This is from a recent post on EconLog with the title Leveraged to the Eyeballs. While the post itself is interesting, there are a couple comments I find quite enlightening. Patri Friedman discussing high LTV (loan-to-value) ratios states:
Reason 1: "My guess is that paying high mortgage rates in order to own stock is relatively inefficient." Unless the after-tax interest payments as a percentage reach the same level as the after-tax payoff from index funds, how is this less efficient than making larger mortgage payments?
Reason 2: I think this: "you will have less wealth than if you took out a lower-cost mortgage and got your high-leverage stock portfolio by using derivatives" is a bit of a false dichotomy. Why not do both?
Kling very well might be right - but without posting any numbers, I can't see how.
Note that Friedman's argument does not work as well in a country such as Canada, where mortgage interest is not tax deductible.
Why do people assume that high LTV and low payments mean buyers are leveraged? I have a high LTV, and an interest-only loan, and I pay the minimum, because I would rather have my money in the stock market. If I ever had equity in a home, I would tap it and buy index funds. So anyone who assumes that my low equity and payments mean I am overspending is wrong.To which Arnold Kling responds:
To my mind, anyone with equity in their house is crazy. They are the ones being financially imprudent. Why wouldn't you get a loan at 6%, with tax benefits that make it effectively 4%, and put it in the stock market and earn 10%-12%?
Patri,I have to give the points to Patri on this one, for two reasons:
There are many other ways to own stock in a leveraged manner. You could buy call options on the S&P 500, for example. My guess is that paying high mortgage rates in order to own stock is relatively inefficient. In the end, you will have less wealth than if you took out a lower-cost mortgage and got your high-leverage stock portfolio by using derivatives.
I also think that people tend to over-rate the value of tax deductibility of mortgage payments. But that's another post altogether.
Reason 1: "My guess is that paying high mortgage rates in order to own stock is relatively inefficient." Unless the after-tax interest payments as a percentage reach the same level as the after-tax payoff from index funds, how is this less efficient than making larger mortgage payments?
Reason 2: I think this: "you will have less wealth than if you took out a lower-cost mortgage and got your high-leverage stock portfolio by using derivatives" is a bit of a false dichotomy. Why not do both?
Kling very well might be right - but without posting any numbers, I can't see how.
Note that Friedman's argument does not work as well in a country such as Canada, where mortgage interest is not tax deductible.
Comments
I’m glad you added those last two lines, relating this material to Canada. I was beginning to feel like a total idiot until then, since I couldn’t figure out what tax break you had in mind.
I may do a blog post on this because it is such a misunderstood point but -
1) The interest deductibility is likely neither here nor there unless you buy munis because you will have to pay taxes on your returns in the market. Maybe the difference between cap gains and your marginal tax rate makes a difference but unless you are in the highest bracket and/or have a differential cap gains rate at the state level I doubt it.
2) The mortgage makes money two ways. One you have a garunteed return that likely yeilds significantly above t-bills. Also, you lower your interest rate by selecting a traditional mortgage so your gains are even larger than your interest rate.
3) Returns in the market are likely overestimated. The market has returned as well as it has because the it includes the 1987-2000 bull market which is unprecendented in history. It is highly unlikely that the future stocks will give as good of a return.