Hefty Mortgage Debt:
Not Worth the Gamble
So much for good intentions.
Total mortgage debt has soared over the past five years. That's been partly driven by rising home prices, low interest rates and foolish consumers tapping their home's equity to pay for their next shopping spree.
But I believe this rash of mortgage borrowing has also been fueled by some flawed financial thinking. Many homeowners have convinced themselves it's smart to load up on mortgage debt. But trust me: It just isn't so.
Losing Interest: House prices are up a cumulative 39% over the past five calendar years, according to home-finance corporation Freddie Mac. But Federal Reserve data indicate that mortgage debt, including home-equity loans, has risen even faster, up 58% over the same stretch.
The temptation is to dismiss all this borrowing as financial recklessness. But I blame part of the increase on a trio of dangerous misconceptions, starting with an excessive fondness for the mortgage-tax deduction.
Yes, this is one of the last great tax breaks. Yes, it's better to borrow against your home than take on other types of debt. But all that mortgage interest is still costing homeowners a truckload of money.
For instance, if you are in the 25% federal income-tax bracket, you will save 25 cents in taxes for every $1 you incur in mortgage interest. What about the other 75 cents? That comes out of your pocket.
Moreover, this assumes you itemize your deductions on your tax return. What if, instead, you take the standard deduction? Every $1 of mortgage interest is costing you the full $1.
Gaining Little: Which brings us to our second misconception. Many folks have happily borrowed more money to buy bigger homes, because they figure the bigger house will be a great investment.
"A lot of people think that real-estate prices only go up and that it's the best investment they can make," says Douglas Poutasse, chief investment strategist at AEW Capital Management, a Boston real-estate investment adviser. "Our average house size has grown dramatically in the last 20 years," with a 39% increase in the size of newly constructed single-family homes.
Yet I fear many homeowners, if they bother to do the math, will be sorely disappointed with their massive real-estate bet. Think of a home's return in two parts, price appreciation and rent.
Historically, the price appreciation has been fairly modest, with homes climbing 6.1% a year over the past 30 years, barely ahead of the 4.9% inflation rate. Moreover, much of that gain would have been offset by the hefty costs of homeownership, including property taxes, maintenance costs, homeowner's insurance and mortgage interest.
By contrast, the rental income from a house can be mighty impressive. How impressive? If you rented out your house, you might collect an annual sum equal to 7% or 8% of your home's value. But, of course, most homeowners don't rent out their house. Instead, they occupy the place themselves and live rent-free.
Now, imagine you bought a house that's far bigger than you really want or need, because you believe all the nonsense about homes being a great source of price appreciation. Sure, you get to live rent-free. But you aren't getting a whole lot of extra value out of the bigger house, because you would be almost as happy living in a smaller place.
Meanwhile, you have locked up a ton of money in an asset that, after you figure in all costs, probably won't earn you much through price appreciation. Over the long haul, you would almost certainly amass more wealth by buying a smaller home and taking out a smaller mortgage, and then using the extra money to fund your 401(k) plan or your individual retirement account.
Losing Time: The surge in mortgage debt has been driven not only by home buyers, but also by folks refinancing their existing mortgages. In recent years, when homeowners have refinanced, they have often taken the chance to cash out some of their home equity, which is then lavished on home improvements, new cars and other purchases.
But I don't think this is just about simple greed. Rather, I suspect many homeowners overestimate the advantages of refinancing, and that lulls them into borrowing more.
To understand this third misconception, suppose you have a 30-year mortgage that you have been paying down for nine years, so that you have only 21 years left. If you go to refinance and take out another 30-year mortgage, your monthly payments will fall, even if the interest rate is no lower. The reason: You are spreading the loan repayment over an extra nine years.
Toss in the gain from lower interest rates, and many folks may find they can cash out a decent chunk of home equity and still lower their monthly payments. But this seemingly nifty financial maneuver could have grim consequences down the road, because these borrowers are now faced with all those additional years of mortgage payments.
"There are a lot more people who are going to reach retirement age with mortgages outstanding, rather than a paid-off house," says Chris Mayer, a finance professor at New York's Columbia Business School. "These people are either going to have to find some way of paying off their mortgage or they're going to have to work longer or work part-time in retirement."
-- Mr. Clements writes the Getting Going column for The Wall Street Journal Online. WSJ.com subscribers can view past columns in the Getting Going archives.
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