Pre-paying Mortgage Perspective after the "Crash"

[ziggy29]

I agree, it is a personal decision - no right/wrong about it.

However - I seem to find an inconsistency among people who choose the 'sure thing' side. I think that many of them have no problem having some money invested in stocks while they are in the process of paying off their mortgage.

But, doesn't that 'sure thing' view really say that you should not have a single penny invested in stocks until the mortgage is eliminated?

Only if you think people have to opt for "100% sure thing" or "100% riskier thing." But I would tend to reject that idea; there's something to be said for assuming *some* risk while also seeking preservation of capital with some of it as well. Isn't that the idea behind asset allocation?

You can view "spreading out" extra cash flow into both "sure things" and higher risk/return investments as a form of asset allocation, can you not?

In that sense, wouldn't using half of a windfall to pay down a mortgage and half to invest be like having a 50/50 asset allocation? Is someone who chooses a 50/50 asset allocation being "inconsistent" because they aren't putting ALL of it into the market or into the "sure thing?"

 

[ERD50]

I agree ziggy99 - but similar to the posts above, if some people say "You should not take out a mortgage to buy stocks", they should also say, "you should not have any stocks if you hold a mortgage". It's the same thing.

I think that part of the problem is, either statement may be ignoring total asset allocation. As you say - you can balance your overall risk with AA combos. And holding a mortgage or not plays into that total AA. So a black/white view of a mortgage versus stocks is just too simplistic - it does not take into account total AA. I guess that is why I hate those broad brush, one size fits all statements (that I hear from some others).

In case I'm not being clear - I'm pretty sure I'm agreeing with you

-ERD50

 

[growing_older]

There's never a more important time to maximize your liquidity than when the economy stinks. Unless you are securely retired or have a ridiculously secure job, it's hard to have too much cash right now.

I'm more in the asset allocation camp. I do want to pay down my mortgage because I believe it gives me more options for flexibility when I FIRE, and I want to pay it off sooner since I want to RE. However with the economy so down and employment shaky, I've actually reversed that and taken larger debt and put the cash in CD just to have the insurance of extra liquidity. Last thing I want to get into is difficulty paying bills because I've parked extra cash in my mortgage where I cannot access it - potentially forcing a fire sale in equity positions or the house itself.

 

[rayvt]

If you never pay off your mortgage than you are always going to a a negative x% to compete with for all your investments. Getting an 8% return on your investment rather than paying down the 5% mortgage only leaves you keeping pace with inflation. Once that house is paid off all of your investments gains are actually gains and don't have to be siphoned off to pay for your debt every month..

Actually, no. The investment gains are whatever they are, and are not reduced by your mortgage rate. The mortgage interest is just another personal expenditure and really has nothing to do with market gains or losses.

The question to ask your self is: Say you've got $20,000 in the market and a $100,000 house. Would you recommend to your friend with $80,000 debt on their house and no money in the market to refinance their house for $100,000 so they can put $20,000 in the market?

Possibly. Depends. What is the LTV? What are the total assets? What percentage of the total assets is the house? What is the liquidity, or cash available?
In general, the answer is probably "Yes".
Your friend's asset allocation is out of whack. 0% allocation to equities is just too small. Equities are necessary to beat inflation. Also, if a time comes when he needs to raise cash, it's a lot quicker & easier to convert stock equity to cash that no convert home equity to cash. And if he can comfortably make payments on a $80K loan, he can almosr certainly comfortably make the payment on a $100K loan. In either case, his S.H.T.F. risk is the same----if he goes into foreclosure the bank will take the house and he'll loose all his equity, no matter if he owes 80K or 100K. Or 5K.

In fact, that is exactly how I got my start in stock investing. Which is how I was able to RE at age 58 12 years later. We refi'd our house to get a lower rate, and instead of keeping the same size loan with a lower payment, I pulled out $20,000 in cash and kept the same payment (at the lower rate).

 

[Bestwifeever]

IMOH the continuous releveraging of an asset is what got us into this economic situation in the first place. So to me paying off the mortgage is economically more palatable than realizing how much negative equity/upside down we can be with that asset. We also forget that we've used that equity for something else--for example, when a mortgage has been refinanced we forget to subtract the value of the stocks, or whatever we used the equity for, from the outstanding mortgage balance. If I borrow $100,000 in a heloc, buy stocks (that didn't subsequently lose value haha), and then my house dives $100,000 in value, is my mortgage really upside down? Maybe, but that $100,000 still exists.

 

[ERD50]

Getting an 8% return on your investment rather than paying down the 5% mortgage only leaves you keeping pace with inflation. Once that house is paid off all of your investments gains are actually gains and don't have to be siphoned off to pay for your debt every month.

I don't think you are accounting properly here. You have the money in two places at once.

When you pay off the house, that money that you stuck into the house is not *available* for investment - so that money makes zero 'actual gains'. You save the debt repayment, but you lose the opportunity cost of investing that money.

That hypothetical 8% return minus 5% debt payment provides a 3% that you would not have otherwise. Which is actually pretty nice. The downside is there is no way to know if you will get the 8% or not.

And no, the money is not really 'invested' in the house. If my house goes up/down $100K, my net worth changes by $100K, whether I hold a mortgage or not.

I'm not saying go one way or the other, but you should look at the real numbers.

-ERD50

 

[haha]

It makes no more sense to evaluate a long term decision right at the point when stocks are down, than it does to evaluate that long term decision right at the point when stocks are way up.

While I agree with you 100%, the dominant POV on this board until the recent dust-up was that all times are equal for investing. Posters would say "equities return x%"; not "equities are priced to return x% at this time".

IMO some liquidity provided by a mortgage note will very likely pay off if well invested at today's equity and corpotate bond rates. Of course there is more risk. But having $hundreds of thousand stuck in one house is not necessarily risk free either. If an earhtquake levels your house, there is at least a chance that you can walk from the loan, or that the Bailout Boys will ride to the rescue. Also, if you are a man, houses tend to stick to women in divorces.

Ha

 

[REWahoo]

Also, if you are a man, houses tend to stick to women in divorces.

Is this based on statistical research or personal experience?

 

[Running_Man]

I don't think you are accounting properly here. You have the money in two places at once.

When you pay off the house, that money that you stuck into the house is not *available* for investment - so that money makes zero 'actual gains'. You save the debt repayment, but you lose the opportunity cost of investing that money.

That hypothetical 8% return minus 5% debt payment provides a 3% that you would not have otherwise. Which is actually pretty nice. The downside is there is no way to know if you will get the 8% or not.

And no, the money is not really 'invested' in the house. If my house goes up/down $100K, my net worth changes by $100K, whether I hold a mortgage or not.

I'm not saying go one way or the other, but you should look at the real numbers.

-ERD50

You are missing the offset which is the money that is going to pay off the mortgage is no longer available for the individual who mortgages, while the prepayee is able to invest that stream of cash. Who makes more money over the life of the mortgage will depend on the gyrations of the stock market. A prepayee from last year is getting 40 percent more equity for the dollar than the mortgagee did a year ago. The longer the market stays below the entry point the more equity the prepayee will have. Over time even if the market returns 8 percent over 30 years it is entirely possible the prepayee will do better than the mortgagee.

 

[ziggy29]

You are missing the offset which is the money that is going to pay off the mortgage is no longer available for the individual who mortgages, while the prepayee is able to invest that stream of cash.

This is certainly true. But it's also true that draining liquidity can be a dangerous move, especially when the economy stinks.

Over a very long period of time, plowing a pile of cash into the market is likely to "beat" prepaying a mortgage or holding a lot of cash. But not *all* of financial planning is about maximizing returns; some of it is about securing what you have as well.

If one prepays a mortgage with a lump sum of cash today, I only hope they either (a) can honestly and confidently state that they have a VERY secure income stream and (b) they still have a sound emergency fund. The worst thing one can do is take most of their liquid cash, prepay the mortgage, and then lose their job while the roof leaks and the car breaks down.

We're living in a time when liquidity is crucial to financial security for most people. And even if stockpiling cash at 2% stinks, it stinks less than having almost nothing in the bank when a pink slip heads your way.

 

[haha]

This is certainly true. But it's also true that draining liquidity can be a dangerous move, especially when the economy stinks.

Over a very long period of time, plowing a pile of cash into the market is likely to "beat" prepaying a mortgage or holding a lot of cash. But not *all* of financial planning is about maximizing returns; some of it is about securing what you have as well.

If one prepays a mortgage with a lump sum of cash today, I only hope they either (a) can honestly and confidently state that they have a VERY secure income stream and (b) they still have a sound emergency fund. The worst thing one can do is take most of their liquid cash, prepay the mortgage, and then lose their job while the roof leaks and the car breaks down.

We're living in a time when liquidity is crucial to financial security for most people. And even if stockpiling cash at 2% stinks, it stinks less than having almost nothing in the bank when a pink slip heads your way.

This is an excellent point. It isn't hard to be unemployed and hungry in your paid off house.

In some ways the greatest security is flexibility. You can livea long time in an apartment off cash in the bank. You can also move easily to find another job, or double up with your brother or sister, or move into Mom's. Imagine having a paid off house and no job and a family to feed in today's economy.

Ha

 

[ziggy29]

Imagine having a paid off house and no job and a family to feed in today's economy.

Especially with a return to more conservative (aka "tight") lending standards. It's pretty hard to use the paid-off house as a ATM when you don't have a job. Those days are over, at least for a while.

 

[stephenandrew]

This is an excellent point. It isn't hard to be unemployed and hungry in your paid off house.
Ha

This is true---but people do have some options--three things that immediately come to mind are drawing on home equity line of credit , get a reverse mortgage (if you are old enough), sell the house. Correct me if I am wrong, but isn't there some truth in the idea that having a paid off house relieves you of the financial stress/pressure of having to make payments if funds are tight? I guess this is sort of the question I was trying to address in the original post---if one had invested the market instead of prepaying a mortgage and then the market fell like it has done now, and then they lose their job, the liquidity they thought they had may not be there when they need it most. I mean just like you don't want to sell a house in a down market, you probably don't want to sell your equities in a down market either. As always, thanks!

 

[ziggy29]

This is true---but people do have some options--three things that immediately come to mind are drawing on home equity line of credit , get a reverse mortgage (if you are old enough), sell the house. Correct me if I am wrong, but isn't there some truth in the idea that having a paid off house relieves you of the financial stress/pressure of having to make payments if funds are tight? I guess this is sort of the question I was trying to address in the original post---if one had invested the market instead of prepaying a mortgage and then the market fell like it has done now, and then they lose their job, the liquidity they thought they had may not be there when they need it most. I mean just like you don't want to sell a house in a down market, you probably don't want to sell your equities in a down market either. As always, thanks!

Some thoughts, one at a time:

This is true---but people do have some options--three things that immediately come to mind are drawing on home equity line of credit , get a reverse mortgage (if you are old enough), sell the house

Assuming you already have a HELOC, maybe. Still, how are you going to make the payments without income? And if you don't already have one, forget about getting one with no job. Reverse mortgage? Maybe in some cases as a last resort, assuming you're at least 62 -- and I think most of us either have (or plan to) not NEED a j*b by age 62. And sell the house? Sure, if you have hundreds of thousands in equity and you buy a much cheaper house or rent (and even renting could be difficult without a job, though maybe with a year's prepaid rent you could get around it.)

but isn't there some truth in the idea that having a paid off house relieves you of the financial stress/pressure of having to make payments if funds are tight?

Sure -- in fact, this is why some people recommend getting a 30-year mortgage and paying it off like a 15 instead of opting for the 15 -- particularly when the difference in rates are (say) 1/4 point or less. When money is tight, make the minimum payments; other times, pay it down like a 15.

Then again, even with *reduced* cash flow needs, you still have some, and if you've depleted too much cash, you may not have long to meet even the reduced cash flow needs.

Yes, if you prepay the mortgage and manage to hold your job for another couple of years so you can rebuilt a strong emergency fund, it works. But how many of us have that guarantee (or are willing to assume it)? My own financial planning is far too conservative to allow me to assume that and sleep at night.

 

[ERD50]

Originally Posted by ERD50
It makes no more sense to evaluate a long term decision right at the point when stocks are down, than it does to evaluate that long term decision right at the point when stocks are way up.

While I agree with you 100%, the dominant POV on this board until the recent dust-up was that all times are equal for investing. Posters would say "equities return x%"; not "equities are priced to return x% at this time".

Ha

Thanks Ha, I realize now (not unusual for me) that I worded that poorly though.

What I really intended, was to say that it isn't realistic to claim (brag, deride?) that a long term investment strategy is/was successful based on some intermediate point in time. But people do tend to do that at intermediate highs/lows. And I think that is what the OP is doing, to an extent. Just because his money was better off going to his mortgage than the market during the recent downturn, does not mean that it will be the best place going forward. Likely the opposite, but probably not by much.

My stance is pretty much aligned with yours - if we have any faith in the long term viability of the market, then stocks today are certainly a better value than they were at the peak (and if we have no faith in the market - we don't even need to ask the question). And that would seem to make mortgage arbitrage more attractive now than at the peak. So from that standpoint, it makes sense to evaluate it, and re-evaluate it as needed. But not judge it's success/failure - that is where the long term view is needed. Hey, I wish I paid off my small mortgage at the market peak, I'd re-invest now. But that would just make me a dirty market timer

-ERD50

 

[stephenandrew]

Some thoughts, one at a time:

Assuming you already have a HELOC, maybe. Still, how are you going to make the payments without income? And if you don't already have one, forget about getting one with no job. Reverse mortgage? Maybe in some cases as a last resort, assuming you're at least 62 -- and I think most of us either have (or plan to) not NEED a j*b by age 62. And sell the house? Sure, if you have hundreds of thousands in equity and you buy a much cheaper house or rent (and even renting could be difficult without a job, though maybe with a year's prepaid rent you could get around it.)

Sure -- in fact, this is why some people recommend getting a 30-year mortgage and paying it off like a 15 instead of opting for the 15 -- particularly when the difference in rates are (say) 1/4 point or less. When money is tight, make the minimum payments; other times, pay it down like a 15.

Then again, even with *reduced* cash flow needs, you still have some, and if you've depleted too much cash, you may not have long to meet even the reduced cash flow needs.

Yes, if you prepay the mortgage and manage to hold your job for another couple of years so you can rebuilt a strong emergency fund, it works. But how many of us have that guarantee (or are willing to assume it)? My own financial planning is far too conservative to allow me to assume that and sleep at night.

Points well taken---and thanks for taking the time to explain.

 

[ERD50]

You are missing the offset which is the money that is going to pay off the mortgage is no longer available for the individual who mortgages, while the prepayee is able to invest that stream of cash.

And you are missing a big point (common in these discussions). The person who does *not* prepay, *has* that money invested. He does not need a 'stream of cash' that becomes available from not making a monthly payment, he already *has* the investment. Use those 8% return 5% mortgage rate numbers above for simplicity. You have to keep it Apples-to-Apples:


Person A & B: $500K in savings; $200K mortgage balance.

Person A: Decides to pay off the mortgage - well, that money comes from somewhere, so he now only has $300K in savings. He lost the income stream from that $200K paying 8%.

Person B: Does not pay off mortgage, he has the income stream from the full $500K @ 8%. Yes, that is offset by the interest payment he is making @ 5%. Principal payments are going to his NW. 8% > 5%. But that is the risk that one must accept.


Your scenario seems to be a comparison between pre-paying a mortgage, and burning the money used to prepay the mortgage (because you are ignoring it). I agree, prepayment is better than burning it .

-ERD50

 

[ERD50]

--but people do have some options--three things that immediately come to mind are drawing on home equity line of credit ,

Please note that this recently, some posters reported that their HELOCs were frozen - that could happen just when you need it the most. You need to read the fine print, but I'm not certain you can count on this - esp when times are bad - that is exactly when you might need it, and creditors are being careful with loans.

Correct me if I am wrong, but isn't there some truth in the idea that having a paid off house relieves you of the financial stress/pressure of having to make payments if funds are tight?

Well, there seems to be a strong *emotional* tie to this 'feeling', but it really does not hold water financially as far as I can see.

For rough numbers, say you had a $200K mort balance and a $1K/month P&I payment. If you pre-pay, fine, you need $1K less per month in cash flow. But you no longer have those $200K in investments.

Say you hit a 6 month bad streak - w/o the pre-pay, you can draw down $6K of the $200K to pay the mortgage, one month at a time. Even if the market was down 50% at that time, it's not like you cash in the whole $200K. Plus, in the current market, a SPY ETF is paying 3% yield - even if it was 2%, that dividend cash flow would pay 1/3 of the mortgage w/o any draw down whatsoever.

IOW - what is so stressful about making $6K payments over half a year - when you have $200K available in liquid investments? I'd me more stressed out about putting food on the table, if all my money was tied up in my house, which is not very liquid, and also subject to market fluctuations.

... if one had invested the market instead of prepaying a mortgage and then the market fell like it has done now, and then they lose their job, the liquidity they thought they had may not be there when they need it most. I mean just like you don't want to sell a house in a down market, you probably don't want to sell your equities in a down market either. As always, thanks!

See above, and remember - that house sure is not liquid!

-ERD50

 

[deepc]

The "opportunity cost" argument to not pre-pay only holds water if you're making more on interest than you're paying on the mortgage.

Using your numbers, $200k needs to make 6 pct after taxes to equal the cash flow of $1k monthly. These are simplistic numbers obviously. But today, what's making more than 6 pct and is as safe as that paid off mortgage?

If you're happy risking this allocation in the market for the potential of a greater return, you MAY reap the benefit. On the other hand, given recent market events I wouldn't count on better than mortgage rate interest level returns for a while. The house is not liquid certainly, but neither is the lost 30-50 pct equities stake.

 

[ERD50]

The "opportunity cost" argument to not pre-pay only holds water if you're making more on interest than you're paying on the mortgage.

Using your numbers, $200k needs to make 6 pct after taxes to equal the cash flow of $1k monthly. These are simplistic numbers obviously. But today, what's making more than 6 pct and is as safe as that paid off mortgage?

If you're happy risking this allocation in the market for the potential of a greater return, you MAY reap the benefit. On the other hand, given recent market events I wouldn't count on better than mortgage rate interest level returns for a while. The house is not liquid certainly, but neither is the lost 30-50 pct equities stake.

Those are all reasonable observations. But some of the other posters seem to be pretending that the money used to pre-pay the mortgage does not exist when you don't pre-pay, and that is not a valid comparison.

To get a bit technical - the opportunity cost argument exists. You have to consider the investment return of the money that would be invested. Whether it is advantageous after balancing risk/reward is the calculation and personal decision that needs to be made.

No reason for an equity investment not to be liquid. I could sell my SPY in 6 seconds. Yes, I would take a loss on the amount I need to withdraw ($6K in the example above), if it comes to that. That does not make it illiquid, and the majority is a paper loss at this point, which you might also have in your house.

All I'm saying is, you need to keep it apples-to-apples. I think you will find the differences to be minor, and unpredicatable.

-ERD50

 

[Running_Man]

Those are all reasonable observations. But some of the other posters seem to be pretending that the money used to pre-pay the mortgage does not exist when you don't pre-pay, and that is not a valid comparison.

To get a bit technical - the opportunity cost argument exists. You have to consider the investment return of the money that would be invested. Whether it is advantageous after balancing risk/reward is the calculation and personal decision that needs to be made.

No reason for an equity investment not to be liquid. I could sell my SPY in 6 seconds. Yes, I would take a loss on the amount I need to withdraw ($6K in the example above), if it comes to that. That does not make it illiquid, and the majority is a paper loss at this point, which you might also have in your house.

All I'm saying is, you need to keep it apples-to-apples. I think you will find the differences to be minor, and unpredicatable.

-ERD50

The money doesn't exist? This is a capital investment question, the hurdle rate is five percent. Now whether one decides to invest on that basis is understandable, you anticipate a 3 percent return advantage. However there are cash flow issues present and the future cash flow payments reduce the ability to invest in stocks in the future.

At the end of the mortgage both will have a home paid off and stock equity. Who did better is not determined by the average over the entire period versus 5 percent but the amount of after tax cash advantage that the prepayee is able to purchase versus the original equity the mortgagee purchased.

The average return over the period may be a reason to choose an investment but the volatility of stocks makes that not the determining factor at all. IF the stock market were to advance like the ninties and fall off at the end to average 8 percent the advantage of the immediate investment could be far greater than 3 percent.

 

[rayvt]

The "opportunity cost" argument to not pre-pay only holds water if you're making more on interest than you're paying on the mortgage.

Using your numbers, $200k needs to make 6 pct after taxes to equal the cash flow of $1k monthly. These are simplistic numbers obviously. But today, what's making more than 6 pct and is as safe as that paid off mortgage?

If you're happy risking this allocation in the market for the potential of a greater return, you MAY reap the benefit. On the other hand, given recent market events I wouldn't count on better than mortgage rate interest level returns for a while. The house is not liquid certainly, but neither is the lost 30-50 pct equities stake.

No, at this instant equities are not making 6%. But at other times equities are making 30%, 40%, and 50%. The overall average gain for the S&P500 is about 10.5%.

The problem with paying off the mortgage vs. stock investments is that it is pretty much an irrevocable decision. One you pay principal on the mortgage you can't get it back. The bank won't give any of it back to you if you change your mind. You can only extract money by taking out a new loan or selling the house. So when the time comes where stocks are returning 30%+, your money is locked up in the house, "saving" you the 6% interest you'd otherwise be paying.

 

[stephenandrew]

Please note that this recently, some posters reported that their HELOCs were frozen - that could happen just when you need it the most. You need to read the fine print, but I'm not certain you can count on this - esp when times are bad - that is exactly when you might need it, and creditors are being careful with loans.



Well, there seems to be a strong *emotional* tie to this 'feeling', but it really does not hold water financially as far as I can see.

For rough numbers, say you had a $200K mort balance and a $1K/month P&I payment. If you pre-pay, fine, you need $1K less per month in cash flow. But you no longer have those $200K in investments.

Say you hit a 6 month bad streak - w/o the pre-pay, you can draw down $6K of the $200K to pay the mortgage, one month at a time. Even if the market was down 50% at that time, it's not like you cash in the whole $200K. Plus, in the current market, a SPY ETF is paying 3% yield - even if it was 2%, that dividend cash flow would pay 1/3 of the mortgage w/o any draw down whatsoever.

IOW - what is so stressful about making $6K payments over half a year - when you have $200K available in liquid investments? I'd me more stressed out about putting food on the table, if all my money was tied up in my house, which is not very liquid, and also subject to market fluctuations.



See above, and remember - that house sure is not liquid!

-ERD50

Agreed--and again thanks.

 

[rayvt]

Some interesting stats, on the S&P500 rolling 12-month returns, ignoring dividends, from Jan 1972 thru Nov 2008. 432 such periods.

Average 12-month gain: 8.3% (Adding in assumed 3% average dividend, you'd get 11.3%)

Note that these are rolling 12-month periods, so there is some overlap. One very good (or bad) month will be included in the next eleven 12-month periods. For example, of the top 10 gains, 4 are in 1983, 1 is in 1987, 3 are in 1997, and 2 are in 1998. Of the top 10 losses, 6 are in 1974, 1 is in 2001 (September 2001---imagine that!), and 3 are in 2008.

The 3 losses in 2008 tell me why so many people are so scared now.
We are more emotional about recent events than events far in the past. The string of large losses that are happening now are right in our faces.

# of 12-month periods with gain: 312
# of 12-month periods with loss: 120
Average gain of all periods with gain: 16.4%
Average loss of all periods with loss: -12.54%

Average of top 10 gains: 43.9%
Average of top 10 losses: -31.8%
Average of top 43 gains (10th percentile): 35.3%%
Average of top 43 losses (10th percentile): -21.9%
Top gain: Jun 1983, 52.9%
Top loss: Sep 1974, -41.4%

Top 5 gains: 52.9%, 51.8%, 49.1%, 45.5%, 45.1%
Top 5 losses: -41.4%, -39.5%, -37.5%, -31.8%, -30.8%

 

[haha]

# of 12-month periods with gain: 312
# of 12-month periods with loss: 120
Average gain of all periods with gain: 16.4%
Average loss of all periods with loss: -12.54%

Average of top 10 gains: 43.9%
Average of top 10 losses: -31.8%
Average of top 43 gains (10th percentile): 35.3%%
Average of top 43 losses (10th percentile): -21.9%
Top gain: Jun 1983, 52.9%
Top loss: Sep 1974, -41.4%

Top 5 gains: 52.9%, 51.8%, 49.1%, 45.5%, 45.1%
Top 5 losses: -41.4%, -39.5%, -37.5%, -31.8%, -30.8%

Top gain: Jun 1983, 52.9%
Top loss: Sep 1974, -41.4%

Are these the 12 month periods ending on the month and year mentioned?

Ha