Real Estate Leverage and ROI – Part Deux

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Kitty PoP’s brain on RE.

A few weeks ago we ran a post called How Much Real Estate Leverage Should You Use?  In it, I examined the relative ROI for real estate investments given different varying down-payment amounts. (If you didn’t read that post, it might be helpful in understanding this one to go back and give it a look-see before reading this one.)

Well, in that first post, some readers took issue with my (intentional) omission of opportunity costs in that post, so here’s the follow-up where we’re going to look about how some opportunity costs play a role.

Specifically, I’m going to try and answer Cash Rebel‘s question that he left in the comments from the previous post:

What if I had the money for a 20% down payment, but wanted to evaluate that against buying the same priced home with a 3.5% down payment and investing the 16.5% in the stock market or something?

 

Just A Quick Review

I’m going to use most of the same values that I detailed in the original post, but here they are again for a reminder.

Purchase Price – Median US home price was $173,200 in Jan 2013, so I’ve used that for all these examples.

Percent Down Payment – The examples here are for the minimum conventional loan (20% down) and the FHA minimum of 3.5% down.

Mortgage Terms – Interest Rate, Points Required, # Years. We’ll fiddle with these assumptions a bit in the examples below.

PMI Rates – Rules for PMI recently changed. FHA increased the PMI yearly premium to 1.30% of the loan value and required that PMI be paid for the entire duration of the loan. That’s right. PMI payments no longer disappear once you hit the magic 20% equity unless you refinance into another loan. (Though my model assumes you have a no-cost refi into an equivalent loan for your remaining term when you reach 20% equity. That’s a pretty generous assumption if you’re using historically low interest rates…)

Loan Origination Costs – The US nationwide average for mortgage origination costs on a $200K loan are $1,600.

Marginal Tax Rate – What tax bracket are your mortgage interest deductions saving you money in? I use 25% for all the following examples (mostly ’cause that’s our marginal tax bracket). In all of these examples, I am VERY generous and assume you get the full benefit of your tax deduction from mortgage interest despite the fact that many people cannot itemize tax deductions . (The PoPs included.)

** Long Term Capital Gains Tax Rate (A new addition to this list) – I used the current rate of 15% for individuals in the 25% tax bracket and up. But because of the $250K exemption for LT capital gains on a primary residence, this tax only applies to the gains that you make on the cash that gets invested.

Inflation – I took the average CPI from the past 20 years. It was 2.50%. That was used as the inflation rate in all of these calculations.

RE Growth Rate – Long term, on a nationwide basis, RE growth tracks inflation. But I left it as a variable we can toggle to test what happens if you’re in an area like SF or NYC that has had long term growth rates above inflation.

Realtor’s Fees Upon Sale – I assumed 6% since that’s a pretty fair industry standard for the seller to pay.

 

So getting to Cash Rebel’s question…

What would it be like if we had the cash for a 20% down payment but opted for a 3.5% down payment and invested the rest in the S&P 500?

 

Let’s Look At It Visually…

For these charts, I’m assuming that we’re getting a long term S&P 500 CAGR of 7.49% (that’s the actual CAGR from Jan 1 1950 to July 1 2013) and compounding it on our market investment every year. Then we’re comparing the return of that “diversified” portfolio (RE + stocks) to what return you’d be looking at if you had used a traditional 20% loan or just a 3.5% loan on JUST a real estate purchase.

The results might surprise some of you.

Note: For all these graphs, the yellow line is your 20% down payment ROI, the red for your 3.5% down payment, and the purple if you invested the difference (16.5%) in the stock market.  Refer back to this post if you want a review of what numbers go into the ROI calculations and remember, the ROI is negative in the first few years because of all the front-loaded costs associated with a mortgage (origination fees, points…).

An Average Market (one that grows at the same rate as historical inflation, 2.50%)

First, here’s what it looks like for mortgage with terms approximating average mortgage over the last 20 years (6.45% APR and 0.97% points). You can see that the option where you’re investing money in the market doesn’t start to beat your 20% down payment until year 7, and doesn’t really start to make any significant difference until year 12 when you’re no longer subject to PMI.


We see a similar scenario if we got to use average 2012 mortgage rates (everyone loved those historic lows!) of 3.66% APR with 0.7% points, but the crossover point is a little later and you get rid of PMI a little earlier, by year 10.

So in this average market, it seems to be close to a wash in the first 10 years of ownership, largely dependent on whether or not the market will be over or under performing that long term average during that period. Until you get rid of PMI, any market performance is basically being eating up by PMI.

 

A Boisterous RE Market (Like SF with 4.40% RE appreciation)

For a 20-year average mortgage (6.45% APR and 0.97% points), in year 15, your “diversified” investment split between the RE market and the S&P 500 is still under performing. And yes, this is AFTER your PMI has been concluded, which takes place by year 12.

 

Under 2012 mortgage rates (3.66% APR and 0.7% points), a similar story is taking place, where you lose PMI in year 10, but a diversified investment is still underperforming RE in year 15.

It’s might not be your gut reaction when you first think about it, but it makes sense that the stronger you expect your RE market is, the harder it will be to beat the investment returns you get there. Even though the RE market is “just” growing by 4.40% in this boisterous SF market, and we’re assuming that our stock investment is growing at 7.49%, in 15 years a diversified portfolio STILL wouldn’t have caught up because of the amount that you’re paying in interest and PMI charges.

 

Mrs PoP’s Take On the Whole Idea

Opting for a 3.5% mortgage and paying PMI when you have the savings (or can get there pretty quickly if you put your mind to it) for a 20% mortgage seems like a waste to me. PMI basically eats all of your market returns as long as you’re carrying it. And, since PMI rates are on anything but a downward trajectory, this differential could get even worse as PMI rates rise.

Take Home:

If you’re looking at your home as an investment (especially if you’re not planning on living there for decades and decades), do your best to save up for a 20% down payment. Paying PMI is like throwing money down the toilet.

 

Are you surprised by the numbers? Did you think it might be easier to get better investment returns by leveraging using a smaller down payment and tossing money in the stock market instead?

 

Final Note: As always, if any other excel junkies want to check out the spreadsheet, toss me an email and I’ll shoot you a copy to play around with.

23 comments to Real Estate Leverage and ROI – Part Deux

  • Wow, great overview. I’ve thought pretty hard about whether it’s a good idea to own a home or not. My wife and I own our home and it works for us, but I realize it isn’t for everyone. It’s kind of crazy how much of an impact PMI and interest charges have on your overall return. We’re planning on having 20% down on our next property or at least be able to get there as quickly as possible.
    Jake @ Common Cents Wealth recently posted..Weekly Recap – July 19th, 2013My Profile

  • Wow, fascinating conclusions! I guess I figured that PMI would eat up a bunch of the investment returns but that’s pretty dramatic. It certainly doesn’t match my gut instinct, but you explained the reasoning well.

    I was actually having a conversation with my Dad the other day about leveraging yourself to pay for a house. Thanks to your previous post I was able to convince him that it’s pretty much never a good idea to leverage yourself down to a 3.5% down payment. Just wait and save up 20%. This just adds more credibility to that argument.
    CashRebel recently posted..Should I get a car loan to build my credit score?My Profile

  • This isn’t surprising to me at all, though the illustrations are great. It does bring up the next question though, which is deciding whether to put more than 20% down or investing the difference. Or whether to make extra payments on the mortgage. If PMI doesn’t exist and your mortgage APR is low enough, it can make sense to use the leverage.
    Matt Becker recently posted..The Dual Benefit of Increasing Your Savings RateMy Profile

    • Once you get past paying PMI on these graphs (I assumed you REFI to get rid of it once past 20% equity), the effect of having money in the market is very positive to your overall return, especially the lower your interest rate is. So for us, I think we’ll be slowly paying off our 3.25% mortgage and keeping money in the market.

  • That is interesting.

    The new rule that PMI is permanent — it no longer goes away when you reach 20% equity — basically means you’re a fool if you buy a house without 20% down. Once people begin to understand that, it’s going to get a lot harder to sell a house.
    Funny about Money recently posted..Fell Off the Diet Wagon!My Profile

    • My gut says people won’t think about it when it comes to buying a house because the average person stays in a house about 8-9 years (it was as low as 6 during the RE boom), so if they start with PMI, the average person will still be < 20% equity when they are exiting that house... I was thinking more along the lines that we're likely to see more 20-year loans where people reach 20% equity under their FHA loan around year 10, and then refi into another loan for the remainder of the 30-year period. Worst case they'd refi into another 30-year loan and stretch out repayment over 40-ish years.

  • Debi

    Thanks for doing all the number crunching for us! 24 years ago I bought my current home for $135,000 with 50% down @6.5% (personal loan from a family member). The term of the loan was 20 years but I chose to prepay and paid it off in about 7 years. I’ve always wondered if I should have invested the extra I paid over the 7 year period rather than paying the loan early. Since it was my parents who loaned me the money I probably would make the same decision again but financially, which would have been the better way to go?

  • PK

    San Francisco (and the rest of the Bay is pretty ridiculous. You’re looking at 20% YoY – glad I bought in 2011, heh. Buy now or be priced out forever, eh?

    Do you have a link on the PMI change on FHA loans? I’d love to dive deeper on that (possibly for a piece).
    PK recently posted..Predicting S&P 500 Closing Prices – July 2013 EditionMy Profile

  • Jonathan

    Did your analysis assume you’re also re-investing the savings between the 20%-down mortgage payments and the 3.5%+PMI mortgage payments?

    Also, I consider myself lucky to not know much at all about PMI, but is that 1.3% of the loan value you mention based each year on the initial loan value, or does it go down as the value of the loan decreases? I’m inclined to think that it is based on the initial loan value, but if that’s accurate then it just kills you on payments, especially closer to the end of the amortization, when you may be paying effective APRs in the double digits.

    • PMI rates are based on the original principal on the loan, and reductions are not automatic. I think you’re right that your effective APR near the end of the amortization would be very high. But I kindof think that’s the FHA’s goal. They don’t want to be providing as many loans as they are and being the lender of last resort, so they’re trying to get people incentivized to leave the FHA roles. (At least that’s my take.)

      As for the re-investing the difference between the payment cost, I didn’t do that. Rather, since the payments are smaller on the 20%, it has a lower cost basis, so boosts the ROI by having a smaller denominator in the division. It’s not the exact same result as what you’re asking, but similar.

  • I’m humbled by your excel & finance skills. Great write up and now we’re especially happy that we put more than 20% down to avoid PMI.

    As Matt noted, after you’re avoiding PMI, there’s a point at which putting additional funds towards the downpayment no longer makes financial sense if you assume the S&P500 CAGR is going to outperform your interest rate.
    Done by Forty recently posted..Use Your Tax DollarsMy Profile

  • I completely agree that PMI is wasting money, and as B says, it’s benefiting no one but the bankers. I’m so impressed with your analytical skills, Mrs. PoP!
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  • Anne

    You essentially covered this by having the borrower “refi” once they hit 20% equity in your scenarios, but PMI is only permanent for FHA loans. I ended up putting only 10% down to buy into our market while prices and rates were still low, but with a conventional loan.
    I think sometimes people who don’t have 20% get trapped into thinking that means they need an FHA loan, but conventional ones will go as low as 5% down. More importantly, my interest rate was lower with a conventional because they take your credit into account when determining the rate, rather than just having a cutoff where you qualify or don’t.

  • Meghan

    But if the rate is 3.5% or whatever now but would be 7% by the time you got 20% down, what do you suggest?

    Also I wouldn’t do FHA anymore. At 5% down, at least someone could get their PMI down to .6%.

  • Excellent post, Mrs. PoP – a huge help for us as we contemplate real estate investing after the debt is gone. Thanks!
    Laurie @thefrugalfarmer recently posted..Some Link Love, and Last Chance to Win $480 in Cash!My Profile

  • Yikes, I hadn’t heard about PMI changing like that. 1.3% for the life of the loan is nuts! For most people the allure of owning a home will outweigh the fact that they’re getting taken advantage of by paying PMI, but for the rest of us its extra incentive to make sure you save up 20%!
    The First Million is the Hardest recently posted..Understanding How Economic Data Triggers MarketsMy Profile

  • Great post! A 20% downpayment is definitely the way to go. That PMI is a killer!

    When we bought our home we waited until we had a 20% down payment. It actually helped us make the right home buying decision as well since it forced us to wait an extra year until we had the funds. This gave us plenty of time to get to know the city and where we wanted to live.
    GamingYourFinances recently posted..The road to financial freedomMy Profile

  • […] Planting Our Pennies: Following up on their great article from a couple of weeks ago, the Pops look at the numbers comparing a 20% down payment to a 3.5% down payment while investing the difference. The results are pretty interesting and well worth checking out. […]

  • […] Planting our Pennies continues looking at real estate leverage and ROI. […]

  • […] Planting Our Pennies: Following up on their great article from a couple of weeks ago, the Pops look at the numbers comparing a 20% down payment to a 3.5% down payment while investing the difference. The results are pretty interesting and well worth checking out. […]

  • […] – I am a numbers gal and help people understand their data. Hence the love of spreadsheets and charts. […]