Another "Do I pay off my mortgage" scenario

[DawgMan]

Been searching the site, but can't quite find this specific scenario vetted out. I would suspect my dilemma is relevant for many others, but will use my specifics to get some feedback. Relevant points...

- Currently working, plan to RE end of 2019
- Once I RE (both myself and DW will be 55), will be 100% dependent upon investments (no pension, no working DW)
- AA currently 60/40 (current plan is to ride this thru RE) split about 50/50 in taxable/tax differed (will run mock tax returns and iOrp to determine best mix of withdrawals, but will have access to early 401K accounts if desired)
- Planning on using a flexible 4% SWR with a much higher RE spend/budget than most (heavy in the discretionary department), so have a good bit of flexibility.
- Plan to stay in home a min of 5 yrs, but frankly it could be indefinitely with no plans on the horizon to downsize. As others, at this point, I view my home as my home and not part of my assets factored into my SWR
- Currently mortgage balance of $348K (home value +/-$1M) at 3.6% with roughly 24 yrs to go and P&I = $21,726/yr.
- For now, I have underwritten this $21,726/yr as part of my static fixed expenses since it has 24 yrs to go and we have no plans to move
- For me, while I am leaning towards the pay off of the mortgage the day I RE for emotional reasons, I am still balancing that with the financial arguments. The $348K will either be paid off or stay in my AA.

So here is the pickle... While I am currently working and making more income than my planned RE annual spend, I am 1) very conscious of maximizing any tax deductions and 2) still being in the phase of putting money away, I choose to keep the low mortgage betting my $348K will get a better return in the market. However, I really wonder if I need to look at this differently (financially speaking, putting the peace of mind of a paid off mortgage to the side for a min) once I RE and go from zero earned income to 100% dependent on the 4% rule. In simple terms, once I RE, my $21,726/yr fixed expense really requires $543,150 in my AA to support it, does it not? IOW, the $348K I am currently keeping in my AA only covers $13,920 in expenses so does this not make the financial argument to pay off my mortgage based on my specifics noted above? I realize there will be some tax benefits to keeping the mortgage, but not significant enough to close the gap.

Where I struggle is the financial argument for keeping the cheap money and betting on higher returns by keeping the money in the market vs the financial argument I just laid out once RE. Somebody tell me what I'm missing here.

 

[flintnational]

In simple terms, once I RE, my $21,726/yr fixed expense really requires $543,150 in my AA to support it, does it not? IOW, the $348K I am currently keeping in my AA only covers $13,920 in expenses so does this not make the financial argument to pay off my mortgage based on my specifics noted above?

Dawg, unless I am mistaken, the $21k is principle and interest. For the comparison you are making, I would think you should look at interest only. The principal portion is just moving an asset from one bucket to the other. Your real "expense" is the interest only and would require less investments to support that portion of the payment.

 

[DawgMan]

Dawg, unless I am mistaken, the $21k is principle and interest. For the comparison you are making, I would think you should look at interest only. The principal portion is just moving an asset from one bucket to the other. Your real "expense" is the interest only and would require less investments to support that portion of the payment.

Well, I am thinking I need to be looking at this as I need 4% of X investments to cover Y in expenses, regardless of what they are. If I don’t pay off the mortgage, the principle is still part of my annual expense. Isn’t this how we come up with the “number” we need to RE?

 

[The Cosmic Avenger]

Remember, the bulk of that $100K+ in interest will be paid in the earlier years; in the later years, it will be mostly principal. If you change your mind and pay it off in 10 years, you won't be saving $50K of that interest, it will probably be more like 1/4 or less. So in my mind the important thing is how sure you are that you're going to keep the house and the mortgage for the next 21 years. If you're sure that you want to spend your retirement in that house, then you have the time frame to recover that $100K by the principal instead of paying off the mortgage early. (Although with that time frame, my personal opinion is that you should be a little more aggressive, more like 70/30, but that's probably not going to make or break this situation.)

And believe me, I'm a fan of minimizing debt. We have our mortgage paid off in anticipation of paying cash for our only child' college tuition...and maybe med school! But then we're retiring right after (or possibly at) their graduation!

 

[bobandsherry]

As Flint has mentioned, about 42% of your payment is principal. At least I think that's the case as given the figures you provided you had around $400k mortgage originally. So about $12,500 is your actual "expense". So that's roughly $320k in investments to pay the interest. The other amount is just right pocket/left pocket.

 

[RunningBum]

Well, I am thinking I need to be looking at this as I need 4% of X investments to cover Y in expenses, regardless of what they are. If I don’t pay off the mortgage, the principle is still part of my annual expense. Isn’t this how we come up with the “number” we need to RE?

4% is a rough guide, not a precision measurement. Paying off the mortgage is basically a 50/50 proposition--you can very possibly do better in the market, or you can be safer paying the mortgage, or you can adjust your AA depending on whether you have the mortgage debt or not. But it's still basically 50/50. If you are calculating a big difference one way or another, it's likely your calculation is flawed, and using the 4% "rule" is probably the cause of that flaw.

 

[bobandsherry]

Well, I am thinking I need to be looking at this as I need 4% of X investments to cover Y in expenses, regardless of what they are. If I don’t pay off the mortgage, the principle is still part of my annual expense. Isn’t this how we come up with the “number” we need to RE?

It is, but at same time you are putting money into another asset.

For me, I've been happy to have kept my mortgage. I'm paying just over 3% and have managed to return over 12% annually for the past 2.5 years I've been RE. I realize chances of those returns continuing are not high, but who can say. I also view as I have more than adequate funds available should emergency/disaster come up.

Do whatever makes you feel happiest.

 

[DawgMan]

As Flint has mentioned, about 42% of your payment is principal. At least I think that's the case as given the figures you provided you had around $400k mortgage originally. So about $12,500 is your actual "expense". So that's roughly $320k in investments to pay the interest. The other amount is just right pocket/left pocket.

I must be dense here... I get all of the make up of the P&I, but if my RE budget has a fixed line item expense which dictates the required AA balance needed to meet a 4% WR, does it really matter? In my case, my house is not being included in my AA so it is just an expense. It seems like there is a paradym shift once we go to a RE SWR plan that somehow adjusts the logic?

 

[pb4uski]

However, I really wonder if I need to look at this differently (financially speaking, putting the peace of mind of a paid off mortgage to the side for a min) once I RE and go from zero earned income to 100% dependent on the 4% rule. In simple terms, once I RE, my $21,726/yr fixed expense really requires $543,150 in my AA to support it, does it not? .....

Somebody tell me what I'm missing here.

Here is what you are missing. First, the $21,726 annual cash outflow is not for life like other spending... it is for 24 years and then $0 thereafter. Second, the 4% "rule" anticipates that after the initial year's withdrawals that each subsequent year's withdrawals are indexed for inflation, but your mortgage payments are fixed.

Users run into the same problem in FIRECalc where they include their mortgage payments in their spending.... they should exclude their mortgage from spending and include their mortgage payments as an off chart spending with a corresponding offset via a pension of the same amount once the mortgage is paid off.

I look at it this way. According to Vanguard, the historical total return for a 60/40 portfolio from 1926-2017 was 8.8%. Your mortgage is 3.6%... that is a 5.2% difference. To be conservative, let's haircut that by 2% so that is 3.2%. Your average mortgage balance for the next 24 years will be $174k (half of the $348k as it declines to $0). If you benefit by 3.2% for 24 years on $174k average balance that would be $134k. What fun could you or your heirs have with an additional $134k?

OTOH, it is a calculated risk but your mortgage is small in comparison to your resources.... if the bet goes sideways you will not be ruined, just dinged a little.

I would keep the mortgage.

 

[DawgMan]

Appreciate everyone’s input in helping me vet this out. I suppose the “4% cult” has me drinking too much koolaid!

 

[pb4uski]

I must be dense here... I get all of the make up of the P&I, but if my RE budget has a fixed line item expense which dictates the required AA balance needed to meet a 4% WR, does it really matter? In my case, my house is not being included in my AA so it is just an expense. It seems like there is a paradym shift once we go to a RE SWR plan that somehow adjusts the logic?

From a cash flow perspective it doesn't matter... it is $21,726 out the door each year for the next 24 years. However, from a NW perspective it does matter... because while you'll write checks for a total of $521k, your home equity will increase by $348k... so ignoring investment income on the money that would be used to pay off the mortgage, your net cost is only $173k (interest).

 

[corn18]

6 one way, half dozen the other. There is no wrong answer.

I use the flexible retirement planner and I input the mortgage as an expense that is not inflation adjusted. It is quite magical to see the net present value of the mortgage do down over time. That convinces me to keep the mortgage.

Then I look at how much more I need to retire with the 4% rule to cover the mortgage ($650k @ 4% to cover P&I) vs. the payoff amount of $400k. That convinces me to payoff the mortgage.

Then I get cornfused, run a gazillion more numbers in myriad calculators, read all the posts about paying off a mortgage and end up doing nothing because that is what I do when faced with indecision with my finances:

"Don't just do something, stand there!"

And I like Occam's razor:

Occam's razor (also Ockham's razor or Ocham's razor; Latin: lex parsimoniae "law of parsimony") is the problem-solving principle that the simplest solution tends to be the right one. When presented with competing hypotheses to solve a problem, one should select the solution with the fewest assumptions.

And I can't figure out which one has the least assumptions or is the simplest.

So I go back to "Don't just do something, stand there!" and I pay my mortgage every month.

 

[bobandsherry]

I must be dense here... I get all of the make up of the P&I, but if my RE budget has a fixed line item expense which dictates the required AA balance needed to meet a 4% WR, does it really matter? In my case, my house is not being included in my AA so it is just an expense. It seems like there is a paradym shift once we go to a RE SWR plan that somehow adjusts the logic?

I guess look at it this way, for the principal you take from one investment to pay that. However you then build up the equity in your home. Thats why I said right pocket / left pocket. Eventually you'll cash in on that equity/investment regardless if you factor in now or not. When you die, and we all will, your heirs will real that nest egg. But I get how you are looking at it as well.

If the market crashes you'll smile all the way to the bank, if market continues to perform at the roughly historical level of 8% you'll then regret that you gave up so much opportunity for gains.

But as I said, do what makes you feel happiest. No right or wrong answer until you know what the future will be, then it's too late.

 

[orangehairfella]

No good reason to relitigate the math on the topic. We know that all things equal (which they aren’t) there is a higher probability of ending up with a higher net worth by keeping the mortgage than by paying it off at these interest rates. We also know that home equity is less liquid. The statistics are not in favor of paying off the mortgage.

But, there’s a reason mortgages exist: it allows the issuer to make some low risk money. In theory they could make more by making higher risk loans, though as we’ve seen that doesn’t always work out. So it’s the same question for all parties involved: Is the probability of additional gains worth the risk and what do you lose if the bet doesn’t pay off?

I paid off my mortgage. It felt great. I would have more money now if I didn’t. I sometimes second guess the decision given the returns of the last couple years, but not so much that I wouldn’t do it again. Someone in some thread on this topic once asked “Would you take out a loan against your home to buy stocks?”

 

[joeea]

Where I struggle is the financial argument for keeping the cheap money and betting on higher returns by keeping the money in the market vs the financial argument I just laid out once RE. Somebody tell me what I'm missing here.

Unless I missed it...

You missed noting the size of your portfolio, your anticipated expenses in retirement, and the affect of taking $384k in investable assets from that portfolio and putting into the illiquid walls of your house.

If your portfolio isn't significantly affected by a $384k reduction, the you can indulge in the emotional impact versus optimizing your finances.

And you missed noting your goals. Do you want to leave a huge legacy? Leave nothing more than a paid-off house? Give away a lot of your assets to charity? Die the the you spend your last dollar? Although an important part of a plan, spending 4% isn't really a goal.

Personally, I'm guessing that a 3.6% mortgage rate will seem like cheap money down the road, and so would not hurry to pay it off. But that's me, with my portfolio and my goals in mind. Your mileage may vary, objects in the mirror are closer than they appear, past performance is not a predictor of future returns, lather rinse repeat, a fool and his money are soon parted, a watched pot never boils, if you see something say something, remain calm and carry on, yada, yada...

 

[Texas Proud]

My first comment is that you only need $348K of assets to support the mortgage... that money is invested and will almost always make enough to pay any interest..


So, for a mortgage, forget the 4% rule... it does not apply...


BTW, I did a calc recently and I have made over $80K more by not paying off the mortgage and investing that money over the last 8 years... and my mortgage is about 1/3rd of yours... but mine is 15 years and lower interest... only a bit lower..


I would never pay off your mortgage if I had it...

 

[Trawler]

one thing is to consider if you pay off mortgage based on your age I am assuming the money is coming out of money bucket that the income tax has been paid. If so does it leave you enough to get to the age where you want to tap into the tax deferred accounts. We paid off mortgage for the comfort but in hindsight I could use a little more $$ in the already taxed bucket to help better mange our taxable income to minimize tax and ACA Health subsidy especially from age 60 to 65 when we become Medicare Eligible. We FIRED at 51. Like you 100% dependent on portfolio. Ability to manage income thru Roth conversions until we take SS is great. So I would look at that this if I was considering peeling off 384K of liquid assets. Just a thought from been there done that.

 

[SevenUp]

Appreciate everyone’s input in helping me vet this out. I suppose the “4% cult” has me drinking too much koolaid!

In your case, 24 years doesn't differ that much from 30 years. But the non-inflating nature of the mortgage payment does differ significantly from the "4% rule" assumptions.

Does the need to have higher annual income (to support the mortgage payment) have much effect on marginal tax rates, and/or other (medicare premiums, FAFSA, ACA, etc.) items that might apply to you?

 

[DawgMan]

In your case, 24 years doesn't differ that much from 30 years. But the non-inflating nature of the mortgage payment does differ significantly from the "4% rule" assumptions.

Does the need to have higher annual income (to support the mortgage payment) have much effect on marginal tax rates, and/or other (medicare premiums, FAFSA, ACA, etc.) items that might apply to you?

Jumping back in here...

In addressing many of the comments, my NW is upper 7 figure range with all but about $1M in investments split 50/50 taxable/tax differed. I have placed a majority of my investments (other than some real estate investments) in my 60/40 AA. Paying or not paying off the mortgage does not jeopardize any part of my RE withdrawal spend to be projected around $300K/yr (significant discretionary). I was really pulling my house out of the analysis since we all need a place to live. Yes, it's part of my NW and from a pure net worth perspective, I buy into keeping the mortgage and letting the $$ otherwise used to pay it off ride. It just appeared to me if you look at it as an expense, there was some logic to paying it off. As Corn18 said, I will probably do nothing at this point and just make an emotional call on paying it off perhaps the day I launch.

 

[joeea]

my NW is upper 7 figure range with all but about $1M in investments split 50/50 taxable/tax differed.

I will probably do nothing at this point and just make an emotional call on paying it off perhaps the day I launch.

Assuming a reasonable level of expenses in retirement, with that kind of wealth, the $384k amount isn't significant enough to worry about. Do whatever makes you feel best.

 

[pb4uski]

.... Someone in some thread on this topic once asked “Would you take out a loan against your home to buy stocks?”

That is the theoretical dilemma.... while I feel strongly that it doesn't make sense to pay off my 3.375% mortgage early since I think it more likely than not that my investment returns will cover the interest, at the same time I concede that there is some risk that it might not. In my case, my mortgage was about 10% of my nestegg, so if I was wrong I would be dinged and not ruined. I think the OP's decision has similar dimensions... slightly higher interest rate but lower mortgage in relation to nestegg.

All of that said, I'm not sure that I will refinance and invest the proceeds to earn a spread, so I concede that I am somewhat inconsistent, but in the pay off the mortgage case the fact set is that the mortgage already exists.

 

[bobandsherry]

The only rational benefit I can see in paying off your mortgage early is if you were near the ACA cliff. Then paying off the mortgage would reduce the need to pull money from taxable accounts and reduce the MAGI (go forward basis). Don't think you will be in that situation.