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5 things you should know before getting a mortgage

As Vox's own Dylan Matthews has written, over the long-term investments in a diverse portfolio of stocks tend to outperform any other asset class. But there is nonetheless a solid case to be made for investments in housing for one simple reason — mortgages. A typical middle class American can't get a loan to buy stocks on favorable terms, but can get a loan to buy a house. That makes a big difference. But to take advantage of it, rather than be taken advantage of, you need to understand the system.

Here are five things you should know.

1) A mortgage can magnify your gains



Imagine putting $60,000 into a stock investment that appreciates in value 5 percent. That reaps you $3,000 in profit. Nice work. But now imagine instead that your $60,000 represented a 20 percent downpayment on a house worth $300,000. Now the house appreciates in value just 4 percent.

That leaves you with a $312,000 house and a $240,000 debt to the bank. Pay the bank back, and you're left with $12,000 in profit. That's way better than the stock, even though the 4 percent return wasn't nearly as good as what happened with the stock.

This is the power of what's known in finance circles as leverage. The ability to finance your investment with debt operates like a lever that allows you to reap much larger profits than are possible with non-leveraged investments. Mortgages are the ordinary investor's easiest access to leverage, and that makes larger profits possible.

2) Mortgages make houses very risky



The stock market is a weird abstraction. Diversified investments like index funds are even more abstract. What's more, the value of stocks swings considerably on a day-to-day basis for reasons that are often hard to discern. By comparison a house seems solid, easy to understand, practical, and safe.

But this intuition is very misleading. The same leverage that can create huge profit opportunities also make investments in mortgage-financed houses very risky.

Say you put $60,000 into the stock market and it declines 25 percent. You're going to be pretty sad. But you still own $45,000 worth of stocks. If you're lucky, the market will go back up down the road. But if you're faced with a financial emergency and need to sell, you still have meaningful money. Now suppose instead that $60,000 was your downpayment on a $300,000 house. If the house declines 25 percent in value, you have a really big problem — your house is now worth $225,000 (which is still a lot) but you owe $240,000 to the bank. Just like with the stocks, you can hope the value goes back up again in the future. But if you're faced with an emergency, you're screwed. Your investment is worthless. In fact, it's less than worthless. You're underwater and owe the bank more than your house is worth.

Don't let looks deceive you. Your house may be solid, but your mortgage makes it a risky investment.

3) There is such a thing as a discount lunch

Fannie Mae stole my job

At least some folks got cheap mortgages (Elizabeth Murphy)

Because investments made with borrowed money are risky, in general you need to be prepared to pay for the privilege of borrowing the cash. If things go south, the person who lent you the money isn't going to be able to get it all back and he's going to want to be compensated for that risk in the form of a high interest rate. Which is to say that in general there's no such thing as a free lunch when it comes to leverage and investing.

But mortgages are special because of Fannie Mae and Freddie Mac.

These were two companies set up by the government to buy mortgages from banks, making mortgage-lending much less risky. In turn, Fannie and Freddie financed their activities by selling bonds. Since the federal government had set the companies up, investors believed those bonds were implicitly guaranteed by the taxpayer and were willing to lend to Fannie and Freddie on the cheap. When they went bust in 2008, the Treasury Department did indeed step in and provide a bailout. Now the government formally owns Fannie and Freddie and formally stands behind their debts.

That means that while there's no total free lunch in mortgage-financed housing investments, there is a discount lunch available. The federal government is bearing a share of the lender's risk, which means banks are willing to lend most people mortgage money at an artificially low price. This public policy initiative is why leverage in the specific form of mortgage financed housing can be especially attractive.

4) Long-term mortgages are good if you plan to stick around

Home Sweet Home

Refinanceability makes it especially sweet (Tim)

Fannie and Freddie don't just bring you discount interest rates, they're also largely responsible for the broad availability of the most common type of home loan — the 30-year fixed-rate mortgage.

This lets you lock in an interest rate on very favorable terms. If economic circumstances change over the next few decades and market interest rates go up, you can keep paying the low rate you agreed to originally. But if economic circumstances change in the other direction and market interest rates fall, you can refinance your loan at a new lower rate. The "heads you win, tails the bank loses" aspect of this makes fixed-rate loans ideal for people who know they want to settle down in a house for the long run. These products exist primarily because of government subsidies, and there's a strong case for taking advantage of the subsidy if you fit the model.

Basically similar 15-year and 20-year loans are also fairly common. These loans carry higher monthly payments because you're repaying the principle on a more aggressive schedule. But they also carry lower interest rates because they're less risky for the bank. If you can afford the higher payments, they might be a good deal for you.

5) ARMs are good for reckless speculators


Spin the wheel (Zdenko Zivkovic)

The major alternative class of mortgages is adjustable rate mortgages where you start off with a low teaser rate for a number of years (three or five, usually) and then after that the interest rate resets to a higher level pegged on market conditions.

The appeal of these products is supposed to be that they are ideal for people who don't plan on living in the same house for very long. You get the advantage of the low rates, and since you unload the house to a new buyer after a few years you never actually have to pay the adjustable rate. That's fine as far as it goes, but if you're not planning to stick around for long you really might want to consider renting — the traditional solution for short-term housing.

Mortgage finance, as we've seen above, makes investments in housing riskier than they otherwise would be. And shorter-term investments are riskier than long-term ones. So a mortgage-financed investment in housing with a three or four year time span is actually a very risky investment no matter how solid and stable the house itself seems. If a very aggressive, very risky investment is what you're looking for then by all means fire away. But keep your eyes open about this.

Mortgage brokers and real estate agents who collect fees if you buy a house and not if you rent one will be eager to explain to you that there are financially optimal ways to engage in short-term home ownership as a strategy. But just because ARMs are a good way to be a short-term home owner doesn't mean short-term home ownership is a good idea.

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