Are Mortgages Really a No-Brainer?

You hear it all the time. With mortgage rates so low, you best take out the largest mortgage you can, invest the proceeds into higher-yielding securities, and make minimum loan payments for 30 years in order to pocket some easy money.

Sensible enough if approached with an appreciation for the finances involved.

But then this advice somehow morphs into a common refrain of “never pay cash” when you can borrow.

Take this article from Dollar Disciple from a couple of months ago where he’s trying to convince us to never pay cash for real estate. Then consider his section on “hard money” lending (emphasis mine):

This brings me to my favorite method of financing: hard money. …These loans are usually targeted at real estate investors because it allows you purchase distressed property with a short closing period. …The biggest downside to hard money is the cost. The hard money companies in my area charge 14% interest-only and 3 points to fund the loan.

Now, hold on a second and ask yourself, in this example, are we borrowing money at low interest rates to arbitrage the money into high interest returns? Or are we just borrowing money because we don’t have enough money?

The former could be a smart way to take on a bit of risk in order to use your property to get some additional returns on your equity. The latter could still be smart, if you’re able to make money and still pay those high interest rates and fees, but let’s be candid, you would be better off not having to pay those high interest rates and fees if you had enough cash on hand to handle the repairs yourself. Unless your securities portfolio is averaging better than 14% plus points? In which case, I don’t know why you would be bothering with the headaches of real estate at all.

He goes on to show that, because of all this financing, his actual out of pocket expenses are miniscule compared to his ultimate gain. Conveniently ignoring the risk of default. Which I’m sure, in his mind, is a complete impossibility, but ought nevertheless be considered when making an investment. Might it be a low risk? Sure, but it’s there. Let’s not forget the many landlords defaulting on their financing who have given us this plethora of cheap real estate to pick through.

It’s kind of like pontificating on how amazing your securities returns could be if you just leveraged yourself a few times, completely forgetting to mention the possibility of a margin call.

Then again, maybe I bring my own bias into this since I’ve owned three pieces of real estate and have had a total of zero mortgages. It just makes things so much easier, particularly during the transaction, where I’m able to buy properties with title/property border issues, or in need of repairs, and I can be my own inspector. I can then do all the repairs as I see fit, without needing to use state-sanctioned contractors or having to get permission from the bank, or having to bother with complicated accounting schemes required to satisfy the giant headache that is a rehab loan. I can send out multiple offers at a time without worrying about getting permission from a lender if I happen to want to buy two places instead of one, or buy a multi-family instead of a single, or a commercial property instead of a residential. I can just go after the best, most readily available deal. I can get an insurance policy that makes sense for me, not one that primarily satisfies my lender. And I can get a new new credit card without worrying that it’s going to up the interest rate on my next property.

Another reason not to take out a mortgage might be because your real estate holdings work as part of the diversity of your asset allocation. If you already have 90% of your assets in securities and only 10% in real estate, you might be perfectly reasonable to just leave your money in your property rather than financing it and altering your allocation to 2% real estate 98% securities. It’s sort of a cash-equivalent for the portfolio that keeps up with inflation at the cost of liquidity. Much like holding some money in some CD’s or something.

I don’t know. Maybe I’m just basking in the luxury of being able to afford being less than 100% efficient. Though I do think the massive decrease in paperwork is worth at least a few thousand bucks a year.

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3 Comments

  1. Posted April 9, 2012 at 10:40 am | Permalink

    First, I want to thank you for reading my post and caring enough about the topic to write a great post like this one. I’m open to all criticism and you bring up a few point here I wanted to discuss.

    1. Hard money is a short-term solution, and your goal should only be to pay that 14% for a max of 3 months. If you can achieve that, then it’s a very effective form of financing for distressed properties. I would NEVER advocate paying 14% for a long period of time, just to borrow more money.

    2. You’re right: I completely ignored the risk of default because for me the chances are extremely slim: a good job means I can cover multiple mortgages in case something goes vacant, ample cash reserves ensures that I don’t have to dip into my savings. In fact, without these two points, I wouldn’t have qualified for the hard money loan in the first place.

    3. Margin calls and defaulting on loans are a little different but I see your point here.

    4. I think you’re also overstating the work required to use financing from all side of the deal: purchase, construction, accounting. Personally, I DO feel that the extra 2-3 hours of bookkeeping per year is worth the extra money. I’m already in Quickbooks and I’m pretty good at it. I’m also going to use a contractor anyway because I don’t have the time or inclination to do my own rehabs. Additionally, dealing with a hard money lender is waaaay easier than dealing with a giant bank. They can provide the financing within a week with little paperwork. It’s really the refinance into conventional that takes more work. But it’s absolutely worth it to me.

    Again, I really do appreciate the criticism! I’m positive that I’m equally biased and so I welcome additional points of view on these kinds of things. You’ve inspired today’s post where I will be linking back to this and admitting my own biases and unspoken assumptions!

  2. tooqk4u22
    Posted April 9, 2012 at 1:45 pm | Permalink
  3. Posted April 10, 2012 at 10:59 am | Permalink

    Now this is interesting, two of my favorite bloggers going toe-to-toe.

    I’m so impressed with both these guys I linked to their sites in Part IV of my series on how to lose money in real estate:

    http://jlcollinsnh.wordpress.com/2012/03/25/how-i-lost-money-in-real-estate-before-it-was-fashionable-part-iv-i-become-a-landlord/

    You know, just for those people who were more interested in making money doing it. :)

    In that post of condo disaster I mentioned a 2-flat purchase that turned out well for me.

    Back in the day I read a book called “Nothing Down” by Robert Allen. In it he explained techniques for buying property with no money down.

    Now post 2008 that doesn’t sound all that exciting, but this was in 1980. The days of 20% minimum down payments & 18+% mortgage rates.

    Anyway, I set that as a goal and thru an arduous process I’ll not bore you with here I bought my 2-flat for no money down. Specifically, 75% bank and 25% owner financing. Goal achieved.

    Problem was, it was the wrong goal. The right goal would have been to buy the property for the best terms and most advenatgous methods for my situation. No money down wasn’t it for my unique situation.

    What I like about Lacking Ambition and Dollar Disciple is they both have decidedly unique approaches to investment real estate. Both fine tuned to their individual situations.

    Both work and provide in whole sucessful paths for other RE investors. Or, and this would be my approach, you can read, understand and blend what they say into something that uniquely fits your goals, needs and situation.

    Kudos to both you guys!

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