Pay off mortgage early ?

[sgeeeee]

Quote:

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. *

I agree completely. And I appologize to the entire board for being so single minded about these posts. It is not because I want to convince any of you that you should not pay off your mortgage. But I admit to feeling like my motives and integrity were being questioned unfairly. I may be making the wrong decision (I honestly don't think so) but it is based on some fairly detailed analysis of both the rewards and risks, as well as a thorough understanding of my own situation.

As I mentioned in an earlier post, the interesting thing about this forum is that yo quickly realize there are no "cookie cutter" answers to many of these questions. Everyone is in a unique set of circumstances.

My biggest problem with paying off the mortgage when you have a low interest rate is that with each additional dollar paid in equity that could have been used to fund another investment, the return on the home asset decreases (the house goes up in value at a rate that is unrelated to the equity level - the more you have tied up in the home the less your annual return will be). In additional, there are asset diversification issues; you will have more $$$ invested in a single asset. While you may plan on living in your home for years to come, if you changed your mind, higher interest rates or some local problem could result in that asset losing value just like any other investment.

I enjoy the input on this issue since it is one I have been struggling with as I prepare to retire in about 6-months.

[Ted]

Quote:

A couple more thoughts, Buffet, et al, suggested future market returns would average 6-8% before last year. *Could that mean we have 'used-up' about 3 years of gains already with last year's stellar results? *OR are the gurus still predicting 6-8% going forward from this 'elevated' point in the market? *I'd sure like to ask them. *If they choose the latter, I'd like to know, how they could be so wrong last year.

As I have stated in other posts, I am one of those somewhat pessimistic people who expects the real rate of return on stocks to decline below its historical average of around 7%, to perhaps 5% or so. Nominal returns on stocks tend (over time) to benefit from inflation, so if inflation increases to perhaps 5%, the nominal return on stocks could still be 10% per year.

Such forecasts are very long-term, and as a result the current level of the stock market has very little to do with them. It appears to me, however, that the total stock market is very close to being fairly valued from the perspective of its long-term trend to date. But whether it's, say, 20% over-valued or under-valued now is practically irrelevant to long-term predictions of real growth.

Oops GDER, while you did a good job of covering
adviceseeker's post re. mortgage payoff, equity, return,
diversification, etc, you slipped over into sarcasm.
That's my department .

John Galt

I don't mind the criticism....like I said, everyone has a different perspective. Let me give you an example - and let me know what you think.

You have a $100,000 home and can either pay it off or take a 5.25% mortgage for $90,000 and 15-years. The home will appreciate 5% per year. At the end of 15-years, the home is worth $208K, regardless of which option you select. If you took the 15-year mortgage, the $90,000 loan costs $40K in interest by the end. If you invest the $90,000 and achieve an annual compounded return of 5%, the $90,000 grows to $187K, superior to the $40K in interest expense. This is without considering the tax implications.

I know peace of mind is an issue, but if you are looking at financials only, and can assume the market risk associated with earning a 5% return, you may choose to finance your home instead of paying it off.

Any thoughts/comments?

[Ted]

Your figures have just "proved" that you can borrow money at 5.25%, invest it at 5%, and make a substantial profit. You'd better go back to the drawing board. The key to the answer is that the $90,000 doesn't grow at 5% per year because every year you need to withdraw the amount required to make the mortgage payments!

Last time on this....you only borrow the $90K at 5.25% for one month (the first). As you amortize the loan you are borrowing less and less...that is why the interest is only $40K at the end of the loan!

My assumption is that the $90K is an independent investment decision, and the house payment would come from other assets (pension, SS, other savings, etc.). Obviously you can look at this several different ways.

Bottom line is that the decision to pay off the house may be as much for non-financial reasons as otherwise, and is a personal decision.

Thanks for the input.

Hey GDER! You don't need to apologize. Sarcasm, invective and hyperbole can make writing more interesting. Someone will get their hackles up, but
as long as we still have the First Amendment, I say
just let it flow.

John Galt

[sgeeeee]

Quote:

And I apologize to you and the board, if you feel I was questioning your motives or integrity. *I honestly feel the analysis is mathematically flawed and while your decision may be well timed and positive, it is NOT a given or a mathematicall certainity. *NO not even a 78% likely-hood.

Yes. You've indicated that you feel that historical analysis is not valid. Although I do understand that past performance is no guarantee of future results, I also believe that there is value in using historical simulators like FIRECALC. That, along with some customized spreadsheets are the best tools I have to look at this problem. I actually believe my odds are significantly better than 78% since I feel that pre-1929 results are less meaningful to today's markets. If I neglet them, I find my odds of beating the payoff better than 90%. But the value of historical data is clearly only an assumption on my part. I recognize that we are in a period of overvaluation and that we face serious challenges going forward. If things turn very sour over the next several years, I may end up retreating from this strategy.

Are you using any specific models or simulations to arrive at your conclusion that the next 30 years will provide returns under 5.25%? What number do you feel is more realistic? Are there other "mathematical flaws" you see in my analysis that you can offer corrections for?

Quote:

A couple more thoughts, Buffet, et al, suggested future market returns would average 6-8% before last year. *Could that mean we have 'used-up' about 3 years of gains already with last year's stellar results? *OR are the gurus still predicting 6-8% going forward from this 'elevated' point in the market? *I'd sure like to ask them. *If they choose the latter, I'd like to know, how they could be so wrong last year.

I am fairly certain that Buffet's comments were made prior to last year's run up, so I assume his expectations are that we are in for several sub 6% years over the next decade. That still leaves me ahead at the 10 year mark in my mortgage and I will have almost 2 decades more to get further ahead -- unless I back away from the strategy at some point in the future. I don't know of any predictions for 30 year returns that I would trust. The historical simulators are the tool I trust most to analyze this kind of situation. You could also use Monte Carlo simulations, but these tools omitt some very important correlations in economic data and are calibrated using historical simulations anyway.

[cute fuzzy bunny]

About the only assumption that I think bears reconsideration is the one on home appreciation rates. I can go look for the source but I read something recently that said home appreciation rates are nearly zero in 80-85% of the US. And they've been roughly zero for some time.

Even where there is appreciation, there is volatility.

Consider my home in the SF bay area. In 1992-93 there was a roughly 20% drop in prices in the immediate area and I bought. I bought a house that had been listed for $180 that I ended up getting for $162 That $162 house turned into a $211 house 2 years later and they sell for roughly $345 today. A pathetic 50 year old 900 sq foot house on a nice sized lot in a fair to middling neighborhood.

My home in the sacramento area originally sold for $410 in 1989. Prices had dropped steadily until I bought it in 1996 for $312. After I bought it prices steadily rose until I sold it last year for $490. Much nicer home, 3000 sq feet on a half acre in a top notch neighborhood...but it suffered from huge swings in volatility.

My most recent home sold for $250 on an ask of $269. Homes in this area just a few years ago couldnt be given away for $175. I'm betting that the value drops in the next few years, perhaps by 20-40k. But by the time I consider moving in 6-10 years, it'll have regained its value and then some.

In the meanwhile, a home you bought for $80k in podunk middle america 8-10 years ago probably still sells for 80k. Some inflation appreciation compensated by depreciation due to aging.

Points: Volatility in RE can be as high or higher than risky equity investments. A fixed and positive return on home equity is not a given...even over a long term. RE doesnt gain much if anything in most areas. Boy can you make a lot of money on a house if you buy and sell at the right times...

Setting aside the calculations based on past performance, how about a not so rosy scenario...

If we had a 5 year sideways or downwards market, and I had to dip into my capital base instead of living off dividends:

If I had a 200,000 mortgage on my property for 15 years at 5.25%, adding in my $24k per year living expenses, my total draw for that five year stagnant period would be $216,420. Without the mortgage involved, my total draw during that down time would be $120,000.

For an ER with a portfolio in the 500k-750k range, that 216,420 pull would probably send them back to work. I dont think you could recover from that level of loss without supplementary income.

Unlikely scenario? Well if you ER'd at the end of 1999 and stayed fully invested, depending on your investment mix you're probably somewhere between still under water and slightly above where you started. Unless we see a nice run-up for the rest of this year, the scenario I just laid out just happened.

Alternative line of thinking: my house can lose 100% of its value and I can still live in it without it costing me a penny vs a home with a mortgage. And I can peg the maximum loss of this investment: the purchase price minus (the cost of the developed land plus the construction cost of the home) minus depreciation...ignoring other factors. However my portfolio invested in stocks and bonds can drop half or all of its value and leave me with absolutely nothing of benefit.

[sgeeeee]

Quote:

About the only assumption that I think bears reconsideration is the one on home appreciation rates. *. . .

I really have assumed nothing about home appreciation rates in any of this analysis. I have implicitly assumed that both the mortgage holder and the person who chose to pay off the mortgage keep the house for at least the life of the loan. If the house depreciates and the investors have to sell, both lose.

But that risk surely cuts both ways. If you own a home outright and something happens to make it an unacceptable place to live, you are stuck with a huge loss. With a mortgage, you do always have the option of walking away from it. Although, lets face it, for most cases both approaches leave you hurt. I'm not sure how you would quantify that risk. Have you got any suggestions?

As far as the downside risk of keeping the mortgage, FIRECALC shows you the historical downside risk. Run the simulation specified in previous posts and examine the cases that failed. The simulator shows how many times and how much the mortgage case cost the investor. If you can't handle that much downside, you should set a stop loss target and pay off your loan if this strategy begins to go too far south.

I think a point that needs to be made is that I can sit around and think about economic calamities that would make any specific investment strategy fail. But without doing some analysis of the probability and impact of that calamity, you can't really conclude that any strategy is good, bad or neutral. If I let this kind of thinking determine what I am going to do, then I will become paralyzed, because nothing will work under all conceivable conditions. In order to get beyond this paralasis, I need to look at models and methods to estimate probabilities, to bound the universe of possibilities. It is probably wise to have contingency plans for certain kinds of calamities. (In this case, there is a clear option to payoff the mortgage at any time.) But beyond that, I would feel more comfortable considering data and analysis than some vague, qualitative hypothesized events.

[cute fuzzy bunny]

Actually the comment about appreciation wasnt targetted at anything you said, it was towards a comment adviceseeker made a few posts ago where he surmised a 5% annual increase in the homes value and asked for comment. I should have been more specific.

I'm also not at odds at all with yours or anyone else analysis using firecalc or any other tool using 30/40/100/1000 years of historical data.

What I said is if you went through a bad 5 year period, and sure as shootin' we just did, having assets in a volatile asset class and doubling your withdrawal rate because over a 30 or 50 year period a tool said you'd probably do better a majority of time, you might find yourself going back to work. This asset class guaranteed me a 5-6% return on investment AND I can live in it no matter what its worth.

Further, its entirely a lot more likely that we would see a 5 year bad time in the market than "something" would happen to my rural area home to make it undesirable to live here. No earthquakes, hurricanes, flood plains, hells angels relocation plans or any other sort of thing evident.

Two things keep pinging at me though. One is that a lot of folks think the economy is really going to suck pretty soon and for a long time...plenty of folks here seem to think so. I would suppose that if one felt that way, investing in ones home might beat the crap out of buying TIPS. Maybe not. But in any case, betting on big years for the stock and bond markets because it was that way most of the time historically may not be a very good idea. I am ALL for using any tools at ones disposal to plan, assess risk and deploy assets.

The other thing is that while we have a lot of devout anti-market timers, a lot of folks still talk about changing asset classes and the type of instruments in those asset classes based on what might be about to happen, but I digress.

However, in this case isnt it just that in one hand you will probably make more money if you keep the cash and dont pay off the mortgage, while in the other hand if you do hit a bad string of investing years - - something that definitely happens and quite possibly could happen again pretty soon, that the balance of benefit slips to preventing the big loss?

Otherwise, wouldnt everyone have a portfolio consisting of emerging markets stocks, foreign stocks, and small cap value stocks because historically those have had the highest returns and in all likelihood, they very well might continue to do so?

Now...the original poster asked consideration whether he should use the majority of their appreciated portfolio to pay off their mortgage. I'd say no to that. I would say that if your mortgage is before the half-way "flip" and the balance is less than 20-25% of your assets, its very well worth considering simply because doing so gives a nice safe rate of return, dramatically reduces your withdrawal rate, and no matter what happens you can still live in it. If you're after the halfway point in the mortgage, plan to move in the next few years, or the payoff would be a substantial chunk of your portfolio, then I'd probably think pretty hard on it.

I think the main reason why I tend to disregard
historical financial data is my very short horizon.
Probabilities of future activity based on past activity
do not impress at all. I don't need to get rich. I just
need predictability.

John Galt

[wabmester]

Quote:

I think the main reason why I tend to disregard historical financial data is my very short horizon.

Heh, I tend to disregard historical data because of my long horizon. If the data goes back 100 years, and I (or more likely, my wife) need to look forward 50 years, the data gives me the same level of confidence I would have predicting tomorrow's events based on what happened in the last two days.

As I opined elsewhere: historical data is a good predictor of volatility, a fair predictor of covariance, and a lousy predictor of future returns.

If somebody could just convince me that the US GDP will continue to grow for the next 50 years, I'd jump back into stocks.

Wabmester...............I don't know what the GDP
will do over the next 50 years, but I can guarantee
one thing. The government itself will continue to grow.
You can take that to the bank.

John Galt

[earlyout]

Over long periods stocks have outperformed other asset classes. However, that out performance has come at a price of greater volatility.

Consider that when in the phase of accululating assets volatility is not crucial and actually may be helpful in accumulating a portfolio. In the consumption phase (i.e. retirement) what is also very important is the stability of an income stream to live on. So most advisors recommend reduction in stock exposure in retirement.

Each individual has there own risk tolerance, which must be considered in putting together a portfolio. These may include low-risk, medium risk and high risk persons.

Buying stocks on margin (keeping a mortgage on your residence) is a higher risk strategy. This higher risk strategy may yield higher returns. However, this is an inherently riskier strategy and should be understood as such. Low or medium risk persons may not want the added risk. Higher risk individuals may like the chance at higher return for the added risk.

for more info see link, click on MPT:

http://www.moneychimp.com/