In the previous article we described how the down payment and the monthly cash flow can be used to build a financing program that serves the financial goal we set. We covered the situations where it makes sense to use a significant down payment (meaning more than the minimum required to get a mortgage). Now we'll continue through the different approaches and focus on the situations where we choose — or perhaps have no other choice but — to put in a low down payment.
The third quadrant: building a mortgage with a low down payment and a low monthly payment
The people in this quadrant are a study in contrasts. On the one hand, someone who plans a mortgage with a low down payment and a low monthly payment doesn't always do so by choice. This can happen when we buy a home that's almost too big for our means — that is, we're stretching our finances to the limit.
Of course it would be better (and more economical) to have bought a cheaper home. If that had been an option, we could have built in bigger safety margins — both on the down payment and on the monthly cash flow. But our choices aren't always driven by economics — and that's a good thing!
There's not much to discuss about the situation above, because for someone who takes out this mortgage, there's no other option. They could have avoided such an expensive deal in the first place, but once they committed to it, there's no going back.
So what we really want to discuss is the case where people with resources and options consciously choose this quadrant. Someone who opts for both a low down payment and a low monthly payment, when they could do otherwise, usually does so in one of several situations — and what they all share is the understanding that a larger down payment or a larger mortgage repayment won't add any economic value for the household; if anything, the opposite. We choose to take a mortgage because the gain from keeping the money outside the walls of the home outweighs the interest cost of the mortgage. To understand why that pays off, let's talk about return on equity.
What is return on equity, and how is it calculated?
Return on Equity (ROE) is a financial measure that expresses the ratio of net profit to the down payment invested. It's used to gauge how efficiently equity capital is put to work to generate profits.
You calculate it by summing all receipts and profits earned over a given period (usually one year) and dividing by the total existing equity capital.
Return on equity (Return on Equity - ROE) is a metric used to evaluate company performance, but it's just as relevant for households. You can use it, for example, to calculate the profit earned relative to the funds the family put in from its own capital.
An example of how return on equity is calculated
Suppose you bought a home worth 2,000,000 NIS, without a mortgage. You rent it out for 5,000 NIS per month, so total rental income is 60,000 NIS per year. 60,000 NIS on a property worth 2,000,000 NIS works out to a 3.0% return (we divided 60,000 by 2,000,000 and multiplied by 100 to get a percentage).
Now suppose we bought the same home, this time with a 1,000,000 NIS mortgage and a monthly payment of 5,000 NIS. Notice that the income from the home now cancels out the mortgage repayment. Not great, right?
But on the other hand, we have 1,000,000 NIS free. We decide to invest this capital now — in an investment vehicle generating a net return of 6% per year.
How do we now calculate the return on equity?
Our current cash flow is:
- Income of: 60,000 NIS from rental receipts
- Expenditure of: 60,000 NIS for mortgage payments.
- Profit of 60,000 NIS from investing 1,000,000 NIS at an annual return of 6%.
Our total cash flow is still 60,000 NIS on invested capital of 2,000,000 NIS — meaning we're still left with a 3% return on equity. So what did we actually accomplish here? Was this move worth it at all?
Which is better — with or without a mortgage?
They're different from each other, and each has its own pros and cons.
🏠Advantages of buying without a mortgage
When you buy a home without a mortgage, you get peace of mind (how great — no mortgage!), freedom from all the bureaucratic hassle (insurance, property appraisal, opening a file, a mortgage broker, and so on), and — almost most importantly — independence from how the investment of the other sum performs.
🏦Advantages of buying with a mortgage
- Boosting our return on equity by choosing an investment with a higher return. The math is simple: if we can earn a net return higher than the mortgage interest rate, then taking a mortgage pays off financially.
- We benefit from the liquidity and marketability of our money. If we need, say, 100,000 NIS in a hurry, we can pull it from our investment in the capital market. By contrast, getting money from the bank is very hard (and expensive) — that's a loan called a "general-purpose loan".
- Tax savings: if the capital earmarked for the home is already invested and earning attractive gains in the capital market, choosing a mortgage lets us save on capital gains tax.
- Diversification: every investment can fail. A share price can drop, a home can become uninhabitable, or a tenant can stop paying. Spreading our investments around (even if we put money into riskier channels) reduces volatility, and with it the risk of the investments we make.
So when does a person choose a mortgage with a low down payment and a low monthly payment? When they want to take advantage of the benefits of a mortgage described above. Here are a couple of examples:
The real-estate investor
Low rents relative to high housing prices drag down the return on equity. Investing 2,000,000 NIS for 60,000 NIS a year is a deal that, from a pure cash-flow standpoint, isn't profitable enough — and there are investment vehicles that deliver a higher cash flow, sometimes at lower risk: money market funds, bonds, dividend-distributing funds, and so on.
The main profit from holding a home comes from capital appreciation in its value. If we're buying the home as an investment, might there be a way to make that investment more profitable using a mortgage?
A real-estate investor buys investment property for the chance to benefit from the asset's appreciation, while leveraging the money at low risk. If a home was bought for 2,000,000 NIS and its price rose to 2,300,000 NIS after three years, we benefit from that appreciation whether we bought it without a mortgage or with a 1,000,000 NIS down payment and a 1,000,000 NIS mortgage.
The remaining capital we can invest in another property or in other income-producing investment vehicles. That way we benefit from diversification, reduce risk, and stay exposed to rising housing prices.
The financial investor
A financial investor looks at liquid investment vehicles such as shares, bonds, real estate, or mutual funds, aiming to increase their return on equity and manage risk wisely. Instead of locking all their money into the property, they keep a liquid portion of the capital and invest it in other channels (for example, the capital market) whose potential return is higher than the interest cost of the mortgage. That way they keep their liquidity — the ability to pull cash quickly if they need it — while spreading the risk across several different investments.