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Re: Pay off mortgage early ?
Old 01-17-2004, 12:04 PM   #41
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Re: Pay off mortgage early ?

Well, the Enron perps can hang photos of their nice estates on their prison cell walls.

Thankfully, I only owned Enron stock one time...when I bought it for about 50c just prior to bankruptcy and sold it a couple of days later for 70-something cents. Funny how drawing a paycheck allows for making riskier play-investing decisions...

I was sitting in the doctors office for a physical about 20-22 months or so ago. Of course they had the obligatory nearly year old magazines, including some financial rag that was published just before the bubble went pop. I laughed and laughed reading the stories about how you just "MUST OWN ENRON AND WORLDCOM, EVEN AT THESE PRICES...THESE BABIES STILL HAVE A LOT OF ROOM TO GO UP!!! BUY NOW!!!!". Not to mention thoughtful analysis on why internet stocks really do make sense and should be a core holding.

The house asset item is a real benefit and one I frankly hadnt thought of. While cash and investments can be seized or garnished for a variety of sins and ailments, the home is usually considered sacrosanct.
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Re: Pay off mortgage early ?
Old 01-18-2004, 06:24 AM   #42
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Re: Pay off mortgage early ?

Quote:
I believe you'll find that the simulation is a valid simulation for a legitimate situation. *It does overestimate the value of paying off the mortgage for a couple of reasons, but provides a worst case analysis for *that situation. *You may have simply misinterpreted the simulation. *
This isn't by any means the first time that I have seen a "proof" of something that was based on a completely unrealistic assumption, i.e., that a borrower can take out a mortgage for which the lender will pay THEM interest. A reasonable assumption is that the interest rate on the mortgage would be 5%, which means that the annual payment required to retire a $100,000 balance over 10 years would be $12,700 per year, and not $6,440 per year. (The latter is the annual payment required to amortize $100,000 over 30 years!)

Running the FIRECalc analysis using the correct annual mortgage payment demonstrates that a person's probablity of sustaining any particular withdrawal rate is higher if they pay off the mortgage than if they invest the $100,000 and continue making mortgage payments for 10 years.
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Re: Pay off mortgage early ?
Old 01-18-2004, 10:40 AM   #43
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Re: Pay off mortgage early ?

Quote:
A reasonable assumption is that the interest rate on the mortgage would be 5%, which means that the annual payment required to retire a $100,000 balance over 10 years would be $12,700 per year, and not $6,440 per year. *(The latter is the annual payment required to amortize $100,000 over 30 years!)
Err, I believe that SG's reasonable assumption was that you had 10 years left on a 30-year mortgage, not that you got a 10-year loan that paid you interest

Quote:
PLEASE, tell me it isn't intuitively obvious that unless the interest rate on the mortgage(edit: after tax?) is less than the SWR, then it's 'riskier' to have a mortgage than to pay it off.
Hmm? There's no correlation to the SWR and your mortgage rate. What you want to compare is your mortgage rate and expected long-term investment return. And you always have the option of paying off the mortgage if you feel the odds are against you.

Another way to play the game is to invest at your usual asset mix initially, but if/when "safe" interest rates rise above your mortgage rate, then go safe and just take the difference between new riskless return and your old mortgage which you were shrewd enough to get when loan rates were at historic lows.
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Re: Pay off mortgage early ?
Old 01-18-2004, 11:52 AM   #44
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Re: Pay off mortgage early ?

Oh, you're right about the mistaken payment amount in the example. However, I ran the numbers for my own payment and balance and FIREcalc gave me an 80% chance of investment returns outpacing mortgage payments.

SWR assumes inflation-adjusted withdrawls. Mortgage payments and rates are fixed, so you only need a nominal return greater than your mortgage, not a real return implicit in the SWR.

If you don't trust FIREcalc's historical return data to tell you if you can beat a 5% nominal return, why would you trust it to tell you that you can safely withdraw 4%?

In any case, I agree that you should do whatever your heart and the numbers tell you to do. No different than any other decision....
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Re: Pay off mortgage early ?
Old 01-18-2004, 09:14 PM   #45
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Re: Pay off mortgage early ?

Here is how you can simulate your own mortgage situation to see what your odds are of coming out ahead by paying off your mortgage. I took this example for a personal choice I had to make a few years ago. Should I buy my new home outright or get a loan. I was considering a 5.25% loan for $149,500 with 30 year duration. Below, I tabulate the inputs into FIRECALC for this situation and list and discuss the outputs. Your milage may vary.

FIRECALC Simulation to analyze risk/reward for paying off your loan: this example is specific to my situation. You can easily personalize for your own situation.

Withdrawals: $9907 (annual payments on 5.25%, 30 year loan)
Starting Portfolio: $149,500 (loan amount)
Lifespan of portfolio: 30 years (duration of loan)
percent of portfolio in stocks: 60% (specific to your portfolio)
where is the rest of investments: TIPS (specific to your portfolio)
Annual investment expenses: 0.2 (specific to your portfolio)
inflation estimate: None (since loan payments are fixed)
Check first year withdrawal box (loan payments begin immediately)

FIRECALC results:

We looked at the 101 possible 30 year periods from 1871 until 2002, and the 30 partial periods from 1972 until 2002, starting with a portfolio of $149,500 and taking out $9,907 the first year, and the same amount after adjustments for inflation (no inflation adjustment applied) each year .


Your Success Rate is 78.8%
==========================
The success rate represents your historical probability of coming out ahead by continuing to make regular payments on the loan rather than paying it off. In reality, this number may underestimate your odds since it does not account for the tax benefits of keeping the loan. The tax benefits can be significant in early years.

Details: The simulator shows that if you only consider data after 1894, your probability of success is better than 90%. Only twice since that time would the choice to keep making payments not have resulted in a financial gain over choosing the payoff -- Once in 1906 and a second time related to the great depression in the years 1926 - 1931. The 1906 case missed beating the payoff option by a total of $1813 (so with tax advantage, it too would probably have been a better choice).
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Re: Pay off mortgage early ?
Old 01-18-2004, 09:45 PM   #46
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Re: Pay off mortgage early ?

I found some additional analysis I did on this topic when I was making the loan vs payoff decision. I put together a spreadsheet that evaluated annual payments (principle and interest) then computed the tax advantage due to interest payments. The net actual cost was then subtracted from the unspent loan value and I applied my personal annual rate of return to that value. I looked at how I would have faired had I taken a 5.25% loan at the beginning of any of the last 10 years. I assumed a 20% tax rate. (Actually I played with that as a variable, but 20% is a number that probably underestimates my actual tax rate in Arizona in retirement by a small amount) Just for you guys, I have added the last couple of years to those spreadsheets so I could present a more complete story.

The worst case occured had I chosen to take this loan at the beginning of 2000. For that situation, I would now need to make an annual return on my investments of about 7% for the next 26 years in order to make the loan choice beat the payoff choice. That's the only case that I thought was marginal. Every other year looked like a no-brainer to me.

Next worse is to have taken the loan in 2001. To beat the payoff option, I would need to achieve an annual return on investment of 5.75% over the next 27 years.

Results of taking the 5.25% loan during other years:

YEAR REQUIRED ROR TO BEAT PAYOFF OPTION
2003 2.94%
2002 4.25%
2001 5.75%
2000 7.04%
1999 5.16%
1998 3.89%
1997 2.15%
1996 0.9%
1995 -1.49%
.
.
.

In case you are wondering, here is the personal rate of return I used which is calculated by Money. It represents what I earned on my overall portfolio for each year. Stock options and company investment plan constraints had a major effect on my performance, but I don't think these numbers are too far out of line for a more typical portfolio.

Year personal annual % return
1990 7.52%
1991 20.20%
1992 7.61%
1993 17.13%
1994 4.17%
1995 23.36%
1996 13.50%
1997 18.05%
1998 14.34%
1999 19.39%
2000 -4.63%
2001 -8.68%
2002 -9.70%
2003 22.19%

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Re: Pay off mortgage early ?
Old 01-19-2004, 05:54 AM   #47
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Re: Pay off mortgage early ?

Here are the specific results of analyzing this example with FIRECalc, using Salaryguru's original assumption of a person with $1 million net worth deciding whether or not to pay off a mortgage at 5% interest with 10 years remaining. *Per Salaryguru's original assumption, the $1 million is invested 75% in stocks and 25% in commercial paper, and so is the $100,000 if it is not used to immediately pay off the mortgage. *But I will use a higher withdrawal rate that will not result both scenarios having a "100% probability of success," because that result masks the true differences in the riskiness of the respective strategies.

Case 1: *Pay off mortgage. *Invest $1 million. *Initial withdrawal rate $50,000 per year, increasing with inflation. *Probability of success: 88.6% *Mean remaning balance: $2.75 million.

Case 2: *Pay off mortgage over 10 years. *Invest $1.1 million. *Initial withdrawal rate $50,000 per year, increasing with inflation, plus $12,700 per year for 10 years to pay off mortgage. *Probability of success: 88.6%. *Mean remaining balance: $2.95 million.

(NOTE: To do this in FIRECalc is a bit tricky because the $50,000 increases with inflation, but the $12,700 doesn't. This post is revised to reflect that, and makes the outcome of Case 2 more attractive. However, the outcomes are essentially equal.)


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Re: Pay off mortgage early ?
Old 01-19-2004, 09:19 AM   #48
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Re: Pay off mortgage early ?

While not a major slam dunk, here's a conservative approach:

Take the money you would have used to payoff your mortgage and stick it in a federally insured 5.5% 7-year CD at PenFed. After seven years, look around for a better rate. If you can't find one, pay off your remaining balance.

I actually took this one step further. I got a HELOC at PenFed with a 1-year teaser rate of 1.9% and put that money into various safe short-term instruments that yield just shy of 3%. After one year, I plan to pay down the HELOC, but keep the credit line open as a disaster fund.
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Re: Pay off mortgage early ?
Old 01-19-2004, 09:44 AM   #49
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Re: Pay off mortgage early ?

Quote:
A couple thoughts: *Just how many of the last 10/20/30 years would obtaining a fixed 5% or 5.25% mortgage (after expenses) been possible? *If one used the "real" expense adjusted mortgage rates for those years what would the results look like?? *
Although that may be an interesting question, it is not the question at hand. I personnaly don't care what the odds of finding a low interst loan was at some time in the past, I care about whether I am likely to do well by keeping the loan that is possible for me to get today. The strategy of keeping your 13% loan from 1985 is probably a poor one, but the question is, if you hold a 5% or 5.25% loan, what is the best strategy.


Quote:
As far as "tax advantage", since cap gains, dividends, and interest earned would all be taxed, it could be more tax advantaged to pay off the mortgage, if you're NOT able to deduct 100% of all mortgage interest. * For me Less than half the interest would be deductible and that would decrease as the std deduction continues to rise and annual mortgage interest decreases. * While nearly all the investment proceeds would be eventually taxed.
That may be for your case. That's why you should run your own numbers. Of course the FIRECALC analysis does not include any tax advantage or disadvantage. If you bother to run those simulations and look at the results, you can see that the tax difference is not likely to make a big affect on the conclusions. *It could in a few of the cases.

In the spreadsheet analysis I did originally, I eventually plugged in my actual tax estimates which included my working tax bracket in the first two years of the loan and then dropped to my retirement tax bracket estimates for the remainder. Since that was very specific to me, I did not include the results from those simulations in the post above. Because I was actually in a very high tax bracket for the first two years of the loan (when interest payments are high), it made the analysis even more favorable toward keeping the loan than the results I presented. But as I have said countless times, you need to run numbers specific to you yourself. The tax advantage will be small for most people, but not necesarily insignificant. And as you point out, there may be cases where it is a tax disadvantage -- certainly not for me.

Quote:
I'm still NOT convinced there is any slam dunk here and the 80% chance of succes may well be based on some fairly faulty assumptions. *
I have not heard anyone suggest that it is a slam dunk. What I've said so many times that I can bearly stand to repeat is that people should run the numbers for their case. I've given instructions on how to do that fairly accurately and simply using FIRECALC (but neglecting tax advantage/disadvantage). And I've described some spreadsheet analysis that is not too difficult to do on your own that would allow you to put in specifics of your tax situation.

At this point, I certainly don't expect (or care) to convince anyone on this board that choosing not to pay off your mortgage is a good idea. Please pay it off and we will never discuss it again. I am more than $30,000 ahead today because of my own choice and I have significant probability to gain far more than that over then next 2-3 decades. That will be my reward for doing the analysis myself.

As far as faulty assumptions go, I haven't heard any specific faulty assumptions discussed as they relate to my analysis of my own situation.
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Re: Pay off mortgage early ?
Old 01-19-2004, 01:36 PM   #50
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Re: Pay off mortgage early ?

Quote:
MOST HELOCs have some additional costs (appraisal & recording fees etc) which could eat into that 'massive' ~1% advantage--not to mention taxes.*
In my case, I opened the HELOC as part of a refi before I retired a couple years ago. There were no upfront fees, no annual fee, and no appraisal required if you had an appraisal that was less than 1-year old I believe.

I had already paid the HELOC off, and they sent me an offer with a 1-year 1.9% teaser if I started using it again. So, I figured why not -- if anybody wants to pay me $1000 for taking out a loan I don't need, I'll take the money. (And the interest is tax deductible to boot.)

Now, the 1% I'm making from arbitrage is actually on the low side. I could have bought another rung on a bond or CD ladder that would have paid approx 5%, and then paid off the loan when a lower rung on the ladder matured. All about as risk free as you can get.
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Re: Pay off mortgage early ?
Old 01-19-2004, 02:13 PM   #51
 
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Re: Pay off mortgage early ?

Hello wabmester! It's like I said before. If it's raining
money, find the biggest bucket you can and run outside.

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Re: Pay off mortgage early ?
Old 01-19-2004, 02:33 PM   #52
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Re: Pay off mortgage early ?

Quote:
I would say the assumption that future performance can be predicted by past perfomance is a fairly faulty assumption. *Every fund I've ever seen has included that as a disclaimer. *
You are absolutely correct. Based on that, of course, no analysis FIRECALC can offer is valid. In fact, there is really no analysis you can do that would be unarguably meaningful.

Quote:
While you may be up 30k with your decision, MY decision not to borrow at the markets peak has 'earned' me at least double that. *Are we near another market top? *Who knows? * If we are, your 30k advantage may be temporary. *
True, I could lose my advantage over the next several decades. But, of course, I could always pay off my mortgage tomorrow and lock in the gains. Those who have already paid off their mortgage do not have an analogous option if I keep running up the gains.

Of course your statement that your choice not to borrow in market peaks is meaningless bravado. You couldn't possibly know when market peaks hit till after they have passed, so you could not have decided a priori not to borrow durring them. Also, the statement is a little like saying I made $500,000 today. I decided not to invest that money in company XYZ and they went bankrupt. But if it makes you happy to think in those terms, enjoy those thoughts.

Quote:
The fact mortgage rates are at historic lows reflect an expectation future returns will be lower than those in the past. *Those historic higher mortgage rates reflected a belief that future returns then would be higher. *Using today's mortgage rates in yesteryear's investment climate to conclude anything is definitely faulty analysis. *It may work out for you and if it does I congratulate you on your good fortune. *
Yes, and none of us know what those "lower" returns than in the past might be over the next several decades. I have heard some of the more successful investors suggest returns of 6% to 8% as reasonable guesses over the next decade. That would put me in very good shape. If we see a market that acts like that of the Great Depression, I may be retreating from this strategy in a few years. I have enough financial cusion to absorb it. If we see a market worse than the Great Depression, we may all be in trouble.
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Re: Pay off mortgage early ?
Old 01-19-2004, 03:23 PM   #53
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Re: Pay off mortgage early ?

Goodness I think I may have to go into the clothes closet and look for that white shirt with the thick vertical black stripes on it, along with my whistle...

I think its safe to say that in an average 30 year period, the chances of making a better return on a lump of cash while investing in instruments having a similar risk factor to a mortgage (uh, treasuries and what else?) is not so good.

If investing in riskier instruments, then certainly one can do better.

If you already paid through more than half your mortgage, as many people have, then the remaining interest isnt too interesting to avoid and one can most likely do better investing than paying off.

As pointed out, one cannot see into the future and it all may go to hell in a handbasket, but as likely as not, the next 30 years should have a lot in common with the last 30 years...more or less. We've certainly had a little bit of everything.

However, its also worthwhile to note the other perspectives of being able to take more risk in ones investments having "bought back the bond" of their mortgage (I dont have to worry about losing the house), or being able to accept less risk in ones portfolio because they have smaller monthly payments (I dont need as much money thrown off monthly, so why take that risk?).

For me, it was worthwhile for the latter reason. I dont need to take as much risk because I dont need to make the mortgage payment every month, and conversely I need to keep less cash buffer on hand in case I experience a topsy turvy time in the markets.

And while it was also pointed out that someone who hasnt paid off can always do so, its also possible for me to take out another mortgage at any time, or draw from my HELOC if needed.

I sleep good. If you sleep good with your decisions, and believe me I think we've covered every perspective, analysis and piece of data needed for anyone to make a decision, then your decision is equally good.
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Re: Pay off mortgage early ?
Old 01-19-2004, 07:21 PM   #54
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Re: Pay off mortgage early ?

Reducing Risk: I haven't ever heard others on this board discussing making their portfolio more aggressive after paying off their mortgage, but if risk is what drives your mortgage decisions, that would seem the reasonable thing to do. Alternatively, you could keep a mortgage and reduce your equity/fixed allocation to reduce risk. Using the example from before, here is how that might affect your probability of gaining financially:

EQU/FIXED PROBABILITY OF
RATIO BEATING PAYOFF RESULTS
80/20 78.8%
70/30 78.8%
60/40 78.8%
50/50 76.5%
40/60 72.0%
30/70 70.5%

Again, the assumptions are:
Withdrawals: $9907 (annual payments on 5.25%, 30 year loan)
Starting Portfolio: $149,500 (loan amount)
Lifespan of portfolio: 30 years (duration of loan)
percent of portfolio in stocks: 60% (specific to your portfolio)
where is the rest of investments: TIPS (specific to your portfolio)
Annual investment expenses: 0.2 (specific to your portfolio)
inflation estimate: None (since loan payments are fixed)
Check first year withdrawal box (loan payments begin immediately)

So if you want to make a high probability investment and reduce your risk, the odds are still with most investors. This strategy won't work for John Galt. John made the right choice for his investment strategy.
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Re: Pay off mortgage early ?
Old 01-19-2004, 09:05 PM   #55
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Re: Pay off mortgage early ?

Ok, here are a couple of different thoughts on this issue. Would you consider holding a 5% mortgage an inflation (or hyper-inflation) hedge? If inflation really shoots up, which the financial markets have not priced in currently, then having the mortgage money in the bank earning 10% would feel real good. As some have said - hold it for a few years and see what happens.

On the risk side, I would say I'm off the wrong end of the safety scale. I had the opportunity to pay off the mortgage a year ago, but took the money and put it down on a 20 unit apartment building. It looks to make me about 18k tax sheltered per year, more whenever the economy picks up a little. With that, and maybe some increase in real estate prices over the next 10 years, I should be in good shape. Without it, another bear year would have had me worried, so I guess I am taking more risk early on, to build up my portfolio to the point I am comfortable at. Do the others who favor a mortgage also feel that their net worth is 'borderline' for retirement, and therefore, either conciously or unconciously, favor the extra risk/return?

On the lower risk side, we do have enough equity in our house, to move to a smaller house and have it paid for, which we will do at some point. With two teenage daughters, I am not ready to move back to a 1-bathroom house yet!

Wayne
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Re: Pay off mortgage early ?
Old 01-19-2004, 10:00 PM   #56
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Re: Pay off mortgage early ?

On the portfolio size, I felt more than comfortable that I'd make it with or without paying off the mortgages...in my case I paid mine, my parents, and my fiancees off. I did about 5 minutes thought on the benefits of investing the money, but given that was 18 months into the recent 3 year bear market, and given my published thoughts about market over valuation, I didnt think too hard about keeping the money and investing it.

I summed it up by thinking..."heck, if it all goes to hell in a handbasket and somehow I lose most or all of my investments, I can pull part time at the quick-e mart and still pay the bills."

Tell ya what though...if the market lost 25% or more of its value due to some crisis or other major event, and I was happy with where my current investments are, I might think very hard about pulling 100k out of my HELOC at 4% and laying that out there. I've got the assets to cover it if needed, and in the middle of a minor disaster I doubt the fed would be jerking up the rates to affect that 4% any time soon.

In the meanwhile my fiancee pushed the money she was paying on her mortgage into increasing her retirement plan deductions, so when she retires we'll have a pretty nice nestegg to work with. And my dad said he wont have to sell any of his savings bonds for a couple of years, the Social Security is more than covering expenses. I know he went to sleep a few times a week wondering if the money was going to last. Now I know he probably doesnt do that anymore.

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Re: Pay off mortgage early ?
Old 01-20-2004, 03:22 AM   #57
 
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Re: Pay off mortgage early ?

We've been in this house 2 years and 6 months. Paid cash and
happy with that. I have a couple of things holding me
back from any temptation to get a HELOC. For one thing,
we are in a flood plain, so most any lender would require flood insurance whcih we opt not to carry.
However, I have never been so fond of where my money was invested that I would borrow on the house
to avoid moving my invested cash. I have thought about
"pulling hours at the QUIK MART" if things got really
sticky. Hopefully that won't be necessary.

John Galt
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Re: Pay off mortgage early ?
Old 01-20-2004, 06:08 AM   #58
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Re: Pay off mortgage early ?

Quote:
*Alternatively, you could keep a mortgage and reduce your equity/fixed allocation to reduce risk. *Using the example from before, here is how that might affect your probability of gaining financially:

EQU/FIXED * * * PROBABILITY OF
RATIO * * * * * * * BEATING PAYOFF RESULTS
80/20 * * * * * * *78.8%
70/30 * * * * * * *78.8%
60/40 * * * * * * *78.8%
50/50 * * * * * * *76.5%
40/60 * * * * * * *72.0%
30/70 * * * * * * *70.5%

So if you want to make a high probability investment and reduce your risk, the odds are still with most investors.
Given that the expected (most probable) return on stocks (at least based on historical data) is about 10.5% per year, and that the expected return on TIPs is about 5.5% per year, it stands to reason that the gain on a portfolio consisting of stocks and TIPs will probably exceed the payments on a 5.25% mortgage. The longer the holding period that is considered, the higher the probability will be. So for a person who is accumulating wealth, having a mortgage at 5.25% and investing the principal in stocks and TIPs is a "good bet."

But retirees face a different situation. Presumably, most retirees are attempting to maximize the probability that they will successfully sustain a particular withdrawal rate over a particular number of years. In general, they are not trying to maximize their "most probable" wealth when they die. Because of this, and the fact that most retirees would be approaching the mortgage/investment choice with a time horizon of perhaps only 5 to 10 years, the option of keeping the mortgage and investing the principal would either reduce or at least not significantly increase their probability of sustaining a particular withdrawal rate. This is because of the risk that the investments might either lose value, or not gain enough to equal the interest payments on the mortgage.
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Re: Pay off mortgage early ?
Old 01-20-2004, 06:20 AM   #59
 
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Re: Pay off mortgage early ?

Good morning salaryguru. Excellent post!

Like many others, I have pondered this issue a great
deal. Several reasons I remain in a paid off mode on the house (mostly psychological). The "time horizon"
you mention is a big one. I always assume
(obviously I hope I'm wrong) that my time horizon is very short. This is another "given", along with my no-stocks portfolio which simplifies my investment
decisions. I'm already thinking about money 24/7,
so taking a few possibilities off the table helps me to remain
functionally lucid.

John Galt
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Re: Pay off mortgage early ?
Old 01-20-2004, 07:33 AM   #60
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Re: Pay off mortgage early ?

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But retirees face a different situation. Presumably, most retirees are attempting to maximize the probability that they will successfully sustain a particular withdrawal rate over a particular number of years....
Good point, and probably the key to understanding the differences of opinion here. At the two ends of the spectrum, early retirees (<50) with marginal assets may have a different viewpoint and need than later retirees (>60) with sufficient assets. The early ones, either from habit or concious choice, may still be in an asset accumulation mode. This includes the semi retired, such as me, who work (sometimes quite reluctantly, sometimes not) a few days a month.

Wayne


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