Should I Lock Into My Investment Gains?

[nico08]

Due mostly to the bull market, my net worth has substantially increased in the last four years. Due to additional investment of funds, and return on investment, my net worth has increased by 156%. Yes, my net worth today is worth approximately one and a half times more than it was worth four years ago. And I am not factoring in the increase in equity that I have in my home when I obtained the 156% return rate.

Assume the following: a downward market correction will occur within the next two years; I can still contribute the maximum to my 401k and Roth IRA; and I have recently become a homeowner with a competitive interest rate of about 3.5%. In light of these factors, does it still make sense to lock into some of my investment gains and use these gains to pay off some, or all, of my mortgage. The goal would be, by getting rid of monthly mortgage payment, my overall annual cost of living would be reduced. I plan to stay in the home for at least the next five years if not longer.

Oh- one other thing, there is a strong likelihood that my employment position will be relocated and I will not be moving, so I will be laid off.

Please offer any helpful advice, and please don't limit your comment to "this is another should I pay off the mortgage early question." I am trying to retire early and I am trying to figure out how to maximize the likelihood of being able to do it as soon as possible. Thank you.

 

[slowsaver]

I'm not sure whether it was the best "financial" decision or not, but I really am glad I paid off my house. It's a lot easier to save money when you don't have a mortgage.

I can't tell if you are very worried about getting laid-off. Do you think it would be easy to find a new job? Maybe start looking now -- it's a lot easier to get a job when you already have one, since employers are suspicious about hiring unemployed people. At least, that's how it seems in my industry.

 

[Kimo]

I can say from experience that paying off the house will not only make your payment disappear, you will feel much better at some point in the future when something else happens and you realize you are able to deal with issue much easier because the house payment has been gone for x years.
You will have to make a big decision though if in order to pay the house off in full, if it will take all of your savings. Will they be from a taxed account or a retirement account.
The other item to think about is how long it will take to build up another investment portfolio.

When you sell, the other decision is when to buy back in. I faced all these thoughts and about 4 or 5 houses ago I started just paying cash right from the start.

I would suggest to not listen to someone who thinks the tax write off is better than making no payment instead. Remember, it is based on a percentage for your right off vs. not paying ANYTHING. Talk to anyone who paid there house off and ask if they would do it any different if they could have.

 

[clifp]

It is hard question to answer without knowing some additional facts.

If you get laid off are you currently financially independent. If not how much of a a reserve fund do you have?

My thoughts are in general 3.5% is pretty inexpensive money. It is not a particular high hurdle to beat in for most portfolios over an longer period. If you are out of work and looking for a job, you certainly can benefit from the additional liquidity.

I have been mortgage free for six or seven years while working, and roughly 1/2 the time I've been retired. I currently have a modest home equity loan. While there is some psychological benefits to not having a mortgage. I would have a lot more money if I had invested it and kept the mortgage in all cases. It is difficult to know the exact amount but I would say at minimum it is an additional $50K and possibly as much as 80K. Was the peace of mind worth it. Heck no that is $2,000 or $3,000 additional spending money per year. So yes I regret paying off my mortgages instead of refinancing at lower interest rates.

 

[LOL!]

Now is not the time to cash in investments in order to pay off the mortgage unless you will pay no taxes on the income from cashing in the investments.

When you are laid off or retire, your taxable income should drop so that you are in the 0% tax bracket. At that time, you can decide to pay off mortgage or not and it will not cost you any extra in taxes.

As for locking in investment gains, that's just a rebalancing question. If you have gained so much that your asset allocation is out of balance, then yes, you should rebalance. But do so in a tax-efficient manner. One should not have to pay any costs to rebalance: no commissions and no taxes.

 

[scrabbler1]

Nico, the question you are pondering is somewhat similar to what I was going through in the late 1990s although there are some differences.

In the late 1990s, I was still working full-time and my annual earnings were at their peak. I had a 1-year ARM on my co-op apartment and was looking to pay it down, if not off completely. I created a spreadsheet to compare the net interest saved (after taxes) by paying it off versus the net interest (and/or cap gains) lost by diverting some of my portfolio to paying it off. I had more than enough in the non-retirement part of my portfolio to worry about running my accounts too low.

What tipped the balance for me was discovering that I would hit the "floor," or the Standard Deduction on my state income taxes if I paid off the mortgage. This lessened the tax increase caused by losing the tax deduction of mortgage interest and made it a better deal by paying it off. That, combined with the slowly rising interest rate on the loan itself (it had crept up from 6% to 8% from 1993-1998) made the loan less desirable.

After I paid off the mortgage, I saw how much my living expenses had fallen, to the point that one biweekly paycheck more than covered my monthly expenses. This was a key step toward my ER because I was able to safely switch to working part-time 3 years later (in 2001) which greatly improved my life and led to my complete ER in 2008.

 

[nash031]

Tough to answer the question in full without knowing what your plan for retirement is. Though you may get laid off, are you planning to find other work, or is that it for you?

As others have said, "locking in gains" is an asset allocation/"market timing" question. Rather than trying to sell at a market high, I would let my AA plan drive what I do (non-emotionally). As equities rise, your % of stocks will rise accordingly, and if that takes your AA from 50/50 up to 60/40, and that's above your tolerance, then you rebalance by selling some stocks and keeping cash or buying bonds.

Right now, I'm not selling anything in any taxable account. I recently rebalanced out of some bonds into international market index fund in a tax-free account, but domestically I don't really see any good values yet. I'm hoping for that market correction, baby!

 

[Chuckanut]

I locked in some gains earlier this year when the market was bumping up against its high. The gains I locked in where just enough to cover next year's anticipated withdrawals needed to keep me in my lavish life style.

That's about the only exception I plan to make to anticipated AA adjustments.

 

[nico08]

Thank you for the feedback. Here is some additional information that may be helpful.

What is my post-tax saving rate from the job?

My current post-tax saving rate from the job is about 50% and that includes my 401k and Roth IRA contributions.

How many years of living expenses are involved in the 156% gain?

The 156% gain represents about 12 years of living expenses.

How many years of living expenses are needed to pay off the mortgage?

In order to pay off the mortgage, I would need to pay about three years worth of living expenses.

Is my home appreciating faster than 3.5% annually?

There was a recent run up in value of the homes in my area. Zillow suggests that the value of the home will increase by 0 percent next year. While the home is marketable, I do not think it will appreciate in value faster than 3.5 percent annually on average.

What is the annual yield of my investments (not counting capital gains)?

The annual yield of my investments is approximately 7.24 percent over a ten year period and represents a mixture of stocks and bonds.

 

[Meadbh]

The 156% gain represents about 12 years of living expenses.

In order to pay off the mortgage, I would need to pay about three years of living expenses.

This is a very personal decision. I would see it as a great opportunity to get the mortgage paid off while still keeping most of my portfolio intact. Given the above information, I would take the gains required to pay off the mortgage and keep the remainder invested at my normal asset allocation. I would use the extra cash no longer needed for mortgage payments to continue to invest.

 

[MichaelB]

In his most recent booklet (thread here http://www.early-retirement.org/forums/f28/deep-risk-by-william-bernstein-68196.html#post1354965 ), William Bernstein says the 30 year mortgage is an excellent hedge against inflation. It is a good point, and a long term low fixed rate is not easily replaced.

 

[ERD50]

... It's a lot easier to save money when you don't have a mortgage. ...

This always sounds like circular logic to me. So you take a bunch of money you saved up to pre-pay the mortgage, so that you can now save more money?

I don't expect it would make a huge difference financially one way or the other, unless you happen to miss a big move in the market. But in general, being able to borrow money for 30 years and lock in historically low rates is very likely to be a positive move.

And don't underestimate the power of liquidity. If I git in a crunch, having my money locked up in a not-very-liquid house would not be good. A big pile of money can keep paying the mortgage and property tax and utilities and maintenance for a long time. I doubt a repairman would be very interested in a share of your paid for home.

-ERD50

 

[Fermion]

I am also in a situation where I have locked in some investment gains, offset against past losses. I plan to take the money ($150,000) and pay off our 3.5% home loan if the market does not drop by Nov 1. If the market drops by more than 10% between now and Nov 1, I will put the money into the market instead of paying off the home loan. We also have an EF and regular investments, but this is already taxed, "free" money that is available to either go back in the market or pay off the home.

It is a psychological thing. I would want to have some dry powder if the market drops, and I believe if it is going to drop it will happen before the usual Christmas rally.

 

[danwhite77]

Fascinating post. After seeing your 156% return, I suspected mine was about the same. Sure enough, I calculated my increase in net worth since January 1, 2009 (so four full years, plus eight months in 2013) and the increase is 162.32%. We must be in the same funds! Like you, my job picture is not entirely clear (although the likelihood of me losing my job is fairly remote -- though certainly not zero).

I have not considered locking in gains or selling. I have a fairly small student loan that I recently decided to pay down at an accelerated rate, but I'm not going to sell any equities in order to do so.

Best of luck with your decision!

Edit: I paid cash for my house last year, but didn't sell anything to enable the purchase.

 

[Fermion]

Talk about returns from 2009...I have a IRA that was rolled over from a 401K balance of $1700 in 2008. I put it into a play account just for laughs...today it is over $38,000 (thanks in part to Nokia and a few other lucky plays).

My wife was like "how come you didn't make our other accounts go from $1,700 to $38,000".

I said "because you would have been upset had they gone to zero"

Going to try and get it to $100,000 by 2020 so I will have a story to tell. We need another 2009 drop...it is all cash right now

 

[pb4uski]

Would the funds to pay off the mortgage come from taxable accounts? If so, what would the gain and tax be on those redemptions and how much would you need to sell as a % of the mortgage. For example, if your federal and state tax on the gains was 20%, then in order to pay off the mortgage you would need to sell 1.25x the mortgage, pay 20% or .25x in tax and then pay off the mortgage with the remaining 1x.

As for me, I think my investment return will outperform my 3.375% mortgage over the next 14 years so I'm staying with the mortgage, but I do take comfort that if I ever want to I can sell some investments and pay it off.

 

[haha]

In his most recent booklet (thread here http://www.early-retirement.org/forums/f28/deep-risk-by-william-bernstein-68196.html#post1354965 ), William Bernstein says the 30 year mortgage is an excellent hedge against inflation. It is a good point, and a long term low fixed rate is not easily replaced.

This is essentially the inverse of holding long term bonds. Your mortgage obligation is a long term bond, created by you and held by someone else. 30 year fixed mortgages are a unique gift of our politics and our very deep bond markets which seem to have an inexhaustible demand for mortgage product. I believe that the decision to forgo a mortgage at todays rates only makes sense under particular conditions- for example, trying to avoid income that might push you over some of sharp margins in the Obamacare subsidy packages. Another would be if you have considerable job insecurity that could lead you to miss mortgage payments.

Ha

 

[Fermion]

There could be a couple of other reasons for not wanting to hold a mortgage. You get control of the escrow account for taxes and such...well you don't actually have to have an escrow account at all then, so you can perhaps earn a bit of return on that money.

Another reason might be you want to eliminate flood insurance. We currently have to have flood insurance because of our mortgage, even though we are on a 8 foot concrete foundation fully 3 feet above the 100 year floodplain. IMO that is $1100 a year that is absolutely wasted.

 

[MDJO]

Paying off a low rate mortgage is a psychological benefit. Mine is paid off, but I would not hesitate to borrow at today's low rates and invest for the long term at a much higher rate (within reason).

 

[haha]

There could be a couple of other reasons for not wanting to hold a mortgage. You get control of the escrow account for taxes and such...well you don't actually have to have an escrow account at all then, so you can perhaps earn a bit of return on that money.

Another reason might be you want to eliminate flood insurance. We currently have to have flood insurance because of our mortgage, even though we are on a 8 foot concrete foundation fully 3 feet above the 100 year floodplain. IMO that is $1100 a year that is absolutely wasted.

Yes, I am sure there are uncountable special situation, though avoiding an escrow account can be done with a mortgage still in place.

Ha

 

[nico08]

Hi pb4uski, yes the funds would probably come from taxable accounts. I would probably pay about 20 percent tax on these accounts.

One person suggested that I not sell the taxable accounts until after I lose my job, when my tax rate would be lower. Makes some sense, but liquidity would be important at that time too. However, I do have a good sized emergency fund account that could be used for living expenses after the job ends.

 

[nico08]

This is essentially the inverse of holding long term bonds. Your mortgage obligation is a long term bond, created by you and help by someone else. 30 year fixed mortgages are a unique gift of our politics and out very deep bond markets which seem to have an inexhaustible demand for mortgage product. I believe that the decision to forgo a mortgage at todays rates only makes sense under particular conditions- for example, trying to avoid income that might push you over some of sharp margins in the Obamacare subsidy packages. Another would be if you have considerable job insecurity that could lead you to miss mortgage payments.

Ha

Considering this to be a long term bond holding is a good analogy.

 

[photoguy]

I think the key is what you mean by "as soon as possible" in your post:

I am trying to retire early and I am trying to figure out how to maximize the likelihood of being able to do it as soon as possible. Thank you.

The way to maximize the probability of retiring early is by keeping your investments in high risk assets and hope they have generous returns in the next few years. However this is also the way maximize the probability of getting delayed a few extra years if there is a slump instead.


It sounds like you have about 20 years of expenses in your portfolio? How many years of expenses are you shooting for? How many more years of savings do you think you have to meet your number?

 

[nico08]

I think the key is what you mean by "as soon as possible" in your post:



The way to maximize the probability of retiring early is by keeping your investments in high risk assets and hope they have generous returns in the next few years. However this is also the way maximize the probability of getting delayed a few extra years if there is a slump instead.


It sounds like you have about 20 years of expenses in your portfolio? How many years of expenses are you shooting for? How many more years of savings do you think you have to meet your number?

Hi photoguy:

I am approaching FIRE in a different way, I am trying to save and invest enough so that I could pull four percent from my investment portfolio and that the four percent would approximate my annual living expenses.

My investment portfolio will need to grow about another 20 percent in order to get to the point described above.

I would guestimate it would take another 4 to 5 years to get to this point.

 

[pb4uski]

Hi pb4uski, yes the funds would probably come from taxable accounts. I would probably pay about 20 percent tax on these accounts.

One person suggested that I not sell the taxable accounts until after I lose my job, when my tax rate would be lower. Makes some sense, but liquidity would be important at that time too. However, I do have a good sized emergency fund account that could be used for living expenses after the job ends.

FWIW, if your taxable income is in the 15% tax bracket (~$72k for a couple filing jointly) then capital gains are 0% tax for federal tax purposes.