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Mortgage Debt: The Good News
The usual advice given to the public by financial planners and the popular press is that less debt is better and in particular owning your own house outright is a desirable goal. This advice can be seriously misguided, because mortgage debt is an inflation hedge and a hedge against declines in local real estate values. Monetary debt decreases in real value with inflation and can thus offset declines in the real value of the assets that are not fully responsive to inflation. These assets may include labor, portfolio or retirement income, and a home. While housing in general is a hedge against inflation, a particular house in a local housing market may not be. Housing prices in particular markets may not only fail to keep pace with national housing prices, or with inflation, but may actually decline.
The example used in the paper supposes a working professional looking forward to retirement in twenty years. If inflation rates increase by 2% per year, the price level of her home will be approximately 50% higher than it is today. But, suppose home prices have stayed flat in her area, so that the real value of the house is 50% less than it was twenty years ago. With a mortgage, the mortgage liability would decrease by an amount that approximately matches the increase in the price level. In some cases the price of housing in a particular area may actually decline, perhaps due to neighborhood deterioration or the loss of a key employer. Mortgage debt allows the homeowner to capture the upside in local housing prices while using the saved equity to diversity into other investments, thus cushioning the blow if local real estate conditions deteriorate. The fixed rate mortgage is a particularly attractive form of debt because of the relatively low rates typical of home mortgages, favorable tax treatment, typically long live, and embedded options.
In this study, a numerical model was developed to compare the financial results for a hypothetical individual assuming 1) no mortgage debt and 2) mortgage debt, with the saved equity invested in either Treasury Inflation-Protected Securities (TIPS), Real Estate Investment Trusts (REITs), or the Standard & Poor’s 500 Index (S&P500). The model uses an Excel add-in program called @Risk to realistically model uncertainty by allowing the user to specify the value of any input cell as a random draw from a particular distribution. Distributions were specified for the following input cells: anticipated inflation rates for consumption, income, and local housing, risk premiums for mortgages, REITs and the S&P500, and an unanticipated inflation shock. The @Risk model allows the user to compare the distribution of an individual’s total equity value at retirement with and without mortgage debt.
The model shows that under realistic circumstances, investors who mortgage their home can outperform investors without mortgage debt. This result holds true even if the equity saved by using mortgage debt is invested in a conservative alternative (TIPs). The advantage to mortgage debt increases as the magnitude of unanticipated inflation shocks increases.
The model can be used to analyze the mortgage debt decision for a broad range of individuals and inputs. The inputs and distributional assumptions can be varied to tailor the model to a specific investor, or the model can be used without the @Risk component if the user wishes to specify a particular forecast of interest rates and inflation.
