The only reason why I open up my primary monthly mortgage statement is to check the split between principal and interest. My payment is fixed for three and a half more years at 2.625% so there’s never a change in absolute payment. It’s just fun to see the principal portion as a percentage of total payment go up over time. Progress is happiness.
The flip side to less interest payments is less deductions. I’ve calculated that mortgage interest payments are only truly worthwhile if you’re in the 28% tax bracket or higher. In other words, if your income is less than around $100,000 for singles or $200,000 for joint you’re not getting that much bang for your mortgage interest buck due to the standard deduction (~$11,900 for married couple, $5,950 for single) and the Alternative Minimum Tax. You’ll still be able to itemize and save on taxes, just not an optimal amount.
In this post I’d like to share with you how every potential homeowner or existing homeowner can live in their house for free using two main strategies that occur over the long run.
THE CASH FLOW POSITIVE WAY TO LIVE IN YOUR HOUSE FOR FREE
Goal: Lock in a mortgage rate equal to or less than the risk free rate.
It’s important to realize that if you take a fixed rate mortgage you are essentially SHORT bonds at that fixed price. If interest rates go up, you are winning because you’re locked in at a lower rate. Shorting a bond means you are making money on principal if the price goes down and interest rate goes up. Saving on monthly mortgage payments and increasing the value of your mortgage holding with the anticipated rate increase is the reason why I’ve been encouraging everybody to refinance their mortgage for the past three years.
If you still have difficulty grasping the concept of shorting bonds as a fixed rate mortgage holder, let me highlight my situation to help elucidate the point more clearly. I’m now living in a single family home in San Francisco for free because my CDs yield a blended return of 3.8% compared to my mortgage interest rate of 2.625%. The CD amount is roughly the same size as my primary home mortgage. With the median SF home price over $1 million dollars, this is a significant milestone.
To ensure that I continue to live for free in my home long after my CDs come due, I can invest an amount equal to my mortgage into a 10-year Treasury bond currently yielding 2.85%. The proceeds from the Treasury bond will pay for my mortgage and property taxes. I’ve been anticipating this day to come since the beginning of 2012 when I went through my 100 day refinance process. Dreaming of one day living in my house for free is what kept me from pushing on through the refinance pain!
Rising rates slow down house price appreciation in the short term because rates move on a daily basis and economics takes longer to adjust. But the reason why rates are rising is because of higher inflation expectations due to higher demand and tapering by the Fed. In other words, if you are a long term holder in property in a rising interest rate environment with a locked in mortgage you should feel BULLISH because your assets are inflating and the real value of your debt is declining. Only those who are trying to flip properties quickly panic.
THE PRINCIPAL APPRECIATION WAY TO LIVE IN YOUR HOUSE FOR FREE
Goal: Invest in a property whose annual appreciation grows faster than your cost of ownership.
We’ve now discussed the cash flow way of living in your house for free. Whether you want to invest only in a 2.85% yielding instrument is another story. Perhaps you’d like to invest in stocks with a strong belief you’ll make more than a total 2.85% return given the S&P 500 dividend yield itself is around 2% and all you need is 1% stock market appreciation. But the only things risk free are US government bonds, CDs, or cash.
Some of you might be thinking why not pay the mortgage off completely instead of arbitrage. You certainly can if you’ve got more liquidity behind and have a stable income flow. For most of us, it’s better to have liquidity just in case opportunities or disasters arise. The last thing you want is Hurricane Sandy destroying your home and the insurance company not making whole on their contract. What if your friend starts the next Twitter and asks you to invest? Keep your net worth diversified because strange things happen all the time.
Let’s now talk about the principal investment way to live in your house for free. Let’s say it costs $25,000 a year in mortgage interest, property taxes, and maintenance (4% annual cost to own on a $625,000 property). Your goal is to essentially make a call on the direction of the property market over the next 10 years. You can look on Zillow.com and punch in your the specific property, city or county for predictions. It’s important to understand the strength of the local job market, zoning laws, and existing housing supply to come up with the best guesstimate.
If your property can appreciate by more than 4% a year in this example, you will have essentially lived in the property for free if you decide to sell 10 years later. If you decide to hold on to the property for much longer by renting it out after 10 years, chances are high you will start making a nice cash flow return on your investment and see principal appreciation at the very least thanks to inflation.
The above chart shows Zillow’s home price appreciation forecasts for 2014. They’ve got a team of housing analysts and economics crunching numbers based on their huge database of tracked homes. You should always conduct your own research given real estate is local.
Based on my example of 4% annual costs, Portland, Oregon is the cutoff for where you want to buy according to Zillow. Personally, I’d buy in Seattle where there’s no state income tax and housing is cheaper than San Diego, the second choice on the list.
What can you say about the West Coast and East Coast dynamics in terms of price appreciation? Remember, as a housing economist you want to be unbiased and focus on demographic trends to make the best investment possible. The markets don’t care that Chicago has some great deep dish pizza with an expected 1.5% depreciation in home prices. Areas are cheap for a reason! (See: Top 5 Cities To Get Rich And Enjoy Life)
LIVING DOESN’T HAVE TO COST A LOT
When you are able to gather at least a 20% downpayment to buy a property, please think about the two dynamics of comparing your mortgage interest rate to the risk free rate of return and the expected price housing price appreciation to your estimated cost of ownership in percentage terms.
I’m pretty confident if you regularly analyze these two dynamics you’ll be a much wealthier property owner in the long run. There’s no greater feeling than getting something for nothing after years of patience, due diligence or both. Don’t be one of the thousands of knuckleheads out there who got in way over their heads, defaulted on their mortgages, and caused pain for the rest of us. Spend as much time as possible before buying what could potentially be the biggest purchase of your life.
Recommendations For Renters And Homeowners:
* Check Your Credit Score: Take a moment to check your free TransUnion credit score through GoFreeCredit.com, a company I trust. 30% of credit reports have errors, which could put a serious hamper on your refinancing or new loan borrowing abilities. I had a $8 late payment I didn’t even know I owed crush my score by 100 points come up during my last refinance! The average credit score for rejected mortgage borrowers has risen to 729 due to more stringent lending requirements. Landlords will often ask for a renter’s credit score as part of his/her analysis.
* Shop Around For A Mortgage: LendingTree Mortgage offers some of the lowest refinance rates today because they have a huge network of lenders to pull from. If you’re looking to buy a new home, get a HELOC, or refinance your existing mortgage, consider using LendingTree to get multiple offer comparisons in a matter of minutes. Interest rates are back down to ALL-TIME lows in 2015 due to tremendous volatility and uncertainty in the markets. When banks compete, you win.