage one’s capital and increase one’s gains. But in a stagnant or falling real estate market, coupled with rising interest rates, adjustable rate debt can cripple you financially and maybe even cause you to lose your home. Predicting the direction of the real estate market isn’t easy and predicting changes in interest rates is even harder. The little white ball that dances on a roulette wheel can do only two things: land on red or on black. Interest rates do only two things: go up or go down. Financial professionals and economists have a hard time predicting the direction of interest rates. Can you? Would you bet your house on whether or not the little white ball lands on red or black? If not, why would you bet your house on the direction of interest rates?
Note on second mortgages. It has become popular to buy homes with little or no money down. Many people take out second mortgages in lieu of a downpayment because they don't have the cash for a downpayment. While that may have made some sense when housing values were shooting up, it makes little or no sense now that housing values are flat or decreasing. Second mortgages have higher interest rates than primary mortgages. The combination of two mortgages makes for a heavy debt load, and it's tough to build wealth when you have all those interest charges. You'll also have a hard time refinancing because taking out two mortgages means that you'll have little or no equity in your home. A second mortgage may be a bit cheaper than mortgage insurance, but it nevertheless is debt. A downpayment is wealth. Save a downpayment and build your wealth. If you have a second mortgage, pay it off as soon as you can.
How you finance your house matters because real estate costs and losses diminish the amount of finite lifetime income you’ll have to fund your retirement. So you’ll live with the consequences of a bad real estate decision for a long time.
The ordinary investor should stick to fixed rate mortgages. That may mean you have to ratchet back your expectations. Maybe you want a manor house so you can live in baronial splendor. Build up your financial resources first, and then buy your personal Versailles.
A more modest home may be better for you in the end. Since housing isn’t intrinsically the best investment, putting less money into the house and more into financial investments could leave you better off. Buy what is reasonable for your needs and your financial situation. As in all walks of life, reasonable people generally do okay. Crazy people don’t.
Don’t Borrow Against Your House to Invest in Other Real Estate
You may have thought about borrowing against your house to invest in rental or commercial properties. Often, this means using a home equity loan to get the downpayment on a rental property, and borrowing the rest with a mortgage on the rental property. If the local economy where your real estate investments are located is doing well, the investment properties are likely to appreciate over time. But if the local economy is weak or the local real estate market is in a popping price bubble, the potential for real estate gains is low. Either way, you’ll have the aggravation of taking care of the investment properties yourself or paying someone else to take care of them. And you’ll have an extra debt against the roof over your house (beyond the first mortgage) that needs to be repaid whether or not the investment works out. If it doesn’t, you could lose both the investment property and your home. The only people who can safely borrow against their homes to invest in other real estate are the ones who don’t really need to borrow—i.e., they have liquid assets such as cash, stocks, and bonds, that can be used to pay down the home equity loan if the investment property gets into trouble. For everyone else, leveraging your home equity to invest elsewhere also leverages your financial risks. A rising real estate market could make you look smart. But a falling market could wreck your life and your retirement.
If you decide to buy investment properties, make sure the price you pay is low enough, and the downpayment you make is large enough, to support a mortgage on the investment property alone. If the bank insists on taking a lien on your home as a condition to the mortgage for the investment property, tell them to eat stale cheese curls. Banks love to “cross-collateralize” your debts, which means that if you default on any debt, they can pump up the charges and seize all of your assets for repayment. Don’t give them this leverage. If you can’t get a loan against the investment property standing alone, the investment probably isn’t such a good idea.
Hint for the real estate aficionados. If you own investment properties, remember to reinvest your earnings. Rental payments and the tax advantages to owning investment properties, like deductions and depreciation, give you cash flow. What are you doing with that cash flow? If you’re spending it, you’re losing an opportunity to build wealth. You’re gambling on the appreciation in the rental properties to provide you with wealth, and that may be less than meteoric. To leverage your financial well-being, reinvest the cash flow from investment real estate. Then, watch it compound and grow. Remember: if you love compounding, compounding will love you.
Don’t Borrow Against the House to Invest in Other Assets
A fast talking financial professional may show you color charts and graphs that supposedly demonstrate that you can make money by borrowing against your home and investing in the stock market or somewhere else. Don’t buy that story. Ordinary investors have a hard time dealing with financial risk, compared to the wealthy. It’s difficult for them to recover from financial losses, because they have fewer resources. Borrowing against the house to invest in something else is a risky strategy. The investment may or may not work out, but the debt and its interest charges are a certainty. Home equity loans often have adjustable interest rates, so not only could the investment go sour but the interest rate on the loan could rise. Someone who is 38 and making $300,000 a year might be able to benefit from taking such a risk. But most people have no business borrowing against their homes to invest in the stock market or elsewhere. Make sure your home is your castle.
Don’t Spend the Equity in Your House
Now that we’ve told you how hard it might be to build value (i.e., equity) in a house, next we’ll tell you not to spend it. In other words, reach for home equity lines of credit and home equity loans like you would embrace an ornery skunk. It’s easy to view your home equity as free money. After all, the only thing you did to get it was own a house. But, any time you regard money as easy, remember the saying, “easy come, easy go.”
Even though home equity seems like found money, it has a crucial similarity to your earned income. You will get a finite amount of home equity, and you won’t get any more. Perhaps a couple of years ago, no one would have believed this. But the bar has closed at the real estate party, and people now understand that their home equity is a limited resource. If you spend it today, you can’t spend it later. Sure, you can pay down a home equity loan and then the value of your home equity is restored. But it took dollars from your income, or other assets you owned, to pay off that loan. The debt didn’t disappear by itself, and the dollars used to repay that debt aren't available for your retirement portfolio. So, no matter how you look at it, spent home equity is gone forever.
Own Your Home
Ideally, you should own your home free and clear of all mortgages and other liens by the time you retire. One thing that happens to most people when they retire is that their cash flow drops sharply, and they have much more difficulty making the monthly mortgage payment. Cash flow is the name of the game in retirement finances. Many Americans enter retirement with only modest savings (less than $100,000) and a house. Your home can serve as your asset of last resort in retirement, but it does so best if you own it free and clear of debt. For more on using your house to finance retirement, please read our discussion of finances in retirement.
Now, let’s go to a discussion of goals for funding retirement.