In the corporate world, businesses have a CEO who makes operating decisions and a CFO who makes financing decisions. The CEO decides to expand a business line. The CFO determines how that expansion is going to be paid for.
When you choose to buy a home, you have made an operating decision. When you elect to use a mortgage in lieu of paying cash for the home, you have made a financing decision. These are separate decisions. The problem is that home buyers often fail to separate these decisions. In my experience, many people treat their home purchase as a financing decision while ignoring the operating decision. This can have dramatic long-term consequences that are not appreciated until long after the initial decision.
Consider a couple, Dan and Susan, with $200,000 saved in an after-tax brokerage account who determine that their after-tax cash flow leaves them an extra $3,000 per month after covering their core household expenses. With a 30-year mortgage rate of 3.125%, they can borrow $700,000 and afford the resulting $2,999 monthly mortgage cost. Armed with that information, Dan and Susan calculate that they can buy a home valued at $900,000 by using their $200,000 savings for the downpayment and financing the other $700,000.
What’s wrong with this thinking? Absolutely nothing if their singular objective is to buy as much home as financing will allow. Dan and Susan will have $3,000 of excess cash flow each month and they can use all this money to pay the monthly mortgage cost (with $1 left over each month).
But consider how this home purchase is reframed if we think of it as an operating decision rather than a financing decision. Dan and Susan first contemplate – based on circumstances – whether it is more appropriate to buy a home or rent a home. That means considering whether their family is likely to expand (more kids) or contract (kids going off to college) in the next 5-10 years, whether the family might relocate to a different state or a different part of town over the next 5-10 years, and the costs of renting versus buying in their specific location.
Fast forward and assume that Dan and Susan evaluated circumstances and decided to buy a home. They now have to make an operating decision about allocating resources to this new home. The CFO says “we have $3,000/month in excess cash flow” and the CEO has to decide how much of this cash flow should go towards the home, how much towards retirement savings, how much towards college, how much towards vacations, or how much towards philanthropy. If coming at this from an operational perspective, Dan and Susan effectively need to decide how much money should be allocated or budgeted to each business line. Ultimately, this means deciding which family business lines are going to get cut and by how much to take on this new business line (buying a home).
And what happens if Dan and Susan elect to allocate the entire $3,000/month towards the mortgage (i.e. only view this as a financing decision of how much home they can afford)? They have inherently made an operating decision to discontinue or de-emphasize funding of their other business lines: retirement savings, college, vacations, philanthropy, etc. As with the business that decides to focus all R&D and marketing on one business line at the expense of all other lines, Dan and Susan are choosing to buy a bigger house at the expense of a delayed retirement, fewer family vacations, more limited college choices they will be able to afford, and cut-backs to other discretionary items in the future.
There’s another important point here – once Dan and Susan make the operating decision and buy this house, future financing decisions don’t change this operating decision. What does that mean? There is a pervasive myth that the way someone finances or does not finance a home changes their exposure to the home value. People think that if they have more equity in their home, they benefit more if the home appreciates in value. This is decidedly not true.
Assume that you own a home worth $500,000. If you have an extra $1,000 in the bank and you decide to use that money to pay down your mortgage, that decision does not change your net worth (you’ve simply moved reduced assets by $1,000 and reduced liabilities by $1,000). Paying down your mortgage also does not change your exposure to the home’s value (your home is still worth the same $500,000). If your house value increases by 10% to $550,000, your net worth increases by $50,000 whether you have a mortgage or not. Same if the home value decreases by 10%.
So when someone says “I have too much money tied up in my house” – that is an operating issue, not a financing issue. The only way to reduce that exposure is to downsize to a smaller home, not change how the home is financed. If Dan and Susan come upon an unexpected bonus and decide not to pay down their mortgage because they “already have too much exposure to the house”, they’re using misguided logic.
All of this is to say that we overwhelmingly tend to treat home purchases from the vantage of the financing decisions while not giving enough respect to the operating decisions. In contrast, we’d be better served by clearly separating these decisions.