Mortgage Paydown as Bond Allocation?

[Hyperborea]

I know the whole series of discussions on keeping a mortgage and investing versus paying it off. This is a sub-topic of that discussion that I didn't see discussed. Let's set up a scenario:

- person in accumulation phase for FIRE
- asset allocation has a set %age towards bonds
- home with mortgage & HELOC (which floats at P +/- some %)

Wouldn't it make sense to use the bond allocation money to paydown the mortgage? At least the floating HELOC which will cost more than the bonds will return? This of course assumes that some "reasonable" amount is kept available in bond/bond-like things.

 

[brewer12345]

I view my fixed rate mortgage as a large short position on the long end of the bond market.

I think it is rational to put your bond allocation into paying down the loans. The only reason I can think of for not doing so is if you can do a little tax arbitrage by paying tax deductible interest while receiving tax free or deferred interest inside a 401k or Roth.

 

[cute fuzzy bunny]

Wow, thats exactly what my bottom line point was in all of our "mortgage smiting".

Why keep 40%-60% of your money in a bond fund making 3-4% when you can pay off the bond you issued to the bank at (likely) a higher rate. Especially if you arent getting a huge writeoff from the mortgage interest.

Then with your withdrawal rate cut by 25-50%, you will pay less in taxes, and you can decide whether to maintain the resulting higher stock ratio (because you can take a lot more volatility with a lower withdrawal rate), shift it back to the original ratio, or make it even more conservative because you dont need as much money coming out of the portfolio.

The counter argument is that by taking the mortgage payoff money and putting it into stocks, that the historical return exceeds the mortgage rate.

Nobody ever attempted to explain why, with this configuration, you wouldnt also take lower yielding assets and pay off the mortgage as well.

Isnt that having your cake and eating it too?

 

[wabmester]

Could somebody explain how paying *down* a fixed-rate mortgage makes any sense?   Paying it off, I understand.   But paying it down doesn't reduce your monthly payments, and doesn't affect your interest rate.   You're effectively shortening your term without getting a better rate (which you would have if you simply started out with a shorter term).

So, why not pay the minimum on your mortgage, invest the amount you would have used to "pay down", and when you've accrued enough, pay it OFF?

 

[brewer12345]

Could somebody explain how paying *down* a fixed-rate mortgage makes any sense?   Paying it off, I understand.   But paying it down doesn't reduce your monthly payments, and doesn't affect your interest rate.   You're effectively shortening your term without getting a better rate (which you would have if you simply started out with a shorter term).

So, why not pay the minimum on your mortgage, invest the amount you would have used to "pay down", and when you've accrued enough, pay it OFF?

Hmmm, I hadn't thought about that. Personally, I took a 15 year mortgage in part because I knew that I would want to be done paying it off within that time frame and I liked getting a lower rate for it. partial payoff still works for an ARM, though.

 

[farmerEd]

Could somebody explain how paying *down* a fixed-rate mortgage makes any sense?   Paying it off, I understand.   But paying it down doesn't reduce your monthly payments, and doesn't affect your interest rate.   You're effectively shortening your term without getting a better rate (which you would have if you simply started out with a shorter term).

So, why not pay the minimum on your mortgage, invest the amount you would have used to "pay down", and when you've accrued enough, pay it OFF?

I guess the argument would be that there are very few, if any, places right now where you can get a *100% guaranteed* rate of return that exceeds even these low mortgage rates...paying off your mortgage, all at once or bit by bit, is a guaranteed return...sure you could invest the additional principal, but wouldn't it stink to have the money to payoff your mortgage and then lose 30-40-50% of it ins some investment gone wrong?

 

[Hyperborea]

I guess the argument would be that there are very few, if any, places right now where you can get a *100% guaranteed* rate of return that exceeds even these low mortgage rates...paying off your mortgage, all at once or bit by bit, is a guaranteed return...sure you could invest the additional principal, but wouldn't it stink to have the money to payoff your mortgage and then lose 30-40-50% of it ins some investment gone wrong?

It's not even that. It's that there is no bond/bond-like investment that beats paying down the mortgage/line of credit. If I'm going to have any asset allocation to bonds doesn't it make sense to reduce my "negative bond" before I build up my "positive bonds"?

Now if the argument is about whether to have or not to have bond allocation then that is a different discussion. Deciding to put the investment money allocated for equities into paying off the mortgage is equivalent to the how much bond allocation discussion.

My mortgage is an ARM but even in the worst case (it climbs the max amount at each adjustment - it's fixed for a number of years though) it will still be cheaper than a fixed rate mortgage for the duration that I will be in the house. However, we do have a HELOC (line of credit) that was used to allow us to purchase the house using a non-Jumbo loan. The rate is roughly comparable to what a 5 year CD returns. It seems that if I was to have any bond allocation I should use it to get rid of the HELOC.

As I understand it, the ARMs payments won't be reduced until a recalculation point. That means that on a 5/1 ARM you won't get a reduction until the first 5 year mark and then at yearly intervals if you make extra principal payments.

 

[johnblake]

This is consistent with the logic that I used to pay off my mortage. For me in didn't make sense to hold bonds paying less that what I was paying in interest.

 

[wabmester]

Maybe an example would help. Let's say you have a fixed-rate 5% 30-year mortgage. You decide to pay it down by $100K. Maybe you knocked 10 years off your maturity date, but your return on that $100K is 0% for the next 20 years! That's right; you don't magically get a 5% return on that money, you get zip.

Compare 0% with other yields, and even a money market starts looking good

 

[Hyperborea]

Maybe an example would help.    Let's say you have a fixed-rate 5% 30-year mortgage.    You decide to pay it down by $100K.    Maybe you knocked 10 years off your maturity date, but your return on that $100K is 0% for the next 20 years!  That's right; you don't magically get a 5% return on that money, you get zip.

I'm not going to grind it out but the return is not zero. If you make an extra principal payment then as you say the monthly payment will be the same but a smaller amount of it will be for interest and a larger amount towards the principal.

In the case of an ARM or a HELOC the amount that needs to be paid every month will change at the recalculation points. If you want to shorten the payment time you will need to continue to pay the same amount as before but to make extra principal payments.

 

[wabmester]

I'm not going to grind it out but the return is not zero.  If you make an extra principal payment then as you say the monthly payment will be the same but a smaller amount of it will be for interest and a larger amount towards the principal.

You're saying that the bank recalculates your amortization schedule everytime you make a payment? That's not my understanding, but it would be interesting if that could be confirmed.

In the case of an ARM or a HELOC the amount that needs to be paid every month will change at the recalculation points.  If you want to shorten the payment time you will need to continue to pay the same amount as before but to make extra principal payments.

Correct, it *might* make sense with a variable-rate, but these days those rates are so low, that I wouldn't be surprised if you could find a *safe* investment that would do better.

I just played the variable rate game with my CU. They gave me a 1.9% rate for a year, so I took it and invested it safely at 3%/year. Not a huge win, but I'll take all of the free money anybody wants to give me.

 

[farmerEd]

>>You're saying that the bank recalculates your amortization schedule everytime you make a payment?

Absolutely...how else are they going to keep track of your extra principal payments and when the loan is paid off?

The payment stays the same, but evertime you pay extra principal the next months regular payment allocates more money to principal and less to interest...the difference between the old interest allocation and the new interest allocation is your "earnings" on the extra principal you paid.

 

[Hyperborea]

You're saying that the bank recalculates your amortization schedule everytime you make a payment?   That's not my understanding, but it would be interesting if that could be confirmed.

Yes, that's exactly what I'm saying. One good place for mortgage information and calculators is "The Mortgage Professor", Jack Gutentag professor emeritus at Wharton. http://www.mtgprofessor.com/Default.htm

http://www.mtgprofessor.com/A - Amortization/how_do_amortized_mortgages_work.htm

When borrowers elect to increase the amount of their payment, the increment reduces the balance by the same amount. For example, if the borrower paid $699.56 on May 1, the balance would drop by an additional $100 to $99,700.38, which in turn would reduce the interest due in June to $498.51.

 

[cute fuzzy bunny]

Of course banks adjust the amoritization tables. Otherwise making principle only payments wouldnt have any effect.

Some banks dont let you do it though. Not many.

 

[Hyperborea]

Some banks dont let you do it though.  Not many.

IIRC you are allowed by law to make up to 10% principal repayment per year with no penalty.  A lender can stop you making more than that or may charge prepayment penalties but that should have been on the disclosure forms when you got the loan.

 

[wabmester]

OK, that makes sense. So, the effect is essentially the same as making a larger down-payment on the initial loan. If that's the case, your "return" should be the same as your mortgage interest rate, and the argument is reduced to the same as the pay-off debate, which has already been explored

 

[John Galt]

This is off topic a bit, but does relate to real estate debt.
Real estate can be bought for no money down, or at least nothing oop (out of pocket). Thus, your rate of return is
infinite. Leverage baby! Hard to beat, even if you have
cash to work with. Why tie it up if you don't have to?
There was a phrase from the 60s which described this:
"The creative non-use of cash."

John Galt

 

[sgeeeee]

I know the whole series of discussions on keeping a mortgage and investing versus paying it off.  This is a sub-topic of that discussion that I didn't see discussed.  Let's set up a scenario:

- person in accumulation phase for FIRE
- asset allocation has a set %age towards bonds
- home with mortgage & HELOC (which floats at P +/- some %)

Wouldn't it make sense to use the bond allocation money to paydown the mortgage?  At least the floating HELOC which will cost more than the bonds will return?  This of course assumes that some "reasonable" amount is kept available in bond/bond-like things.

Of course no one really knows in advance whether this kind of tradeoff will be a financial advantage in the long run or not. If you only have a few years left on the loan and the loan is several points higher than current bond rates, it's a pretty good bet that making additional payments will be the most advantageous thing to do.

Of course if your current loan rate is low and has at least a couple of decades left, the early payment will probably not ultimately be the best thing for you financially. Rates change and you may be trading a favorable payment this month for several years of lost payment advantage in the future. Although we can't answer the question of what the future holds, you can simulate the early payment effect using FIRECALC and see whether it would have been likely to pay off financially throughout history.

As wab stated, this is exactly equivalent to the mortgage payoff decision. And as in the mortgage payoff decision, people who feel more comfortable without a mortgage don't need to run the simulation to make the decision that is right for them.

 

[dm]

This is very timely for me. I have just sold some assets and I am having a hard time trying to decied if I should pay down my mortgage or just hold tight and see what happens to rates.

I plan on retireing next May. My loan is at 4 7/8% and I could pay off around 70% now, and the rest by my retirement date if I so choose. I have 12 yrs left on my mortgage. I look at paying it off as locking in 4 7/8% for this term.

I would look at this as a fixed income portion of my asset allocation. Of coarse the problem is getting the cash back out if the need arrises. I also toy with the idea of just buying something like I-bonds figuring rates are rising and odds are that even if rates stay low the spread would not be that great and look at it as insurance if rates were to go up from here.

My other thought is to just payoff the mortgage and continue to invest the former interest part of the payment.

Oh well, 8 months and counting. I'm 47 so I still want to be able to grow my net worth for awhile for a saftey measure. Thus I still want to be able to save in retirement.

 

[cute fuzzy bunny]

dm - do what I did. Get a home equity line of credit. Then you've made your home a liquid asset.

And once again, historic data simulations arent necessary. Hyperborea's original point is a good one. It makes no sense to maintain 300k-500k+ in bonds making 3-4% when you can use that money to pay off a 5-6% mortgage.

The rising rate argument also makes no sense to me. If you think rates and inflation will go up, the last thing you want to do is own bonds right now. Buy them after the rates/inflation surge has driven the NAVs dow with all that extra cash you'll have every month that isnt going into a mortgage payment. If rates and inflation dont go up, then you've made a 100% safe 5-6% on the money you used to make the payoff.

 

[sgeeeee]

. . .
I plan on retireing next May.  My loan is at 4 7/8% and I could pay off around 70% now, and the rest by my retirement date if I so choose.  I have 12 yrs left on my mortgage.  I look at paying it off as locking in 4 7/8% for this term.  

I would look at this as a fixed income portion of my asset allocation.  . . .

The 4 7/8% mortgage rate gives you some long term advantages to keeping your mortgage. But only 12 years remaining and your intent to only consider fixed allocations to offset the mortgage may offset any potential advantage.

Try running the FIRECALC simulations if you have any interest in what would have paid historically. You can use the options in FIRECALC to turn mortgage payments on and off at appropriate times and also include one time payments.

Of course the past may not be an indicator of the future. But then again, making decisions on mortgage rates that will apply for decades based on todays bond rates is a little like deciding your asset allocation based on what the stock market did today.

Good luck. Hope you make the right decision and retire wealthy early.