Absolutely! When I said it above, I only meant that from my own personal perspective. For lots of other people, rather than being a pain, home ownership provides a real degree of happiness.

I’m in the camp of not paying off the mortgage early provided you’ve negotiated a rate under 5% AND you know that your returns are higher in other investments AND you’ve got the discipline to invest it. Investing the money you might otherwise pay down the mortgage with provides liquidity. If you don’t have the discipline to invest the extra cashflow, then you’re much better off paying down the mortgage with it (e.g. 4% return on prepaying the mortgage beats spending the money any day of the week!).

If you are retired, then the mortgage better be paid for unless you have a lot more money than the average person. I like to think of a paid-for home as the savings account that you draw down when you’re 80-85 and are beginning to need extra care… it’s a rare individual who can reach that age and doesn’t require more care.

I absolutely agree that it’s important to look at the after-tax rate on the mortgage when comparing it to whatever return you expect from the home purchase. I’d add, however, that unless your other itemized deductions exceed the standard deduction, your after-tax interest rate is higher than: pretax rate x (1 — marginal tax bracket).

I’ll admit that I’m not entirely clear on what you’re saying about opportunity cost here.

Are you arguing that, if an investor has the choice to either:

• pay cash for a home, or
• take out a mortgage

…then, when comparing the choices, we should subtract (from the mortgage rate) the rate they can earn on continuing to have that additional cash balance?

If so, I may be missing something, but doing so would seem to lead to questionable decisions — specifically, taking out a mortgage at 5% (4ish% after-tax) just to keep more cash on hand earning 3% (2.4% after tax).

As usual, a thoughtful and insightful article that provides much food for thought.

Your formula for calculating the real return from the housing “investment” is straightforward and makes sense to me. And I especially like the idea of separating the return on your housing expense/investment from the decision on whether one is better off taking out a mortgage versus paying cash outright to purchase the residence. However, in reality this latter part of the analysis is an academic exercise for the many folks who don’t have enough spare cash already accumulated to prepay their home purchase.

Here are some observations and suggestions if you don’t mind.

Regarding the issue of deciding whether it makes sense to borrow money for the purchase (“In short: It only makes sense to borrow if you expect a return greater than the interest rate you’d have to pay on the loan.”), I think there are two other financial considerations that can be involved in that equation.

First, there is an “opportunity cost” associated with cash that’s used to prepay the loan. For example, assuming the home buyer used a mortgage instead of paying cash to buy; they could park those funds in CD’s or Treasury investments and earn (in today’s interest rate environment) a pretax return of say 3%. If the buyer’s combined marginal federal and state income tax rate is 20%, their net after tax return on these interest earnings would be at least 2.40%; at a combined MTB of 25% their net return would be 2.25%.

Second, many folks will be able to deduct the mortgage interest and real estate taxes they pay on the purchased home on their annual federal and state income tax returns, which effectively lessens the interest rate they’re paying on the mortgage loan. Assuming a fixed interest rate of 5% on the mortgage loan, their net loan cost would be 4.00% or 3.75%, respectively, if they have a combined MTB of 20% or 25% and are in fact able to deduct the mortgage interest and taxes paid.

Taking these two items into consideration can have a noticeable impact on the decision regarding whether or not to use a mortgage. We can see that using the figures from your example with an estimate of the hosing expenses (item “C” in your formula) added in.

Scenario 1: Your example without including opportunity cost & after tax mortgage rate.
Step 1.
6.67% imputed rental dividend + 1.00% inflation adjusted growth rate – 3.00% estimated annual housing costs [5400/180000] = 4.67% expected real return.
Step 2.
4.67% expected real return – 5.00% pre-tax mortgage rate = (0.33%).
Conclusion.
Toss-up; no clear advantage either way.

Scenario 2: Your example including opportunity cost & after tax mortgage rate.
Step 1.
6.67% imputed rental dividend + 1.00% inflation adjusted growth rate – 3.00% estimated annual housing costs [5400/180000] = 4.67% expected real return.
Step 2.
5.00% pre-tax mortgage rate – 2.40% opportunity cost (savings) – 1.00% mortgage tax deduction (savings) = 1.60% adjusted after-tax mortgage rate with opportunity cost.
Step 3.
4.67% expected real return – 1.60% adjusted after-tax mortgage rate with opportunity cost included = 3.07%.
Conclusion.
These figures would suggest using a mortgage to make this purchase is acceptable.

For someone with a combined MTB of 25%, Step 3 would look like this:
4.67% expected real return – 1.50% adjusted after-tax mortgage rate with opportunity cost included = 3.17%, which leads to pretty much the same conclusion.

I’ve got to run for now; I may post more on this subject later. In the meantime, I’d appreciate hearing your thoughts on these suggestions. Am I missing something here?

Heh, yeah. Looks that way. In any case, thanks as always for reading and contributing your thoughts.

In any case, I’ll agree that it’s a good idea to make you spending decisions based on the most favorable expected result.

No. That’s simply changing your spending.

But if you were given the option to prepay (at a discount) for the next 3 years, then yes, I’d definitely call that an investment.

Of course, whether it’s a good investment is up in the air. And not coincidentally, I’d say that it depends on all the things that investment analyses always depend on:

• What’s the payoff (how much money does it save you)?
• How good are the alternatives for that cash?
• What’s the risk involved (how likely is it that you wouldn’t actually keep paying for all three years)?

As for an action that saves you $20 vs. earning you $20, yes they are essentially the same impact on you cash flow. A penny saved is a penny earned. But just because a particular course of action saves or earns money doesn’t make it an investment.

I generally use “investment” to describe something you do after expenses with surplus cash, not the surplus itself. The surplus is “invested” by using it with the intention of turning it back into cash at a profit at some point in the future. People usually don’t buy their home for the purpose of turning a profit and typically don’t fret that they don’t.

Not exactly. I’m arguing that anything that reduces costs you’re already paying (or, more precisely, costs that you will pay if you don’t change course) is an investment.

I don’t see a meaningful difference between something that pays you $20 per month and something that reduces your monthly costs by $20 per month (taxes aside).

That said, calling it a “cost savings” works perfectly fine for me.

I wouldn’t characterize it that way. I get what you are saying, but I’d call it cost saving not an investment. The word “investment” has many meanings, but I do not consider owning a home to live in to be an investment like I would owning an ETF. By your definition, anything I could have spent more money on but elected not to would be an investment if I can determine the amount.