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2021/03/09

How to Buy a House with Risk Instead of Cash

Intro

It's not common today that someone will buy a house with 100% cash. Mortgages are expected for most home purchases. It's already well-known by home owners to pay for at least part of their house with risk. This risk comes in the form of leverage. They borrow a percentage of the house's value instead of paying all cash. Leverage is naturally risky, since it amplifies both returns and losses. Houses are accepted as being less risky as seen by their acceptable leverage ratios. A potential buyer needs some cash to pay for the fees and downpayment for buying a house. How to fund this downpayment and closing costs without saving cash or selling investments is what I want to explore in this page.

How Much Cash do I Need to Buy a House?

First we need to determine an efficient amount of cash to use to buy a house. Knowing that, we can then figure out how to get the needed cash for the downpayment and closing costs.

0% Downpayment

If you're a veteran, you can VA loan for 0% down and really good interest rates. You just need to pay closing costs. The big disadvantage of loans under 20% is the mortgage insurance, which doesn't apply for a VA loan. Everything further I explain is not really useful for veterans since veterans can already take advantage of a less-risky, better offer.

3.5% Downpayment

An FHA loan can get you as low as a 3.5% down payment. The problem is the mortgage interest rate is higher, there is an upfront mortgage insurance cost, and a monthly mortgage insurance payments. A conventional loan only requires mortgage insurance until 20% equity, but FHA requires mortgage insurance for even longer. This option is not the most efficient because of these long term payment factors.

3.5%-19.99% Downpayment

Private Mortgage Insurance (PMI) is usually paid for loans that have less than 20% equity. This adds an extra 0.41% to 2.25% of loan value payment. It's not great to pay extra for this PMI insurance since it is only a cost and offers no benefits to the payer (besides putting down less money). It's not the most efficient since this is an extra fee on the mortgage.

21%+ Downpayment

Putting more money down can decrease the monthly payment, but the cost is in the opportunity of what that money could be making elsewhere. Owning a house to live in does not give a high expected value of return compared to other investments.

20% Downpayment

A 20% down payment avoids unnecessary fees, while requiring less cash to be tied up in a negative-to-low rate of return asset. This ignores rent costs saved by owning a home, since these rent costs are already saved by owning a house with or without a mortgage. If we're okay with the risk of leverage from the mortgage, but we want to avoid paying unnecessary fees, then 20% is a good downpayment to do.

How to Get a 20% Downpayment... IN CASH?

A 20% downpayment is a lot of money for the values that houses are going for in many areas in the USA. Holding all of that money in cash isn't great since it's losing to inflation while not producing any meaningful returns. The downpayment could be saved up in stocks. This is fine if you're flexible with your purchase date since you can buy a house as long as the stock market hasn't recently crashed. The problem comes with the capital gains paid on selling those stocks. It's surely better than having no gains, but you'll still need a bit more saved to pay for those costs.

So I could end the article here saying that saving in stocks for a downpayment is efficient if you're okay with a flexible purchase date. There is another interesting option available for high-savers who are okay with more risk.

How to Get Cash? Borrow It With Leverage

Interactive Brokers offers margin loans with rates that are currently 1.57% and lower.

This is extremely cheap. This is even cheaper than a mortgage. This makes sense since it's a collateral backed loan with the ability to seize the highly-liquid collateral if it drops too much in price. A mortgage carries more risk for the lender considering the illiquidity of foreclosing and selling a house. Of course, there is the chance of the value of investments decreasing enough to cause a margin call. Obviously this is a risk that we want to avoid, so taking a margin loan that is as low of a percentage of portfolio value as possible is preferred.

Why is Margin the Answer?

Margin is currently very cheap. It is cheaper than security backed loans, and easily cheaper than any other type of collateral or non-collateral backed loans. The interest rates make this a viable strategy to get cash out of investments. The benefit of margin over selling securities is avoiding capital gains tax, and allowing the assets to continue growing in the market rather than sitting as equity in a house.

What Are the Requirements?

This strategy requires a large amount of taxable invested assets to take margin against. Assets in retirement accounts are not going to help your ability to pull out cash as a margin loan here. You must also understand and be willing to take the various additional risks that come with this strategy.

Risks of a Margin Loan

There are a few unique risks to a margin loan that should be understood. These risks must have mitigations as well. I will go into each risk and how it should be mitigated during the lifetime of the margin loan.

Risk of Margin Call

The obvious risk of margin is having a margin call. This is when your assets depreciate to a value low enough (50% debt to asset ratio) to issue a margin call. This is bad, since it forces a sale of assets at a depreciated value.

Mitigation strategy: Limit margin to a lower percentage, such as my preferred max, 20%. This will require your assets to drop 60% right after you take on the margin to issue a margin call, which is very unlikely. Also, maintain good taxable cash flow that can be used to reduce the outstanding margin quickly.

Risk of Margin Increasing in Price

Margin interest rates are based off the Benchmark Interest Rate (BM). This rate depends on the what the federal reserve bank targets for interest rates. Currently it is low, but it can be updated every quarter. The government hasn't done drastic increases quickly, but the interest rate on the margin loan will be increased if the rate from the federal reserve bank increases. These interest rates are lowered during bad economic times, and raised during good economic times. The cost of the margin can become expensive with rising rates.

Mitigation strategy: Pay off the margin quickly with high taxable cashflow. All extra taxable cashflow should be reducing risk by paying off this margin as quickly as possible. If the margin increases to a high enough rate, there's the option to sell stock to pay off the margin. The margin will increases should correlate with stock market increases, so the risk of selling depreciated assets is reduced. Selling assets to pay off the margin is no worse than selling assets for a mortgage downpayment if assets don't depreciate.

Risk of Loss of Cash Flow

While this risk exists for paying a mortgage as well, it is concerning to lose cash flow in relation to having margin that needs to be paid. If cash flow stops while a margin loan is demanding interest, assets will need to be sold.

Mitigation strategy: Have multiple streams of cash flow. Have streams of cash flow that are unlikely to be completely stopped.

Combination of Multiple Risks

Asset depreciation, increase in margin price, and losing cash flow all at the same time would be a terrible combination for this strategy. There's at least a negative correlation between asset depreciation and margin price increases, but the loss of cash flow is more-likely to occur with a depreciation of assets.

Mitigation Strategy: Take on limited margin. Have multiple streams of income. Have large cash flow. Plan for a short time of holding margin. Start holding margin at a low-risk time of life.

Example

I'll give an example to help illuminate the strategy in practice.

Let's assume I want a $600,000 house. I want a downpayment of 20%, so I need $120,000 in cash for that. I plugged this into a closing costs calculator and got $11,218. I'm not very familiar with how close or far from the truth this is, so I'll go with it. It's not big enough to be extremely consequential. $131,218 in cash needed to buy this house.

I want to keep margin at a reasonable level, so I'll try to keep it at 20%. Therefore, I need $656,090 in taxable-invested stocks to support the needed $131,218 in cash from margin. Closing costs would be a bit less for an all-cash sale, but there would still be some. We would need more invested stock to pay for this house in cash than with margin after considering capital gains taxes.

I can transfer my securities to Interactive Brokers and take out the margin and get a 1.451% rate on this margin for $1,900 a year.

Adding my margin payments with my mortgage payments, I should be paying around $2,700 a month with around a 3.0% interest rate on the mortgage of the remaining $480,000.

Here is a graph of expected returns at different downpayment amounts with and without margin. The assumptions include a 1% real return of house value and a 7% real return of stocks, with a margin interest rate of 1.5% and a mortgage interest rate of 3.0%. The graph does not include the penalty of capital gains taxes incurred by selling stocks to fund a cash downpayment instead of using margin.

Conclusion

Here is a tool I wrote to calculate the returns of 3 different strategies over a 30 year mortgage. The 3 strategies are Renting, Buying with Margin for down payment, and Buying without Margin for Down Payment (Selling equities). The calculator does not account for the capital gains hit that would happen when selling the equities.

Using margin to fund the downpayment to a home increases risk, but also can increase the expected return on an investment. There are ways to mitigate the risk of using margin to make this a viable strategy. Someone with large, steady taxable cashflow, a large amount of investments in a taxable account, and the willingness to take risk can have a more efficient way to pay for a downpayment and purchase a house.

In summary, we come out with some key takeaways to buy a house while maintaining efficient fund placement:

Save up a large taxable account.
Choose a low risk time of life to buy a house
Use limited (20%) margin to fund the downpayment for an easily affordable house.
Keep cash flow high with multiple streams of income.
Pay down the margin quickly with all available cash flow until margin leverage is reduced to 0%.
Enjoy never selling securities to pay for a new house. Once the margin is paid off, you'll enjoy the continued returns of your taxable account with the normal risk a mortgage-bearing home buyer holds.