This is something where I ask myself what my parents (who grew up during the Depression) would do. On the one thing, they didn’t like being in debt. On the other hand, they also didn’t like to have all their cash tied up.
How’s your credit? In some cases having no credit record at all isn’t much better than having bad credit. My daughter had enough cash to buy her car outright, but she had no credit history. After a talk with her bank, she took out a one-year loan (the credit agencies like to see at least a 1-year history), secured by her savings account. IIRC the interest rate was 1%.
So you could take out an ARM at an extremely low interest rate, pay it off before the rate readjusts and get a gold star next to your name on your credit report. Or, if everything goes sour, you’d still have ready cash if you need it.
You’d think that ,wouldn’t you? But you would be wrong. That gold star only lasts until the loan is paid off; anyone who has no current debt and making regular payments might as well be a dead beat trying to skip town.
True, which is why it is important to have liquid investments. When I get home I’ll look up the return on some dividend funds I have (though maybe Rand knows of some off the top of his head) but you are basically saying there are no reasonably unrisky investments out there paying more than the very safe mortgage one.
The OP has cash to buy a house outright. Off the top of my head, I’m paying about 0.6% of the mortgage balance a month, not including insurance and property tax. Selling at the bottom (not liquidating) to pay would be a bummer, but even if the market stayed at the bottom for a year that is only about 7% of the pre-crash investment.
It is nice to assume that property tax (and food bills, utility bills, medical bills) can be magically paid. If cash flow becomes a problem, though, the person owning the house outright is going to have a problem getting any money out, since no one not named Vito is going to give him a loan when he is unemployed. He might wind up having to selling, into a bad market, no doubt. The big problem is that this investment is not diversified, and he winds up in an all or nothing situation.
Now there can be a crash so bad that his entire investment is at risk. But there might also be a flood or earthquake which wipes out his house investment. Or an asteroid can hit. The most probable bad situation is unemployment in an only slightly down market.
This is the point of my crack about homo economicus. He has but one goal - to maximize return on investment, which involves considering risk, of course. In real life we have other goals, such as a feeling of security or a feeling of pleasure in not having to pay the mortgage. The point is not to deny that these goals exist, but only to have people recognize, to repeat what Rand already said, that they are going to cost.
If someone’s desired level of risk exactly matches that of the mortgage, that is fine. I think that this is fairly unlikely, though.
Your point about relative liquidity is a good one - that is indeed a benefit that not investing all one’s eggs in a real estate basket has, no question.
However, I dispute the notion that seeking to minimize investment risk is simply investing in a “feeling of security” or a “feeling of pleasure”. The fact is that humans tend to have irreducable needs for stuff like shelter, upkeep and security, and thus a rational desire never to have fluctuations in their fortunes which risk putting their income/asset mix below these needs.
I also doubt the calculations above tell the whole story. For example, in your calculation in which you conclude that the mortgage payments for a year is only 7% of your investment portfolio pre-crash, do not forget that your investments post-crash may not be worth as much as they were worth before the crash … that figure may be considerably larger, percent-wise, when it comes to selling. All of which is likely to be at a loss. Given that market crashes are an inevitable feature of our economy …
There is no need to assume magic in noting that someone who is able to but a house outright with cash may, perhaps, not be putting every last resource into the house - part of being rational in response to risk is not to spend one’s last dollar on an illiquid investment. For example, one may have, as I do, a reserve fund in ultra-safe investments, just in case. Although we are speaking in all-or-nothing terms, really the issue goes more to weight in diversification of investments - the more you worry about risk, the less you have in high-risk investments and the greater weight to low-risk, low-return, like extra payments on mortgage.
Rand, thanks for your answer on the banks loaning out money at 4%.
Simple as he may be, Dave’s approach works, and works better with human nature. I view him as the Weight Watchers of the personal finances world. Sure, you could get quicker results with eating nothing but spinach, but that’s not how it works with people.
He is also -extremely- good at inspiring. All I know is that in 3 years, he inspired me to go from heavily into CC debt, student loans, to having paid off the house. Granted, that was an extreme example; I earned a lot but I was pissing it all over the place.
And, honestly, the scolding people over paying off low interest debt is like scolding someone who runs half-marathons for not running marathons because he or she is not getting enough exercise. Someone who has the discipline to pay off a mortgage, and afterwards invests the free cash flow in stocks, will be in a very comfortable position financially.
I tend to agree with you there (I’m no Dave Ramsey fan and find him simplistic and annoying) , but his easy “solutions” and mantras are successful for a ton of people. Despite being “wrong” mathematically, the reward of “one less bill” gives people motivation to succeed.
I’m sure someone’s lost weight on the Marshmallow Diet (“One Simple Old Rule from a Mom: only eat marshmallows!”), but that doesn’t mean it’s a good idea.
Add into the mix a consideration whether or not there are investments that are creditor-proof should the investor’s life take a dramatic turn for the worse. For example, here in Ontar-i-ar-i-ar-i-o, if a person has their nest egg in the form of their home, the creditors can get it when very hard times hit a person; if a person has their nest egg in the form of typical unregistered stocks, bonds, etc., through a typical bank or investment company, the creditors can get it; if a person has their nest egg in financial investments through typical unregistered stocks, bonds, etc. through a life insurance company with named beneficiaries tacked on to the investments, then the creditors can not get it. Under this scenario (which is peculiar to Ontario), it makes sense to put a mortgage on the house and free up funds to invest through life insurance products with designated beneficiaries. When everything goes to hell and a handbasket, there is little equity in the house to lose to creditors, and the insurance based investments with designated beneficiaries are protected, as opposed to building equity in the house or the house and non-protected investments only to loose all come hard times. Again, this is applies to Ontario, so don’t assume it is the same where you are. I only put it foward to suggest that a person should look around for creditor-proof investments.
