HOW A MORTGAGE TRANSFORMS YOUR INVESTMENT PORTFOLIO / THE ECONOMIST

How a mortgage transforms your investment portfolio

They turn retail savers into hedge-fund managers

As financial decisions go, borrowing several times your annual earnings to buy a risky asset is a pretty big one. 

Yet for many people, taking out a mortgage to buy a house is something of a no-brainer. 

It generally involves less agonising than, say, how much to save for retirement, or how to split your pot between cash, stocks and bonds.

One reason is that, some short-lived slumps aside, house prices across the rich world have been buoyant since the 1950s. 

More important, you need to live somewhere. 

Until you own a place, you have a natural short position in property, because you need to inhabit one for the rest of your life (whether you rent or eventually buy). 

Short positions are risky (who knows how far rents and prices might rise?). 

Buying a home closes the position, resulting in a neutral one; unlike other investments, it is not really a bet on where prices are headed. 

The mortgage is an unfortunate necessity for those who lack the cash to buy outright, rather than a deliberate punt on the future path of interest rates.

Thinking about a mortgage as a component in the borrower’s investment portfolio might therefore seem odd. 

It should not. 

After all, a fixed-rate mortgage looks rather like a bond, while one with a floating rate resembles the sort of corporate loan often extended by banks and private-credit funds. 

In other words, the mortgage-laden investor has not only closed their natural short exposure to property. 

They have also opened a new short position in an asset similar to those that, elsewhere, they may hold long positions in. 

In many cases—think of most first-time buyers—it will be the investor’s biggest position by far, offsetting any opposing ones and then some. 

Taking out a mortgage can transform your portfolio.

Fixed-rate mortgages can alter a portfolio’s value the most. 

Borrowers are accustomed to seeing just the outstanding balance, which climbs as interest accrues and declines with repayments. 

But the mortgage’s true value changes in the same way as that of a bond: it rises when market interest rates fall (meaning the borrower loses out) and vice versa.

This seems counterintuitive when the interest and repayments are fixed. 

It happens because, though future repayments stay constant when interest rates change, their value in the present does not—which illustrates a concept known as the “time value” of money. 

The promise of $1 in a year’s time is worth less than $1 today, since today the dollar can be deposited in a bank account and earn a year’s interest. 

Conversely, if interest rates fall, a commitment to pay a series of fixed sums in the future, as in a fixed-rate mortgage, becomes a bigger liability today. 

This is also why the market prices of bonds rise when interest rates fall.

By similar reasoning, though a floating-rate mortgage carries the risk of rising repayments, these do not change the portfolio’s value. 

If interest rates climb, future repayments climb with them. 

At the same time, the present value of each future dollar falls by the same amount. 

The trade-off is that the investor must find the cash to meet higher repayments—perhaps by eating into returns from the rest of the portfolio.

Where does this leave the borrower’s broader portfolio? 

The short position created by a fixed-rate mortgage can dramatically change an investor’s overall exposure. 

If their savings follow the classic 60/40 split between stocks and bonds, for instance, but they have a fixed-rate mortgage worth 20% of their savings, their “true” allocation is more like 60/20. 

This effect is reduced by quirks of individual markets, such as America’s and Denmark’s, which generally allow borrowers to repay mortgages early without a penalty if rates have moved against them (since this makes their debt less bond-like).

For investors whose mortgages are large compared with their savings—think again of first-time buyers—the effect is far greater. 

If the short position created by a fixed-rate mortgage is bigger than the value of your savings, for instance, you cannot have a net positive exposure to bonds, however many you buy. 

Instead, your portfolio will look rather like those of the more daring hedge funds: leveraged to the hilt on one side, and long stocks and their outsize returns on the other. 

This is a cheery way of looking at things. 

Unlike the hedge fund, a stockmarket crash will not make you bust, since the debt is secured against your house, not your shares. 

Perhaps being saddled with a mortgage is not so bad, after all.