Should a high-net-worth individual take out a mortgage to buy a home?

Reader's Question: Consider a high-net-worth individual whose assets are fully invested in fairly liquid, leveraged investments that are returning around 15-20% CAGR. If the investor should decide to make a large purchase such as a home, would he be better off A) taking out a mortgage for the purchase, B) liquidating some assets to make the purchase, or C) liquidating assets and purchasing several futures contracts to restore the return potential lost by liquidating the assets?

I will answer your question from two perspectives--first by determining a financial breakeven between the alternatives you propose, and next by referencing behavioral norms among high-net-worth U.S. households.

Financial Breakeven Analysis

Based on wealth data from a 2004 survey conducted by the Federal Reserve, the net worth thresholds corresponding to landmark percentiles in the distribution of U.S. household wealth are: $93,000 at 50th percentile, $830,000 at 90th percentile, $1.4 million at 95th percentile, and $6.0 million at 99th percentile. For concreteness, let's assume that the high-net-worth individual (call him Mr. Rich) in our discussion sits at the 99th percentile, just entering the top 1% of U.S. households with a net worth of $6 million. Further, suppose that Mr. Rich and his family have found a $1.2 million house that will be absolutely perfect for them, and that their banker is offering them a 7% APR loan at 75% loan-to-value (i.e., they can borrow $900,000) for their purchase.

Should the Rich family:

A) Mortgage: Sell investment portfolio assets worth $300,000 to cover the down payment on the home, and borrow the balance of $900,000 at 7% APR to close escrow;

B) Liquidation: Sell assets worth $1.2 million to buy the house, and politely decline the banker's loan offer; or

C) Liquidation and Futures: Proceed as in alternative B above but also call up their broker and place an order to buy futures (e.g., e-mini contracts on the S&P 500) in the amount needed to re-establish the equity market exposure lost through the $1.2 million asset sale?

Using a five-year time horizon, we can run numbers under the three scenarios to arrive at the portfolio return sensitivities shown in the graph to the right.
Notice that there is a breakeven between the "mortgage" and "liquidation" alternatives that sits at the loan APR rate: if Mr. Rich can achieve higher than a 7% annual return through investing his family's assets, he is better off taking out the mortgage (alternative A); on the other hand, if his investment return will end up shy of 7%, he should not borrow money to buy the home (alternative B). The "mortgage" alternative is, of course, the more aggressive of the two, because it adds overall market exposure to the portfolio (adds $1.2 million real estate but reduces equity holdings by just $300,000), rather than swapping one for the other as in the "liquidation" case (which adds $1.2 million real estate by offloading the same principal amount of equities).

The "liquidation and futures" case (alternative C) is a way for Mr. Rich to achieve the economic equivalent of the "mortgage" case (alternative A) without taking out the mortgage. While the mortgage involves an application process, loan fees, a property appraisal, ongoing monthly loan payments and possible prepayment penalties, buying futures contracts also involves management time and costs: initial and maintenance margin requirements, quarterly rolls from current to next contract, brokerage fees, taxable short-term gains and losses, etc. Of course, when all factors are taken into account, there can be measurable cost differences between alternatives A and C; however, since the Rich family's portfolio return five years down the road will be determined largely by the performance of their equity and real estate investments, for the scope of this discussion we can treat A and C as being economically comparable.

Therefore, Mr. Rich really has a choice between 1) maintaining his level of equity market exposure and introducing the real estate market exposure that accompanies buying the house through either of alternatives A or C; or 2) swapping equity market exposure for real estate market exposure to the extent needed to buy the house through alternative B. Alternatives A and C are inherently more aggressive than alternative B, but before deciding on one alternative over another, let's see how other high-net-worth individuals typically manage their personal finances.

How the Rich Differ from the Poor

In an earlier blog entry I discussed U.S. household balance sheets. Here I highlight pertinent results of the Federal Reserve's Survey of Consumer Finances from 2001.

The asset side of household balance sheets shows that as people become wealthier their homes (house) and cars (vehicles) become a lesser percentage of their assets, while their investments (stocks, retirement accounts) and owner-run businesses (closely held business) become their most significant assets. In moving from the bottom 50% to the the top 1% of U.S. households by net worth, the value of the primary residence as a percentage of household assets falls from about 60% to about 10%. As households become wealthier, even though they move into increasingly pricey homes, their homes on average become a smaller portion of their overall portfolio assets. Extreme examples of this inverse relationship between wealth and value of home as a percentage of total assets or net worth are: Bill Gates, whose Medina, Washington, 66,000 sq. ft. mansion, if valued at Zillow's Zestimate of $136 million, comprises just 0.2% of his $56 billion net worth; and the more frugal Warren Buffett, whose Omaha, Nebraska, comparatively modest 6,000 sq. ft. home, if taken to be worth about $1 million, represents a minuscule 0.002% of his $53 billion net worth.

It is also interesting to note that wealthier households tend to have less debt as a percentage of total assets. Whereas the bottom 50% of U.S. households by net worth are leveraged at around 56% household debt as a percentage of total assets, the top 1% of U.S. households have leverage of only about 2% (though I suspect that their businesses and investment holdings could harbor some degree of leverage that escapes coverage by the Fed survey). As a practical matter, people with steady employment and modest savings are typically among those who take out mortgages when buying their homes. On the other hand, I would find it hard to believe that many of the super-rich, such as Gates and Buffett, would ever bother to borrow money against their homes, even though their consistent double-digit portfolio returns tend to exceed single-digit mortgage rates. I would be even more surprised to hear about any of the super-rich actually doing the calculation to buy a handful of futures contracts to replace the equity market exposure they forego by tying up cash in their personal residences.

I, of course, am a mere pauper compared to anyone in the super-rich category, but I too favor the simplicity of owning my home free-and-clear without a mortgage and without having to remember to roll futures contracts every quarter to put my home equity to better use. Sure, when viewed in isolation as a textbook mortgage vs. no mortgage breakeven problem, this behavior may not seem most economically optimal. However, within the real-life context of total portfolio management, I sense that most households in the high-net-worth category are unleveraged, cash buyers of their personal residences who do not bother with futures contracts.

So, if you prefer to focus on your primary investments without bothering with mortgages and futures, just liquidate some assets and use the cash to buy the home (alternative B). On the other hand, if you are eager to give your net worth an incremental boost, confident that your investments will continue to produce the 15% to 20% returns they have been, and don't mind spending a little administrative time on a mortgage or futures, go with either alternative A or alternative C. A factor to consider in deciding between the alternatives is the tax consequences of liquidating assets--if you have large unrealized gains and wish to avoid paying capital gains tax near-term, taking out the mortgage and selling assets only in the amount needed to cover your down payment (alternative A) may be more appealing than liquidating additional assets and rolling futures (alternative C).