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.
RE outperforming since 2001, and roughly inline with the S&P 500 since 2011 at ~12% annual return
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! Perhaps the 760 shooting deaths in 2016 has something to do with Chicago not performing so well.
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.
Real estate owners in the SF Bay Area have been living for free and then some for a very long time.
Recommendations
Explore real estate crowdsourcing opportunities: If you don’t have the downpayment to buy a property, don’t want to deal with the hassle of managing real estate, or don’t want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today.
Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates are around 3% in San Francisco and New York City, but over 10% in the Midwest if you’re looking for strictly investing income returns. Sign up and take a look at all the residential and commercial investment opportunities around the country Fundrise has to offer. It’s free to look.
Less than 5% of the real estate deals shown gets through the Fundrise funnel
Shop around for a mortgage: Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible from them or your existing bank. When banks compete, you win.
Updated for 2019 and beyond.
If you are willing to push yourself through a learning curve, you can “retire” in months, not decades. Just buy one multi-unit residential income property with 30+ units and you can earn enough monthly income to pay all property expenses, a manager to run it and all your personal bills too. With a good manager, this type of income can be 95% passive.
Rentals get a bad rap sometimes because the owners don’t have enough units to afford to pay a manager and to pay others to do repairs. Landlording can quickly burn you out if you try to do it yourself. In my experience, 30+ units is the magic number. I’ve chosen mobile home parks because they provide the most income with the least capital expense. If you self-educate, you really can buy just one property and “retire” as soon as you can complete your learning curve.
Because your tenants are paying all your property and personal bills, you’re living in your home for free despite it having a mortgage. Multi-unit residential rentals are an income stream that you can control. As inflation eats your income, you can raise rents, lower expenses or buy another park.
I self-educated and learned how to buy my first park for $1,000 down and closed on the 5th so I’d get the prorated rents for the remaining month at closing. So I was actually paid over $5,000 at closing to take over the park. When you have no money in the deal, your yield is infinite. Ten years later, the park is worth 1,500 times my original investment, which was more than returned to me at closing.
I now own two parks and my only “job” is to manage the managers. It’s secure, monthly, 95% passive income that allows me to be retired, live in my home for free and own appreciating assets I can later sell, 1031-exchange or just live well off the rents as the properties pay themselves off. Because of the many allowable tax deductions available from owning rental properties, my taxes are very minimal too.
I highly recommend this way to live “free” and retire early.
Gotcha…. Your primary concern is collecting rent for decades (or forever) and riding out property value fluctuations is fine. And you are considering geographical diversification?
The past few days, I’ve been doing some research on California real estate. Those prices are just wow! I can see why lower/middle class people are upset.
They realistically cannot afford a home there.
In the Chicago area, it is common for middle class families to own several homes. I run into this all the time. You have people with a primary home and then they have a home in Wisconsin or Michigan with a lake. Or you have people with a home in Chicago and then a home down in Florida. Or even folks with a house in the suburbs and a condo in the city. And none of these people are landlords.
Yes. I have Hawaii and Tahoe along w/ SF. Wish I had Manhattan too, but I was too poor in 2000 to buy.
Sam,
Interesting link to a very short article in regards to the Chinese purchasing US real estate (as diversification?):
I’m not quite sure I understand the Detroit thing.
Sam,
Are you doing anything to hedge your real estate downside risk? Dude, you have a full blown bubble going on out there.
Those prices left the real world a long time ago. California should reverse Proposition 13. That market is extremely distorted.
You should see how much college graduates are earning out here at Google, FB, Twitter etc. Incomes are huge that it’s no surprise rents and prices keep going up.
Might be a good idea to buy up Chicago though given the expected decline to diversify. I don’t plan to sell my properties for 25+ more years if ever.
Isn’t this really just shifting thought processes about investment returns? For example if I invest my mortgage balance of $375k (3.3% mortgage) in 30yr treasuries (3.65%) I can either say 1. I’m living for free with my returns or 2. I still pay for housing but I make $13687.00 a year in interest. You’re not really living free, you are just making certain your investment returns pay for the cost of your debt service. Its a shift in thinking. A refreshing one, but capital intensive requiring much liquidity. Or, I can leave my $375,000 in the stock market and with the 7% average annual return you should get, sell the winnings every Dec 31…then say I am living for free because I’m now paying off mortgage with my stock appreciation….again, just shifts in how you allocate your investment returns.
I don’t think most homeowners consider these two factors. Great post Sam. I will definitely help spread the word. I’m going to share it next Friday on our Dinks Finance weekly roundup.
Hopefully the appreciation over 3 years will provide a downside buffer, and rates continue to stay low which I think they will. Look at the 35 year chart of the 10-year yield.
We just closed on our new house and I am ready to tackle this mortgage again! It’s a small one, and only at 3.5% but still. I’m over it. I also like seeing the principal part of the payment rise with each passing month. It makes me happy.
3.5% is a great rate. Hope you’re enjoying your new digs!
Hey, you’ve redesigned the site! It looks great.
We are not living for free yet. We are working on it, though. We have a rental component to our primary living property which does help us live for less, but we’ve refinanced as you have mentioned and have taken some solid steps to living for free.
Hi Tushar, good to hear from you man. Hope your new gig is going well and your tenants continue to pay on time!
I live for free as one of my rental properties generates enough cash flow to allow me to cover my living expenses even if I had to rent myself. I am in a paid for house but used to rent when moving countries a lot, it offered more flexibility while the tenants covered the rent. Hopefully principal appreciation will also play a role, I wouldn’t use cash flow as I prefer to have it on the markets, although I do have about half of my rental mortgage on a 3% savings account and the mortgage is 2.29%.
That is an interesting approach for the risk averse though.
I love your posts like this that have great ways of looking at financial scenarios that I never would have been able to think of on my own. You’re a great problem solver Sam. You think in so many dimensions. I need to work on being more analytical when it comes to personal finance situations. I brain tends to freeze when I start seeing numbers, hear unfamiliar financial terms, or new ways of approaching scenarios. And to answer your question, no I don’t think the average homebuyer thinks about these two dynamics. I’m happy to help spread the word about this post. Thanks for the insights!
Thanks Sydney. I really want to come to conclusions and solve problems. We need to do more than just present problems.
Very interesting point about going short bonds by taking on a fixed-rate mortgage.
I think the intended holding period of the property and the price-to-rent ratio are also essential in the principal appreciation calculation, especially if the property is financed on a long-term, fixed-rate mortgage. This is because if the annual ownership costs of the property (your 4% example) are equal to the annual cost to rent the property, or less, then nominal wealth is created over the term of the mortgage.
The net cash outlay for the purchase is the 20% down, the ongoing costs are roughly the same as if renting the property, and then you end up with the full property value when the mortgage is paid off. You will have created nominal wealth unless the value of the property declines by more than 80% over the life of the mortgage, right?
There’s definitely many ways to calculate how one can come out ahead, and the things you mentioned work too.
What I do know is that every 5 years that go buy, I wish I owned more property.
We’re currently going the paid-off mortgage route, but there are big opportunity costs associated with what we did. We’ve made peace with them, and now have a lot of liquidity to invest, while enjoying a pretty risk-free and nearly-cost-free way of owning a home.
Love the analysis, especially the first method with shorting bonds. Pretty savvy stuff there, Sam.
Nothing wrong with paying off the mortgage, especially if is to coincide with full retirement!
I doubt the average home-buyer thinks about this kind of stuff. Most people think housing prices will increase like magic & make them rich. So all they think about is whether or not it has granite counter tops & huge closets!
Imagine a world where every home buyer and owner thought about these dynamics. The world would be much more stable.
My wife and I were JUST talking about how the value increase can let us live for free. I love that example.
I am a huge fan of real estate! I have 8 long term rentals and a 9th under contract. I’m actually trying to buy 100 SFRs in the next 10 years.
I paid off our 7 figure house as I had liquidity and job security. I built an income property on my second lot. The net rental income pays for my property taxes, insurance, and some of my maintenance. Basically, we are living in our house for free!
When we choose to downsize, we can move into the rental home and have a tidy 7 figure sum (in addition to retirement accounts/brokerage accounts) to live on. It’s been a lot of years of hard work and planning, but patience and persistence pays off!
Sam, if my interest rate is higher than the 10 yr would it make sense to actually prepay the mortgage with the “bond” portion of my portfolio?
BTW it is higher since I have a 30 yr fixed because I wanted to avoid the rising interest rate scenario to hurt me down the line.
Please read this article on 30 year fixed vs. ARM mortgages first: https://www.financialsamurai.com/30-year-fixed-mortgage-loan-vs-adjustable-rate-mortgage-arm-the-choice-is-obvious/
I would say to delicately balance the payoff with your desired liquidity.
Sam,
Good article. A couple of thoughts here: If you don’t have a mortgage, rising interest rates are irrelevant!
The west coast is usually the trend setter in the macroeconomic environment. They are the first to collapse and the first to recover. The rest of the country lags by several years (so this is actually a very positive outlook). Although, this double digit appreciation forecast looks to me to be approaching bubble status (of course this is just for 2014). Median house prices should really be closer to about 4 or 5 x median household income at most (healthier at about 2.5 x median income).
The macroeconomic trends going into this decade are really changing rapidly.
1. Wages in China are now approaching $9.00/hour. Once you add the cost of transportation, manufacturing in China is no longer economical.
2. Fracking….. This is a game changer! The USA is well on the way to energy independence.
So…. What are we really looking at? There is a reason why Houston is doing so well. High paying energy/fracking jobs.
What’s next? Cheap natgas means manufacturing moves back to the states….. What states do big manufacturing? Look it up.
Money is pretty irrelevant in general if you are a billionaire also.
“Buy low, sell high” my friend.
Those zillow projections for Riverside and Sacramento are quite stunning, considering how far inland these cities are. I’m rather surprised that they were able to run through excess home inventory so soon.
Sam,
I’d say the cash flow matching is the best way to analysis this. I think it would be a good goal for a new home owner to increase his/her “risk free” savings until it matches the mortgage amount if possible (but this would be too challenging for most people). I prefer not taking on so much liquidity risk. Perhaps a partial cash flow match would be a fine goal?
There is a very active argument from many intelligent people at different websites in regards to paying off the mortgage as soon as possible versus investing the money instead.
Overall, I’m neutral about the argument, but I recognize that most Americans have little investment knowledge and/or undisiciplined (or just generally challenged). I’m begining to think that many families would benefit from setting a goal of paying off their mortgage as soon as practical (provided they maintain an adequate emergency savings account). Afterall, no mortgage, no possibilty of floreclosure. Of course, in California this may be impossible! LOL!
While leveraging mortgage loans in a time of rising interest rates can make living in your house for “free” possible, my wife and I were more comfortable just paying off our mortgage, and also living in our house for “free.” Of course we still pay insurance and taxes for the privilege.
Definitely not a bad thing to be mortgage free. I personally want to keep liquid to move money to potentially higher returning investments with rates still low.
Eventually the markets will turn down, but that still means the money in your house will also go down too.
Great article. I can think of at least three people that should read this immediately. I’ve considered the principal appreciation, but never with this granular of an analysis.
My MT&I carrying cost is a whopping 7.5% of the original purchase price on a 3.25% note. This is because Texas tends to have high property taxes (no state income tax). Because of this burden we bought a home that was priced at about 1.5 times household income.
Please e-mail those three folks to read the article!
I’m happy to pay higher property taxes on a way lower property value in TX and pay no state taxes too. However, I still haven’t been able to get over living in Texas yet.
What is the prop tax rate in Texas? In CA it is 1.2% a year.
It’s different in different cities, obviously. If you’re not in an incorporated municipality it’s considerably less. I believe ours are fairly high compared to some other cities. Where I am it’s roughly 2.6%.
Interesting perspectives on the dynamics of property ownership, Sam.
Personally, I worry more about the principal appreciation aspect than the cash flow. They’re both out of my control, but at least with mortgage rates you can refinance if they go lower. Not ideal due to transaction costs, but it’s more in one’s control than local property values for long term capital appreciation.
I’d be more particular about these criteria for buying rental property – aiming for the best mortgage rate for cash flow and a promising market for capital growth.