uExpress.com: Scott Burns by Scott Burns -- (07/11/1999) DEBT-FREE HOME OWNERSHIP VS. STOCK LEVERAGE

Previous Date | Most Recent Scott Burns | Next Date

DEBT-FREE HOME OWNERSHIP VS. STOCK LEVERAGE

07/11/1999

Gee whiz, do we ever love our mortgages!

Immediately after publication on May 25, readers started sending e-mail questions about my column on how debt-free home ownership provided a tax-free return of about 12 percent a year. They were troubled.

No, they weren't troubled by the idea of an easy 12 percent tax-free return. What bothered the dozens who sent e-mail protests was the idea of giving up the benefits of having a mortgage. Since mortgage interest is tax-deductible, they reasoned, surely it would be better to keep a mortgage and invest money where it might earn a higher return.

Why pay off a 7 percent, tax-deductible mortgage, they said, when stocks are returning 10 percent to 20 percent?

The nutshell answer is very simple: No other financial commitment offers the combination of stability and high return of debt-free home ownership. While outside investing may increase your return, it comes at the cost of increased risk.

Given a choice between stock ownership and debt-free home ownership, anyone with a stable life should take home ownership first. While the tax-free return on debt-free home ownership is 12 percent -- 8 percent from nontaxable shelter services and 4 percent from annual appreciation -- the long-term return on common stocks is lower.

Let me demonstrate.

According to Ibbotson Associates, a Chicago firm that provides the bible of asset returns data, the very best of all 54 20-year periods since 1926 was the 20-year period ending in 1998, a stunning 17.75 percent annualized taxable return. Adjusted for taxes, the return would be lower, perhaps as low as 12.78 percent. (The exact figure depends on when you realized capital gains and at what tax rate you realized them.) The long-term average return for common stocks, however, is 11.2 percent a year, before taxes. At very best, that's an after-tax return of 9 percent.

story continues below

Basically, stocks are a long shot compared to home ownership.

The benefit of home mortgages is that they allow us to get a foothold in home ownership. Without mortgages we would be a nation of campers. Mortgages, however, are only a tool. They are not magic.

By using debt leverage, we can get a higher return on our equity investment in the initial years of the mortgage. Another benefit is that the loan commits us to a long-term savings program: If we don't pay off the mortgage, we never get to enjoy the no-payment, debt-free return.

Now imagine that you have choices most people don't have: You have a stock portfolio equal to the purchase price of a house. As a result, you can ignore home ownership and continue owning the stocks. You could also borrow against the stocks on margin and double the size of your portfolio. Or you can use some of the money for a down payment on a house. Or you could buy a house, debt-free. You can see how the return on your portfolio changes as you commit more to equity in a house.

As you can see from the table below, a debt-free house provides a higher return, at far lower risk, than either pure stocks or a leveraged stock portfolio. You get a higher return than a stock portfolio when you finance a house. The return diminishes as you approach debt-free ownership.