Argument for Keeping Mortgages Small

Over the years, The Times has often carried what I feel is incorrect advice on the subject of mortgage debt. "Pro-debt" writers have repeatedly urged readers to take on the biggest mortgage available and pay it off as slowly as possible.

Is it wise for a homeowner with cash on hand to minimize his or her mortgage through a larger down payment or to prepay a mortgage?

On Oct. 15, 1988, Business writer Carla Lazzareschi built her answer around the following advice from a financial planner:

"The only alternatives this homeowner should consider are buying a larger house and refinancing his existing house to get a larger mortgage. Nothing else makes sense."

And on April 16, 1989, Real Estate columnist Robert J. Bruss had a simpler answer: "No, no, no."

These writers have since reiterated the pro-debt stance.

The principal arguments in favor of high mortgage debt are: 1) By paying mortgage interest, you generate one of the few remaining tax deductions. 2) By putting as little cash as possible into a house, you conserve cash for other investments and for emergencies. 3) By buying the most house for a given down payment, (that is, by having the biggest possible mortgage), you maximize the profit per dollar of invested cash when the price rises.

First, I think there are serious flaws in some of these arguments. Second, there are important opposing arguments that should be presented. And third, high debt should be recognized for the aggressive, profit-maximizing strategy it is, and the risks should be highlighted.

If one must incur a certain amount of expense, it is better if it is tax-deductible. But not incurring the expense is usually the lowest-cost strategy of all. In and of itself, paying interest makes one poorer, not richer. Especially given today's low tax rates, mortgage payments do not put money in your pocket--they take it out.

At today's rates, a taxpayer in the top bracket pays roughly $3 to save $1 in taxes (and the cost is correspondingly higher in lower brackets). Yes, mortgage payments generate write-offs and save on taxes, but this is not necessarily a good deal. In the end, the desirability of borrowing depends entirely on the use to which the proceeds are put.

Mortgage lenders incur a cost of funds somewhat above U.S. Treasury financing rates, and then must build into the interest rate they charge increments to cover overhead, possible credit losses and the profit they are in business to make. The resulting mortgage rates are usually above the returns individuals can earn on safe investments. Given the way the financial markets work, the only way borrowers can earn enough on mortgage proceeds to come out ahead is generally by making investments that entail risk.

Today, for example, one might borrow by taking out a mortgage with an interest rate near 9%. The proceeds (or the cash retained rather than put into a home being bought) might be invested safely in Treasury bonds at 7%, for a built-in loss of 2% per year. Or, the borrower might try for a profit by investing in lower-grade bonds, stocks or real estate, but all of these entail some risk of loss. Thus, it is far from assured that taking out a mortgage will prove to be a profitable proposition.

It is certainly unwise to put so much cash into a home that an emergency can catch you short. But having taken on a mortgage obligation that won't go away, is it wise to put the "conserved" cash into the risky investments required for a profit to be earned? What if the investments decline in value, so that all that's left is the bigger mortgage balance owed and a smaller net worth?

And that brings me to the effect of leverage--getting "the most bang for your buck." It is true that if you buy the biggest house your down payment allows, you will maximize profits if home prices rise. But you will also maximize losses if they fall.

The corollary to a maximum mortgage would be to argue that every stock market investor should be on maximum margin, holding stocks worth twice his equity. But I have never heard such advice offered to everyone; only real estate "experts" seem so partisan as to argue for high leverage in virtually every case.

In fact, one of Bruss' columns was headlined "Borrow as Much Money as Possible to Make Biggest Real Estate Profits." Anyone who ran out to snap up the most property a down payment would buy when that was published 15 months ago would probably lose 100% of his or her equity if forced to sell today.

It is generally true that real estate has risen in price over much of history. But I feel strongly that maximum-leverage advice should be asserted universally only in the case of an asset that can only rise in price--and I have yet to find one.

In the 1980s, corporate acquirers heralded debt as the most efficient, lowest-cost source of capital. The tax write-offs generated by interest payments were widely touted. But leveraged buyouts and the like are responsible for most of the corporate bankruptcies, defaults and restructurings we are seeing today.

What was missed is the fact that debt is also the riskiest capital. Low or no debt is certainly inefficient and old-fashioned, and it does not maximize profits. But it does add greatly to safety and peace of mind. No debt-free house was ever lost to foreclosure. Job loss and declining interest rates on investments are only two of the sources of uncertainty that are protected against through a low-debt approach.

In all, there are benefits to debt and there are costs, and both should be recognized. The financial markets are simply too "efficient" to allow the existence of a strategy that is always good for everyone, and mortgage maximization certainly is not one.

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