EM07 wrote:On an after-tax basis, my interest cost is maybe 30-50 basis points above inflation. Inflation has basically canceled out most of my interest cost. If I continue this pattern going forward, wouldn't I be paying interest on a declining balance in real terms?
Absolutely. Being able to deduct your interest expense basically makes homeownership come at pretty much no cost, aside from property taxes/utilities. This is born out in the long term as well.
Doing so gives you a huge cost advantage over most Canadians who, at the ages of somewhere between 25 and 40, take out a mortgage and pay non-deductible interest almost for the rest of their lives.
I know interest rates can rise but they generally do so in response to higher inflation, which would erode the value of the debt further. My wages would be inflated too which would make servicing the debt easier. Alternatively, if I wanted to make lump sum payments on the mortgage, I would be better off doing it with cheaper dollars in the future.
Long-term evidence has borne this out; as I said earlier, the tax arbitrage possible by funding a house with deductible money is pretty much the best case use possible for the SM and leveraged investing.
Basically, the scenario you describe goes like this:
1) Accumulate enough savings to buy a house;
2) Sell those savings, buy the house,
3) Take out a mortgage on the house, repurchase the savings.
One iteration of the SM contemplates that the debt will not be paid off until death. So let's say, for example, I took out a $45,000 mortgage on a $60,000 house in 1975 and I was able to do it on the terms that I described above. Assume also that I carried that debt all the through to 2008 at 30-50 basis points above inflation. That $45,000 is worth far less now in 2008 dollars and is also a much smaller debt relative to the value of my assets. Even if the value of my house only kept pace with inflation, I would have a $45,000 debt secured by a $250,000 house. Hopefully, I would have also invested prudently and would now have a substantial portfolio of equities.
If you had $60k to spend on a house in 1975, yes, you would have done fairly well.
This only works if there's deductibility hence my comment about including this as a factor in SM analysis.
Well, I don't know how you would include it, but basically, the SM favours a scenario in which there are high interest rates, because the real cost of borrowing money, with deductibility, will probably be negative.
If the SM allows you to deduct 40% of your carrying costs, and inflation is 10%/year and interest rates are 12%/year, your real cost would be -2.8%/year to borrow money.
But if inflation is 2%/year, and interest rates are 4%/year, your real cost to borrow money under that scenario is +0.4%/year. So the SM is a very significant way to defend a portfolio against inflation.
There is a reading series put out by a CFA in the US that describes this phenomena in a free lecture series at
http://www.mortgagesecretpower.com . Its very well written, and I suggest you check it out if you want to read more about the 'theory' behind hedging inflation with debt. Select the "inflation mini course" link, and you'll get a .pdf in your mailbox every week or two with very interesting information.
Webring
