Here’s Why Rich People Take out Mortgages on Their Homes — Even Though They Don’t Need to
Ever wondered why rich people keep getting richer? Here is the perfect example of why
It’s really common for rich people to take out mortgages for the homes they buy, even though they could easily pay for them outright. The question is, why do they do this?
The simple answer is, it’s profitable to do so.
To explain why, imagine you decide to buy a home worth 10 million. You’ve got 20 million in the bank, and so if you wanted you could pay for it outright. But you decide you’re going to take out a mortgage, and so you go to the bank and ask for one.
The first thing the bank is going to do is deem you a safe bet, the safest of safe bets. As a result, they are going to offer you a ridiculously good interest rate. This interest rate will probably be so good that over the course of the mortgage, you will pay a rate that will be below the rate of inflation.
This really matters.
To understand why, let’s say that the bank offers you a 25-year mortgage. Let’s say that as part of this, they request a 10 percent deposit. That means that the loan will be worth 9 million.
For simplicity’s sake, let’s ignore the initial interest rate that is offered, and let’s imagine that over the full course of the loan, the average interest rate that you pay is 1.5 percent.
That may seem like a ridiculously low-interest rate, but remember, this is an average over 25 years, and in the 2010s, central bank interest rates were virtually zero.
So, here you are paying out 1.5 percent a year for 25 years.
At the same time, let’s imagine that inflation averages 2 percent over this period, and for simplicity’s sake, let’s imagine that the property market follows that perfectly. Historically, it has been running higher, but just for simplicity’s sake, let’s imagine it runs in parallel.
If you bring all this together, what this means is that the value of the property will increase by 2 percent a year, yet you will only be paying out 1.5 percent a year on your mortgage.
That gives you a return of 0.5 percent, which means you’re making a profit every year.
You may think at this point, but hell, if I had paid for it outright, I would be making a profit of 2 percent a year.
But no, that’s not the way things work. With inflation at 2 percent a year, and your property only increasing in price by 2 percent a year, if you had purchased it outright, you would not be making a profit on any level.
This is because if you make a purchase outright, the only way to make a profit is if what you buy increases in value at a rate higher than inflation.
To explain, let’s say you purchased the house outright for 10 million. If we imagine inflation is running at 2 percent and property inflation matches that, then the house will be worth 10.2 million in a year’s time.
But that does not mean you have made a profit. This is because that 10.2 million will only be able to buy as much as 10 million could the year prior.
That’s just the way inflation works. It sucks, but as any person who has found their money buying less food each year will attest, it’s the reality.
But anyway, what this means is, if you purchase your property outright, unless its value increases at a rate higher than inflation, you won’t be making a profit. Worse than that, if it increases at a rate less than inflation, you will make a loss.
This is where the power of a mortgage that pays an interest rate below the rate of inflation is so beneficial. If you manage to achieve this, you basically give yourself a running discount on the purchase price.
In the case of the purchase of your 10 million home, that running discount would be 0.5 percent, which would be the profit you were making on your mortgage. Run this over the duration of the 25 years, and you would end up with a discount of over 6 percent on your purchase price.
So, it would be like purchasing the home outright from the beginning for 9.4 million rather than 10 million. Or inflation-adjusted, at the 25-year’s end, it would be like purchasing your house for 15.4 million when it was worth 16.4 million.
Not a bad return for taking out a mortgage, and it’s not the only return.
To explain, you still have 9 million in the bank that, if you had not taken out the mortgage, you would not have had.
This really matters because you can take this 9 million and purchase, say, secure bonds with a coupon rate of 4.5 percent.
As we are imagining low interest rates for the duration of the mortgage, that may seem like a high coupon rate.
But it’s not as high as you think if you have access to secure company bond offerings, which wealthy people do. These are not as safe as government bonds, but they are secure enough if you can get a good mix of top company bonds, which somebody with enough cash would do.
As we are imagining you have enough cash, you would have access to these bonds.
So, combine the 4.5 percent from these secure bonds with your 0.5 percent yearly running discount, and you end up with a return of close to 5 percent a year.
That means yes, you are earning a pretty solid return on your mortgage, and that return is even better than you think.
To explain, 4.5 percent a year on 9 million would bring in an income of 405,000 a year, which over 25 years, would yield a combined gross income of 10.1 million.
This is good, but if you reinvest the income in new secure bonds each year, it could be much better. So much better, that that 9 million would, by the end of 25 years, be worth 27 million. Inflation-adjusted, that’s a profit of 12.2 million.
Yes, 12.2 million.
Even crazier, thanks to the power of leverage, over the course of 25 years, you would have turned 10 million into a cool 43.4 million.
Even crazier still, if property prices had increased at a rate higher than general inflation, that return would be even higher.
Yep, even higher.
That means just round things up, if you had purchased the home outright for 10 million, 25 years later you would have ended up with a home worth 16.4 million — enough to buy you the same house.
But by taking out the mortgage, you have ended up with a combined equity of 43.4 million.
Final words
The above maths may be confusing. To simplify things, rich people take out mortgages even though they don’t need them because it is extremely profitable for them to do so.
It really is that simple.
Even if they struggle to get a rate below inflation, because they can easily make a secure income on the money they would have used to purchase the home, they still can easily make a profit.
That means an interesting paradox of wealth is, if you have it, borrowing money becomes profitable, which is why wealthy people love borrowing money.
It’s just a shame the opposite is true for non-wealthy people.
Disclaimer: no financial advice is offered here, when it comes to borrowing money, always seek out a professional for advice.
That’s all from me, thanks for reading! If you enjoyed this, you may also enjoy the following:
Useful links:
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