Following the post-COVID stimulus hangover in 2022, the bull market has continued to run. One of the key factors was the Federal Reserve’s decision to
Appreciating Debt
Published Date : February 1, 2016
There are many reasons why people accumulate personal debt, and home purchase and improvement decisions are usually at the top of the list. In addition, there are many unique advantages available to homeowners that generally make such debt attractive, including tax exemptions on realized gains and deductions for property tax and mortgage interest. And yet, many good things can be taken to unhealthy extremes. For example, the deductibility of mortgage interest is frequently embraced as reason alone for maximizing borrowing in the pursuit of homeownership, with some feeling they are essentially “saving” money after taxes.
The problem with this reasoning is that debt payments still represent out-of-pocket expenses, even if they do provide tax benefits. If someone is in the 28% tax bracket (not including any state tax considerations), each dollar paid in mortgage interest will “save” 28 cents on their tax return. But 72 cents is spent in order to “earn” 28 cents, which cannot really make cents─ or sense! Of course, spending money to make money—on potential capital appreciation—is another matter entirely, and an additional rationale for owning real estate. And debt leverages the effect. But people need to be careful about the assumptions they make, and the inherent risks they accept, when justifying overall borrowing costs. We all saw the downside unfold in 2008 as housing prices nationwide slid.
On average, homeowners, particularly those at earlier stages in their careers, also move more frequently than one might think. Since almost all of the payments in the early years of any fully amortizing mortgage cover interest costs, the forced savings that happens as the principal payments increase may not have time to kick in if the property is sold in the first several years. And there is obviously no principal reduction with interest-only loans. So, when a home is purchased, price appreciation is often the primary objective and the justification for the initial commitment. The results could be disappointing if prices do not increase as hoped and worse if home prices fall. As a reference point, it is worthwhile to compare the net costs of renting versus owning, as well as other investment opportunities forgone, when the decision is made to invest capital in a home. And taxes alone should not guide the analysis.
Since house prices and remodeling projects continue to climb, especially in the Bay Area, so too does the pressure to borrow more. Owning a home may be one of the best long-term investments a family can make. In fact, it often makes sense to stretch a bit early on when making this major commitment. But it is all a matter of balance. A family lacking sufficient savings to make a meaningful down payment must be realistic about whether it will be able to support mortgage payments during lean times. Younger homeowners, faced with less certainty in their careers and with more limited resources to incur risk, are presented with different circumstances than older homeowners with larger asset bases and the intention to stay in their homes for many years. For everyone, the home should remain a source of security and comfort as well as shelter, and thus it should be protected against commonly known perils like fire, as well as against loss or hardship due to an inability to afford and maintain it.
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