A new debate on paying off the mortgage (or not).

[Ronnieboy]

I am willing to make this offer to anyone who believes that the mortgage interest deduction is a good deal. You send me $10k and I will be more than happy to send you back $3k. In fact I will go one step further - I am feeling the need for economic stimulus - I will send back $5k. Please email me for more details....

 

[cute fuzzy bunny]

I'll be glad to bankroll you in this business endeavor at the usual rates. I'll supply the $5k, you send me the 10k, and I'll kick you back a $1k finders fee for each customer.

 

[walkinwood]

Here's a link to the article.
[FONT=Verdana,Sans-Serif]Finance: Should You Prepay Your Mortgage?[/FONT]

I'm having a hard time understanding it. can someone help?

Say I want a 60/40 equity to bond asset allocation & have a $1M portfolio ($600K equity, $400K bond). I also have $400K house with a $200K mortgage.

Treating this as purely an asset allocation problem (ie. If I assume that the after-tax mortgage rate is the same as the after-tax rate of a treasury bond) Is she saying:

a) my effective portfolio is $800K with $600K in equity, $200K ($400k - $200K mortgage) in bonds, so effectively a 75/25 asset allocation.

b) So, if I want a 60/40 allocation with the mortgage, I really should have $480k (60% of $800K) in stock and 520K in bonds?

Thank you.

 

[aenlighten]

Would I borrow to invest?

Possibly, if the interest rate were low, taxes were high, and I had stable income streams such as annuities or pensions to cover it. Trading a non-indexed pension for a deflating mortgage would reduce inflation risk. Otherwise, not likely.

 

[cute fuzzy bunny]

I think the good question around asset allocation is to note that your risk profile changes substantially without a mortgage, and your spending risk goes down substantially.

So while your portfolio is smaller, you could take on more investing risk (say 75/25 or 80/20) for perhaps an even higher return than you could have achieved with a more staid 50/50 or 60/40. Or since you dont need that enormous upside because you dont have much in the way of payment risk, you could reduce your portfolio risk, shoot for a bit more cheap income, and improve your sleep at night factor.

If your spending is slashed by 30-50%, shouldnt that change other aspects of your financial life?

 

[blessed]

Pete,

I'm one of the people quoted in the "Ordinary People,Extraordinary Wealth"; and I still have a mortgage and my DH and I are retired.

 

[aenlighten]

What is an asset for allocation?

There are not only financial and real assets, but values of income streams. The larger the latter compared to expenses, the more risk one could tolerate. I would also consider these as part of ones portfolio.

As people age they can lower their risk due to a shorter time horizon, but I think many do not because their portfolio becomes large enough that they feel no need to. Their spending may increase but their portfolio increases faster and they may feel they can trim their expenses more easily in a downturn.

 

[slazenger]

Now ask the same people: If you owned your home free and clear, would you borrow $100K against it at 6% to invest?

A lot of the people who would NOT pay off the home with a $100,000 lump-sum windfall would also NOT go $100K into debt to invest.

I believe putting the question this way potentially puts someone in the wrong frame of mind because it sounds more drastic than what it really is. Case and point:

I've never really looked into the costs of a home equity loan and don't imagine I'll ever get one, but I suspect without knowing that there are fees associated with it. I also suspect the interest rates are likely even higher than ~ 6% that a lot of us have on our homes. In short, would I get a fee free, 6% margin loan with no catches, and the ability to tax-deduct all of the interest on my federal return? Maybe. Would I get a home equity loan. No.

............

I have one more kicker in the equation that causes me to fall on the keep the mortgage side. In addition to the near equal returns of bonds over very long periods as compared to a 6% mortgage, and the fact that I can (and do) deduct the interest on the home loan, is this fact: At the moment, I can barely afford to max out all of my IRA options. If i shift money to paying off a mortgage early, then there's an IRA that's not going to get fully funded. I doubt I have to convince many of you guys and gals here just how powerful IRA's are.

Would I borrow money at 6% with a loan that I could deduct the interest on to fund an IRA if I couldn't afford to fund it otherwise? Heck yeah!

I will say this though; I would recommend paying off a mortgage if the only alternative one has is a taxable account (of any kind, be it bonds or stocks). I'm just not at that level of savings yet though.

 

[cute fuzzy bunny]

Many home equity loans are fee free, can often be had at rates under 6% (penfed has had several offerings quite recently), and in some cases the interest may be tax deductible.

It DOES create a frame of mind issue. Many people accept having a mortgage as being "normal" without doing an analysis of the issues.

In this instance, there is very little difference between margin investing with your house as collateral and holding a mortgage to improve the size of your investment portfolio.

Look at it from this perspective. You hold a mortgage, invest the money...but you invest it a little more conservatively because...well...cant have your investments take a dive and have to be selling off depreciated assets to pay the mortgage. And then you set aside 2-5+ years of cash or equivalents to fully insulate you from market swings. And then maybe you eke out a percent or two after costs. Now subtract the reduced investment gains from the more conservative portfolio. Now subtract the weak returns you got on all that cash.

Doesnt it seem like you've just created a series of problems and then spent potential returns solving them and reducing the risk you created?

I've always been big on not making problems, and hence not having to jump through hoops to solve them.

 

[Nords]

Would I borrow money at 6% with a loan that I could deduct the interest on to fund an IRA if I couldn't afford to fund it otherwise? Heck yeah!
I will say this though; I would recommend paying off a mortgage if the only alternative one has is a taxable account (of any kind, be it bonds or stocks). I'm just not at that level of savings yet though.

Since we've debated this issue a couple thousand times on this board, let me point out a couple things that others have previously mentioned:
1. The deduction advantage is only to the extent that it exceeds one's standard deduction. I pay over $18K/year in mortgage interest now so that's no problem this year, but in another 10 years the lines may cross as the deduction is adjusted for inflation and the interest payments drop.

2. It makes no sense to own bonds earning less than the mortgage rate.

 

[hogwild]

Paying off the mortage is a cash flow issue in my case. I only owe about 70k and my PI pmt is 1168/mo. This means, using the 4% rule (or the reciprical 25x) I would need $350,000 just to support the payments. To me, the 70k payoff makes sense.

 

[slazenger]

Look at it from this perspective. You hold a mortgage, invest the money...but you invest it a little more conservatively because...well...cant have your investments take a dive and have to be selling off depreciated assets to pay the mortgage. And then you set aside 2-5+ years of cash or equivalents to fully insulate you from market swings. And then maybe you eke out a percent or two after costs. Now subtract the reduced investment gains from the more conservative portfolio. Now subtract the weak returns you got on all that cash.

Doesnt it seem like you've just created a series of problems and then spent potential returns solving them and reducing the risk you created?

I've always been big on not making problems, and hence not having to jump through hoops to solve them.

If i understand the perspective you just described, it doesn't include a situation where there is earned income (my job) supporting and paying for the mortgage. If I'm recalling correctly, you are retired and don't have earned income anymore. Though there are no guarantees, my job (and its associated income) is extremely stable.

 

[slazenger]

Since we've debated this issue a couple thousand times on this board, let me point out a couple things that others have previously mentioned:
1. The deduction advantage is only to the extent that it exceeds one's standard deduction. I pay over $18K/year in mortgage interest now so that's no problem this year, but in another 10 years the lines may cross as the deduction is adjusted for inflation and the interest payments drop.

I only pointed it out once earlier in the thread (not a thousand times, granted ), but I specifically mentioned I take this deduction. To be clear, I've passed the standard deduction before I even consider the mortgage interest so every dime of my mortgage interest is deducted for the time being.

2. It makes no sense to own bonds earning less than the mortgage rate.

In a taxable account? I agree. But gosh, you throw in all the advantages of an IRA and you've easily got a situation where you end up with more green in the end with the IRA corporate bonds pitted against just paying a mortgage note. Look at this from the perspective of a traditional IRA (though I use Roths which are arguably better). What kind of investment gives you an instant 25% return on your money AND lets that investment grow tax free for as long as you like? A traditional IRA for someone with a marginal rate of 25%. If i choose to go the route of paying more than my regular 30 year fixed payment, this is exactly the kind of account that won't get full funding.

If we're talking about mortgage vs taxable accounts, again I'm on the side of paying off the mortgage.

 

[cute fuzzy bunny]

Last time I checked, this is the early retirement forum, not the I'm still working and making a wage adjusted income forum.

But as I've said a hundred times...if you are still working and your company is paying a wage adjustment in excess of inflation, you ought to have a mortgage. As long as the rate is good.

Unless of course you're a nervous accumulator and have a bunch of bonds paying 3.5% while paying 6% on your mortgage, as Nords pointed out. Thats stupid.

And also for the hundredth time, this isnt about the numbers, this is about risk tolerance and a bunch of financial hairballs designed to provide data for the predetermined answer...90% of the time...

 

[slazenger]

Last time I checked, this is the early retirement forum, not the I'm still working and making a wage adjusted income forum.

Wow, is everyone here as polite as you? Your rudeness aside, I guess I probably should ask if I'm the only one that's still working here and only aspiring to retire early.

But as I've said a hundred times...if you are still working and your company is paying a wage adjustment in excess of inflation, you ought to have a mortgage. As long as the rate is good.

Ok i'm going to break it to you and Nords what apparently isn't evident by my profile; I'm not aware of what's been said 1000 times, or what you've said 100 times.

Unless of course you're a nervous accumulator and have a bunch of bonds paying 3.5% while paying 6% on your mortgage, as Nords pointed out. Thats stupid.

If i was under the belief that the long term return on my long term bonds over the rest of my career was only going to be 3.5% or anything even close to that, I assure you I'd liquidate every one of them immediately.

And also for the hundredth time, this isnt about the numbers, this is about risk tolerance and a bunch of financial hairballs designed to provide data for the predetermined answer...90% of the time...

Then why are we discussing something else?

 

[cute fuzzy bunny]

Should I have put three "winkies" at the end to avoid the lack of politeness comment?

We DID put together an entire section on frequently asked questions, and this item has about 20 threads with a few thousand posts attached. But frankly I dont expect people to read them before asking questions. Its inconvenient.

In the meanwhile, your return from your long term bonds, adjusted for inflation, will be far less than 6%. You'll be lucky to get 3.5%. In fact, at that price point I'd buy them. Otherwise I wouldnt touch long term bonds with a 42' custom made pole. I'm not even thrilled with intermediate term bonds in the sort of market we've had for the last 8 years or will have for the next 10-15.

 

[slazenger]

Should I have put three "winkies" at the end to avoid the lack of politeness comment?

Sorry, it just reminded me of those situations where someone jabs you then they say "just kidding" to make it all better. I was trying to honestly point out where my situation was a bit different than what you described and it was no attack on you.

We DID put together an entire section on frequently asked questions, and this item has about 20 threads with a few thousand posts attached. But frankly I dont expect people to read them before asking questions. Its inconvenient.

Fair enough, .... just saying I wasn't debating/discussing with myself. I could have just been told that initially if the real objective is to thwart repeated discussions. Also, I didn't really have a question

In the meanwhile, your return from your long term bonds, adjusted for inflation, will be far less than 6%. You'll be lucky to get 3.5%. In fact, at that price point I'd buy them. Otherwise I wouldnt touch long term bonds with a 42' custom made pole. I'm not even thrilled with intermediate term bonds in the sort of market we've had for the last 8 years or will have for the next 10-15.

This is a null though, right? Inflation applies to the effectual return I get on paying off a 6% note early, so it just brings us back to where we were.

Ok so lets rap this up because I agree, it's not what the OP was talking about.

 

[cute fuzzy bunny]

Inflation for a non wage earner is a null effect. It applies to your debts and your investments equally. Wages are generally better offset than inflation...just not for the last 7-8 years :

Other than that, I accept your apology and I love you man!!!

I'm not even remotely interested in thwarting repeated discussions if theres new and interesting elements to them.

For what its worth, I get my ass kicked on a bunch of other discussion forums on a regular basis for not reading all 524,285 posts that went before. Its cultural.

 

[popowich]

A lot of the people who would NOT pay off the home with a $100,000 lump-sum windfall would also NOT go $100K into debt to invest.

My original mortgage amount was 96K.

When I was younger I had 40K that I wasted and should have put at least 20K of it into a gigantic payment and knocked down my mortgage balance.

Today at 31 years old I'd pay off my house in a heart beat, no second thoughts. Your home is more than an investment, it's the roof over your head. You don't mess around with that.

At no age would I have borrowed 100K at 6% to invest for a higher rate of return.

A friend of mine and I did joke for a long time about taking out extra college loans at 4% to invest but did not see the sense in taking on additional debt.

-Raymond

 

[CitricAcid]

Hate to continue on a topic that is posted too often and takes over the board, but would like to add onto a comment that CFB made regarding social norms or whatever. I feel the reason that the mortgage debt and 6% interest is considered standard while borrowing at lower rates to earn higher rates isn't is simply because of the tangible and intrinsic value of a home. (I don't believe this, however, because money in essence is tangible and intrinsic in the fact that it can be exchanged for goods and services, so liquid investments, like stocks are after exchanging tangible assets, and could actually turn into a house... but I digress). Borrowing money at a standard rate so that people can have a roof over your head is a lot more socially understandable and accepted because:
a.) homeownership is an ideal many in this country think should be universal
b.) not everybody trusts the stock market
c.) everybody trusts the real estate market
d.) sentimental/psychological value

Paying off the mortage is a cash flow issue in my case. I only owe about 70k and my PI pmt is 1168/mo. This means, using the 4% rule (or the reciprical 25x) I would need $350,000 just to support the payments. To me, the 70k payoff makes sense.

This is partly incorrect. Having $350,000 would be able to pay off that amount INDEFINITELY... and when the payments stop, you would still HAVE $350,000. Also, the $350,000 would grow with inflation and has no timeframe. Considering the amount you can make with other alternatives and the time frame involved with the payments, the value is a lot closer to 70k. At that rate, it seems there are 7 years left on this mortgage. Amortize an amount of money that pays off 70k in 7 years using money today that can be invested elsewhere and it will be around 100k.

 

[Nords]

c.) everybody trusts the real estate market

I'm not sure what you mean by this...

 

[cute fuzzy bunny]

Also, the $350,000 would grow with inflation

Pretty sure the value of the $350k would be reduced by inflation over time, not grow with it, unless you invested in TIPS.

This is why the 'conventional wisdom' of owning a mortgage being beneficial because the mortgage dollars get degraded by inflation doesnt work for an early retiree. A wage earners salary usually gets adjusted upwards to match or exceed inflation and create a positive imbalance, although that hasnt worked very well lately. An early retiree living off of a portfolio gets devalued by inflation at the same rate as the mortgage money thats been loaned to you and any adjustments to that have to come out of your investment returns.

Of course, if you have an inflation adjusted guaranteed pension, then you look like a wage earner and you can use the inflation leverage.

 

[CitricAcid]

I'm not sure what you mean by this...

The real estate market going down is a national crisis because prices can only go up... according to mainstream media and the minds of millions of Americans. Thus, borrowing money to ivnest in the real estate market is much more comonly accepted.

Pretty sure the value of the $350k would be reduced by inflation over time, not grow with it, unless you invested in TIPS.

This is why the 'conventional wisdom' of owning a mortgage being beneficial because the mortgage dollars get degraded by inflation doesnt work for an early retiree. A wage earners salary usually gets adjusted upwards to match or exceed inflation and create a positive imbalance, although that hasnt worked very well lately. An early retiree living off of a portfolio gets devalued by inflation at the same rate as the mortgage money thats been loaned to you and any adjustments to that have to come out of your investment returns.

Of course, if you have an inflation adjusted guaranteed pension, then you look like a wage earner and you can use the inflation leverage.

When I said it should "grow" with inflation, I mean that the 4% SWR takes inflation into account, when you have to take out 4% each year. So, the first year you take out 4% of $350,000, the next you would have to take out, 4.12% (3% inflation) of $350,000 or 4% of $360,000. Thus, to keep up with this inflation, you would need 7.1% a year. Stock market returns tend to beat this, but doesn't always obviously. In the same way that you must take into account the diminishing real amount of debt due to inflation on the mortgage, it is important to understand that to stay even and not keep up with inflation (since it is a fixed payment), you would only need to return 4.16% a year to keep the payments up, obviously a low enough threshhold to keep up with the payments and keep the $350,000 at the end of the payments.

 

[hogwild]

... Thus, to keep up with this inflation, you would need 7.1% a year. Stock market returns tend to beat this, but doesn't always obviously.

Money that is earmarked to pay the mortgage should not be invested in the stock market IMHO. I know of no place where I can get a guaranteed return of 5.875% except by paying off my mortgage, not to mention the much discussed intangible benefits. By paying off my mortgage, I can afford to be more aggressive in investing the $350K than I would otherwise be comfortable with.

 

[CitricAcid]

Money that is earmarked to pay the mortgage should not be invested in the stock market IMHO. I know of no place where I can get a guaranteed return of 5.875% except by paying off my mortgage, not to mention the much discussed intangible benefits. By paying off my mortgage, I can afford to be more aggressive in investing the $350K than I would otherwise be comfortable with.

I am not saying that you should put it in, just saying it is a definite possibility. Similar to ziggy's wonderful exercise of comparing a mortgage to a home equity loan, there are potential advantages to both sides, while most here are risk averse to that.

What I mentioned there was the 4% SWR assumes that you advance past what you are taking out each year to keep up with inflation and maintain your cash balance at the end. Assuming that this is a fixed mortgage, I can do some calculations. Taking your 1168 a month on $70k I will assume there are 6-7 years left, let's just say 7 for argument's sake. I will assume you will make 7% too, perhaps not a perfect assumption, but nonetheless acceptable. If you start with $77,563 and earn 7% a year, you will be able to pay off the $14,016 each year by taking out of your principal (For example, first year you earn $5,429 appreciation and sell off $8,586 of your principal to make the payments leaving you with $68,976. The next year you make $4,828 appreciation and have to sell off $9,187 of your principal leaving you with $59,789... math works, maybe not 100% possible to do with the real world so just add a couple thousand on to the end result). Thus, saying that $350,000 is equal to your mortgage payment cash flow I think is misleading due to the fact that at the end you will have nothing leftover... so an amortization type calculation is necessary.