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Mortgage payment impact on Safe Withdrawal Rate (Math is hard :( )
Old 03-01-2015, 10:50 PM   #1
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Mortgage payment impact on Safe Withdrawal Rate (Math is hard :( )

Ok, I feel like an idiot but I've been trying to figure out what the right way to look at this is.

Here's the short version.
Current liquid assets (approx. 3.6M)
Current Mortgage: 686k
Monthly Expanses: 8k/mo (average over 2 years of tracking)
-I have the details in a "Hi I am..." post so I won't respam that here.

SWR 3% (assuming 10% tax rate) Monthly: 8100$

That cuts it a bit close, but about 4200$ is mortgage/tax.

If I pay off my house, it looks like this
Liquid assets: 2.9M
Mortgage 0
Monthly Expenses: 4800$ (about 1k of the mortgage is property tax)
SWR 3% Monthly: 6525$

That second scenario seems much safer? But this makes no sense to me.

My mortgage is 3.75% and I should be able to fairly confidently match that with a bogle-like index strategy over the next 28 years (time left on mortgage)

If I use FIRECalc to turn the remaining mortgage into my "portfolio" and put 4250 as my fixed, non-inflating costs, my success rate is around 58%. Of course, the liquid assets should be able to easily cover any volatility in the short-mid term.

I feel like I'm doing something stupid. The % math (7% market return > 3.75% mortgage, therefore don't pay off loan) seems to be violating the 3% SWR.

Psychologically speaking, I don't really have a huge positive thrill about being mortgage free because I have no trouble "segmenting off" the mortgage amount mentally. But when the 3% SWR gets so close to my monthly expenses... THAT makes me nervous.

PS. Not RE'd yet... but trying to build a specific plan for the next year or two.
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Old 03-01-2015, 11:17 PM   #2
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Uncertainty plays mean tricks.

You're exchanging portfolio risk for real-estate risk.

Also, SWR assumes that the amount increases by inflation each year. A big portion of your SWR is in nominal dollars.

I don't think there is a definitive mathematical solution to your dilemma. You'll just have to do what makes you more comfortable.

You could section out the mortgage amount into a virtual basket and take your SWR from the remaining amount - and hope that the virtual basket returns greater than 3% (actually, it will need to return less to break even) over 28 years.

It is the old "should I pay off the mortgage" question. Search and you'll find a number of threads on the question here and on bogleheads.
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Old 03-01-2015, 11:37 PM   #3
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Yeah I think you are dead on with the exchanging one risk for another. But I feel like my math is screwy and that's what I'm trying to figure out.


so here's what I did.


Using FIRECalc I put:
Portfolio: 3,400,000
Spending: 80K (just to be safe)
Then on the Other income/Spending Tab I put
Offchart Spending: 51,000 (4250/mo) starting in 2015


Result: 100% success
Range: 1,031,403 to $63,212,385, with an average of $13,166,254




Then I simulate paying off my mortgage:
Portfolio: $2,714,000 (-686000 for mortgage payoff)
Spending: 80k
Offchart Spending: 0


Result: 100% Success
Range: $1,457,686 to $60,378,133, with an average of $13,497,933


so on the lower bounds, It's about a 45% HIGHER return if I pay the mortgage off early vs. on the upper bounds it's a 5% LOWER return if I pay off early).


It seems like the risk/reward of not paying off early isn't very high but I guess this is because if I hit a worst case timing scenario, the fixed payment of the mortgage will eat away at lower investments whereas if I hit a best case scenario after 20-30 years the % benefit isn't that high?


Hermann
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Old 03-02-2015, 06:35 AM   #4
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You are discovering what a lot of people have discovered. If you have an adequate amount of money, it doesn't matter whether you pay off the mortgage or not.

No need to over-analyse it.

The risk of having a mortgage is that you'll not be able to make the monthly payments. That's it. Which means that if you have adequate money and/or income your risk is essentially zero.

The reward of having a mortgage is that -- over the long term -- you can invest the money and earn a higher rate than the mortgage costs you. So, you need to estimate the likely return you'll average over the lifetime of the mortgage. Do you think you'll be able to make more than 3.75% average over the next 15-20-30 years?

If you need something to make you comfortable, carve out a chunk of your $3.4M and call it your "paying the mortgage if the s-hits-the-fan" fund. Put, say, enough money for 2-3 years of mortgage payments in it, put it in something safe but liquid, like a CD or bond fund or T-bills.
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Old 03-02-2015, 06:46 AM   #5
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I think you have gotten good comments already. I agree with you that paying the mortgage off would not be necessary. I think that you'll be in a nice place with that large interest deduction as well, helping you achieve an even lower tax rate. Would be nice for Roth conversion etc.
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Old 03-02-2015, 06:50 AM   #6
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It seems to me that the real issue you have (perhaps without expressing it) is the size of the mortgage as compared to your liquid assets. That is a fairly high mortgage in comparison to your assets. Rates have not risen substantially yet. Why don't you simply refinance and pay down half of the mortgage. That way you cut your "concern" in half and still have half to invest.

I keep a very small mortgage (2.0%) of my liquid assets. I keep it for these reasons:

1. It is a 10 year mortgage with 7 years left at 2.83%.
2. I am not retired yet but in retirement I will be at a very high tax rate and the government will be paying 37% of the interest.
3. It is really the only loan I have so it supports a credit rating in case I ever want or need it.
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Old 03-02-2015, 07:35 AM   #7
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I will go back and read the other responses more carefully in a moment, but …

A mortgage requires cash flow to pay it. The difference between a 12 monthly payments in a year and none is not simply the money itself and the difference in the interest, but also how it affects one's Adjusted Gross Income. The money to pay the mortgage has to come from somewhere.

If withdrawing more or selling more shares or cashing in increases one's AGI and thus one's tax bracket, then the cost can be more than just simple numbers.

Conversely, if paying it off reduces cash-flow needs in future years and drops one into a lower tax bracket, then that can be a big deal, too.

Don't forget about tax credits that come and go with income levels. Also that 0% LTCG tax rate can be pretty attractive even if used only every other year.

As for the RISK where folks say a mortgage is less risk than equities, I say the mortgage is like an OPTION: You have the option to NOT pay off the mortgage when your investments might be doing poorly. You have the option to pay off your mortgage if your investments triple in one year. That option is worth something which adds value to keeping your mortgage.

So in summary: Keeping the mortgage gives you freedom to wait to cash in until your investments have done exceptionally well and the freedom to wait if your investments have done poorly. The cash flow needed to make mortgage payments affects your withdrawals and your tax bracket(s) and probably your health insurance, too. You do have to over analyze it.
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Old 03-02-2015, 07:55 AM   #8
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Here is a slightly different way to look at it. I am going to presume that your current residence is in a desirable and increasing in value location as opposed to neutral. If that assumption is not true then don't bother reading further.

So every year your equity increases to some degree. Every year you can assess whether to stay or go both in terms of your ability to pay the mortgage and in terms of the public evaluation of your location and hence your ability to cash out. And every year the percent of your overall assets that is the home goes down and hence your "exposure".

At any point you can bail if you decide you wish to downsize or move or sell out because the public evaluation of your location is slipping.
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Old 03-02-2015, 08:17 AM   #9
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I went back and read your Hi, I am post. If I was in your shoes I would make the move you talked about when you decide to quit working. So Cal real estate can be a real hot potato.

Find an area with good schools and less expensive housing and then lower or eliminate a mortgage payment entirely. Your kids are young that it will not really have a social impact on them. Even if you paid off your house sounds like you have a minimum of 12K a year in taxes and other costs.
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Old 03-02-2015, 10:24 AM   #10
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Quote:
Originally Posted by petershk View Post
...
Psychologically speaking, I don't really have a huge positive thrill about being mortgage free because I have no trouble "segmenting off" the mortgage amount mentally. But when the 3% SWR gets so close to my monthly expenses... THAT makes me nervous.
Why 3% SWR? You might want to take a look at the VPW calculator (see thread here and on Bogleheads) which will probably give you a higher SWR number.

I'm retired with a mortgage at 3.38%. No plans to pay it off. I count only the interest as an expense, not the principle payments. For us, the tax writeoff helps with our overall tax picture.
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Old 03-02-2015, 10:49 AM   #11
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I think perhaps where the math seems screwy to you is this... It's not really just 3.75% interest rate vs expected market returns. Your P&I cashflow obligation is $39K/yr, which is 5.7% of the $686K mortgage balance. That's obviously going to average-up your otherwise 2.0% WR ($58K/$2900K). With the mortgage, you're at 2.7% ($96K/$3600K). The low success rates you're getting from FIRECalc are based on fixed cash outflows, not interest expense.

From a technical accounting standpoint, the principal portion of your payment is neutral to net worth and only the interest is recorded as expense. But that certainly doesn't change the reality that principal is a cashflow obligation that must be met from portfolio withdrawals.

As long as your portfolio can survive the incremental risk along the way, it's hard to imagine a 60/40 portfolio failing to outperform a 3.75% mortgage over 28 years. But therein lies the essence of leverage, you trade-off some safety for potentially bigger parting gifts. I think you'll be fine either way, but I'd feel better about holding the mortgage if your rate started with a 2.

I paid off my mortgage at ER. The remaining balance was a small % of NW, and I was 21 years down a 30-year amortization table, where the annual P&I was nearly 15% of the mortgage balance. I saw no reason to put that kind of WR burden on my portfolio during the most vulnerable portion of ER.
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Old 03-02-2015, 10:54 AM   #12
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So in summary: Keeping the mortgage gives you freedom to wait to cash in until your investments have done exceptionally well and the freedom to wait if your investments have done poorly. The cash flow needed to make mortgage payments affects your withdrawals and your tax bracket(s) and probably your health insurance, too. You do have to over analyze it.
+1. I wouldn't let the FIRECalc "survival rate" influence me too much when comparing the two options--as you've identified, it can handled by segmenting off the portion of your portfolio needed to service the mortgage.
You'll need to do the math LOL suggests (income taxes, ACA subsidies, being able to take advantage of lower CG rates if income is lower, etc, etc). If they come out close to the same, I'd probably prefer to keep the mortgage and the flexibility/growth opportunity that the extra assets in the portfolio provides. You probably won't be able to get a mortgage like that after you retire, and the rates might not be this low again. So, it will be a one-way door: You can always pay it off, but you might not be able to go back that way again. But--first do the math.
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Old 03-02-2015, 02:15 PM   #13
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Originally Posted by petershk View Post
...
so here's what I did.


Using FIRECalc I put:
Portfolio: 3,400,000
Spending: 80K (just to be safe)
Then on the Other income/Spending Tab I put
Offchart Spending: 51,000 (4250/mo) starting in 2015


Result: 100% success
Range: 1,031,403 to $63,212,385, with an average of $13,166,254



Then I simulate paying off my mortgage:
Portfolio: $2,714,000 (-686000 for mortgage payoff)
Spending: 80k
Offchart Spending: 0


Result: 100% Success
Range: $1,457,686 to $60,378,133, with an average of $13,497,933

....

Hermann
Somethings were not clear to me:

A) were you careful to specify the Offchart Spending aa non-inflation adjusted (mortgage payments are fixed)

and...

B) Did you offset the mortgage Offchart Spending with an equal Offchart Income at the end of the mortgage (the income will zero out the payment)?

C) How many years are you modeling?

For example, if you model 30 years and have 30 years on this mortgage, you never 'see' the benefit of it ending. I see on the other post you are about 40 years old, so you need to model something longer than 30 years. But be careful going above ~ 45 years, due to the nature of historical analysis it needs to start dropping off runs starting less than 45 years ago (it won't have the full 45 years), and that can drop off bad starting years. I just add a year at a time until the SWR starts to improve, and figure I've hit something near diminishing returns at that point.

FWIW, I'm in the same boat as some others here - pay it off or not is not a big deal, and with a decent rate the flexibility of the larger nest-egg, and inflation hedge of a fixed payment is probably to your advantage.

-ERD50
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Old 03-02-2015, 03:32 PM   #14
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so on the lower bounds, It's about a 45% HIGHER return if I pay the mortgage off early vs. on the upper bounds it's a 5% LOWER return if I pay off early).

It seems like the risk/reward of not paying off early isn't very high but I guess this is because if I hit a worst case timing scenario, the fixed payment of the mortgage will eat away at lower investments whereas if I hit a best case scenario after 20-30 years the % benefit isn't that high?
I think that sums it up pretty well. The mortgage gives you the opportunity to borrow money at 3.75% and put it in the stock market. If the market does well, this loan allows you to finish with more money. If it does poorly, you'll end up with less.

You didn't mention asset allocation. It might be worth a little time to think about the nominal yield on any bonds you have today and compare that to the 3.75%.
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Old 03-05-2015, 02:21 PM   #15
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+1 here carrying 3.375% mortgage. The way I figure it if I can't beat that rate with my investments then having a mortgage will be least of my worries.
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Old 03-05-2015, 09:25 PM   #16
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I'm in very close to the exact same situation, but here's the rub for me. I don't hold my mortgage up against investing into my 60/40 asset allocation. I'm considering shifting money from my low yielding fixed income assets and instead holding the house equity. My mortgage is 3.625% and none of my FI is making that.

The question for me is what will the next 27 years (time left on my 240k mortgage) hold for fixed income. I'd like to hope that FI returns will catch up, but it's hard to be sitting on 1.2mm in FI averaging about 1.8-2% and paying twice that on the mortgage I could pay off tomorrow.

You are all probably right that it doesn't matter but it does seem wasteful at least in the near term.
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Old 03-05-2015, 09:57 PM   #17
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Did you change your AA when you got your mortgage? Would you change it if you paid off your mortgage? If no the your portfolio rate is the rate to use.

In my case the proceeds from my refi went into my taxable accounts and I rebalance so to me it is all one big pot (but I would like it bigger)
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Old 03-05-2015, 10:47 PM   #18
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Hi pb4uski,

I don't want hijack petershk question but it's possibly our situation are similar. So all this applies to me personally. My portfolio is 98% in taxable space. I feel less inclined to sell equities generating a capital gain to pay off my mortgage. I have enough bond funds with practically no capital gain. If you view your mortgage as a negative bond then you could argue I should sell some of some actual bonds to payoff the mortgage. I would theoretically come out ahead. I'd be trading the 1.8% bond fund for a guaranteed 3.625% return from the mortgage payoff.

This is different than someone who is redirecting current income toward their asset allocation instead of paying down their mortgage. I'd be selling the most logical and best matched (but underperforming) asset to replace it similar one. I wondered if petershk might be facing the same decision.
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Old 03-06-2015, 07:20 PM   #19
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WE found that it was just easier to pay it off & be done with it.
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Old 03-06-2015, 07:29 PM   #20
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WE found that it was just easier to pay it off & be done with it.
Mine's on auto-deduct, I find it easier to just keep doing nothing than to go though the 'work' of paying it off. But then again, I'm at sub 3%.

-ERD50
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