Mortgage rates headed down - time to refi?

[twaddle]

Interesting. So what did you invest the money in?

Now *that* is an interesting discussion. There are sooooo many opportunites to safely beat a 3.5% after-tax yield.

I'm still deploying the capital, but I like muni CEFs (currently 5% tax-free), high-yield dividend payers (a bunch available at over 4%). I'm even considering wacky stuff like the CPI-indexed exchange traded bonds and real estate with cap rates over 7%.

It's like there's suddenly a cornucopia of interesting investments just as mortgages hit an all-time low.

 

[laurence]

With what money do you pay the mortgage? My emigrant direct is only paying 3.6% and falling and it's taxed. Do you do the bucket thing, dividends enough for the payment? Are all the things you are considering tax free?

My questions are two pronged, one is honest interest and curiousity, and at a larger level, understanding the level of sophistication needed to minimize the increase in risk/volatility and maximize spread. The investment opportunities you mention come and go, is the plan to pay off the mortgage if the investment horizon starts looking bleak?

 

[twaddle]

The munis are tax-free, so today we're in a fairly remarkable situation in which one could pay their mortgage interest using the income from a super-conservative tax-free investment, and you'd still pocket the tax break from the mortgage deduction and have a little left over from your muni investment by the end of your mortgage.

That's the conservative case. Since cash flow isn't an issue for me (my investments already throw off more than I can consume), that means I can afford to take a bit more risk.

If you wanted to, it's a fun exercise to modify an amortization spreadsheet and model the monthly outflow vs inflow, annual taxes, etc using a variety of investment assumptions. Use the munis as the most conservative case (in which you'd have to continuously reduce the principal invested), and compare to CPI-linked investments, dividend yielding investments with low growth and low volatility, and higher return higher volatility investments.

We can all make different choices depending on our unique situations, but the bottom-line for me is that it's hard to lose even if you choose the most conservative investment approach.

As far as investment opportunities coming and going, I've only talked about those that are available today. You can lock those yields in for the life of your mortgage.

 

[ERD50]

Well, we keep talking about the risk associated with a mortgage, but I haven't seen any numbers. So I started doing some FireCalc runs, with the same methodology I used in that "FireCalc Dips in NW..." thread I started. Seems to me the best measure of risk is what your NW balance is after the worst periods in history. We can all relate to that.

I'm finding some 'interesting' results and some data that (I think) has never been discussed before - but I want to triple check these numbers before presenting.

In the mean time, I've seen that CFB brought up the interesting and often overlooked point that there may be a tax hit for the mortgage payer because he needs that extra cash flow to pay the mortgage. Interesting observation, but I think it is not apples-apples. It appears to be ignoring the tax impact on the guy that does not have a mortgage. Consider:

Two people retire and buy retirement houses. Mr Cash has $1M in his portfolio after buying the house, Mr Mortgage takes out a $200K mortgage, so has $1.2M in the portfolio. So, what were the tax impacts of Mr Cash pulling out that $200K to put towards the house? The simplest assumption is it was MM money with no gains, so no tax impact - OK. But to keep it comparable, that means that Mr Mortgage also has $200K with no gains. That will pay the first 15 years of a 30 year mortgage with no added tax burden. And Mr Mortgage might get the interest write off, offsetting (to some degree) any tax paid in those last 15 years.

I'm bleary eyed from the FireCalc runs, I'm not up to figuring the tax savings on the declining interest of a 30 year mortgage vs added tax on the last 15 years, but I'd love to see it if anyone else is more motivated at this point. What is a decent assumption? 5.5% mortgage, with a 25% marginal tax rate?

-ERD50

 

[twaddle]

I'm bleary eyed from the FireCalc runs, I'm not up to figuring the tax savings on the declining interest of a 30 year mortgage vs added tax on the last 15 years, but I'd love to see it if anyone else is more motivated at this point. What is a decent assumption? 5.5% mortgage, with a 25% marginal tax rate?

The tax savings on a 15-year fixed 5.5% $400,000 mortgage for somebody in the 25% tax bracket would be $47,075. Take the total interest of $188,300 and multiply by 0.25.

 

[JustCurious]

The tax savings on a 15-year fixed 5.5% $400,000 mortgage for somebody in the 25% tax bracket would be $47,075. Take the total interest of $188,300 and multiply by 0.25.

Not necessarily. That is only true if all of the mortgage interest is tax deductible. Many people take the standard deduction, and therefore get no tax benefit from their mortgage interest. And even for those who do itemize, they only get a tax benefit equal to the total of their itemized deductions, minus the standard deduction, which is often less than the total mortgage interest.

 

[twaddle]

Not necessarily. That is only true if all of the mortgage interest is tax deductible. Many people take the standard deduction, and therefore get no tax benefit from their mortgage interest. And even for those who do itemize, they only get a tax benefit equal to the total of their itemized deductions, minus the standard deduction, which is often less than the total mortgage interest.

Quite true. Everybody needs to run the numbers themselves, but I chose the example of a $400,000 mortgage so I could assume that the house value was at least $500,000, and I figure anybody with a $500,000 house has enough deductions to make itemizing worthwhile.

 

[ERD50]

The tax savings on a 15-year fixed 5.5% $400,000 mortgage for somebody in the 25% tax bracket would be $47,075. Take the total interest of $188,300 and multiply by 0.25.

Thanks - that part is straight forward (I AM getting bleary-eyed).

Part II:

Now for that mortgage, the $400,000 that you didn't put into the house (and I'm assuming has no unrealized gains for the apples-apples comparison with Mr Cash) would pay the first 122 payments (398,736.26). The remaining payments may be hit by the 25% marginal rate ( increased draw from 401K or whatever). And the remaining payments are (drum roll....)

$189,563.14 - times the .25 tax rate = $47,390.79

So, assuming the same tax rate on all - it's basically a wash with your $47,075 .... right?

-ERD50

 

[twaddle]

Yes, assuming the investment income is taxed at the same rate, the tax savings/cost should be a wash.

What makes this more fun is that there are several classes of investments which are taxed below your ordinary income rate. Muni interest, dividends, and cap gains for example.

 

[Marquette]

That's it, I'm moving back home and living rent-free.

 

[jazz4cash]

That's it, I'm moving back home and living rent-free.

Go for it, but my grown 1st child is pretty close to paying rent to live at home (don't tell DW). Depending on how much rent I can get away with charging, I may bank some or all for her 1st house or whatever.

 

[ERD50]

Alright - I've done the FireCalc runs and 3X checked them. There is one very unexpected result - at least for me.

Here's the comp I used, with a 30 year $200,000, 5.5% mortgage:

Mr Cash:
$1M portfolio, no mortgage, $35,000 spend, 75% EQ.
Worst Case FireCalc result at 30 years, 75% EQ: $87K balance.


Mr Mortgage:
$1.2M portfolio, $35,000 spend, $13,632 annual mortgage pay, 75% EQ.
Worst Case FireCalc result at 30 years, 75% EQ: $103K balance.

Generally, people would say that the extra $200K in the portfolio should go to fixed income to reduce 'risk'. So that gives a 63% EQ ratio.

With that, Mr Mortgage gets:
Worst Case FireCalc result at 30 years, 63% EQ: $161K balance.

So, if you accept the dip in your Net Worth number as a measure of your real, personal, gut-check risk, it would appear that holding a mortgage decreases risk, right? It adds over two years to your portfolio life (difference /$35K = 2.1 years).

OK, now an interesting observation....

You better plan on holding that mortgage for about 25 years. Because if you cash it in at say, 20 years, your portfolio balance will be lower with the mortgage. At 20 years: $290K for Mr Cash vs $253K for Mr Mortgage. And it gets worse the earlier the cash in date.

So, that sure makes points for the Cash people - few of us can be certain of holding our mortgage that long. So, maybe Cash is King after all?

But, doesn't that also lead to....

If you already have a mortgage, this seems to say that paying it off early is the WORST thing you could do!!?? It looks to me like the 'deal has been done', and once you are in you should stick it out as long as you can.

Hmmmm. Let's say that again. Going w/o a mortgage is probably best since we can't be certain of holding for 25 years, but if you have a mortgage, keep it. Can that be right?

I think the explanation is - the whole thing is based on arbitrage of the mortgage. But, we need to go near full term for that arbitrage to 'work', because a mortgage is front-end loaded with interest, while the fixed-income loans that personal investors make are interest-only loans. Does that explain it? Help, my brain hurts!

So, I welcome anyone else running the numbers and reporting back; maybe I goofed somewhere, maybe my assumptions are out-of-line? And I'd love to see a 15 year loan (Twaddle?) - I tried one and it didn't look pretty, but I am not going to 3X check that tonight.

Regards - ERD50

 

[twaddle]

If you already have a mortgage, this seems to say that paying it off early is the WORST thing you could do!!?? It looks to me like the 'deal has been done', and once you are in you should stick it out as long as you can.

I don't think that's the moral of the FIREcalc story. It's more like if you use a mortgage for leverage, and that leverage works against you, then you'll have to ride it out.

It's perfectly safe to pay off a mortgage if you used leverage successfully and didn't hit a worst-case returns sequence, which is the most probable case.

Bottom-line: you're making a bet when you invest your mortgage principal the FIREcalc way.

There are ways to reduce the risk of that bet, and that's what I'm doing. It's even possible to reduce the risk to almost zero, but then you also obviously limit the upside.

As brewer says, there are probably better ways to use leverage. Buy a leveraged fund, for example. Those institutions have access to cheaper capital than we do.

 

[myself]

Can one get the child credits/deductions if one uses the standard deduction? Anyone?

The answer is yes. As long as they are eligible of course.
Tax credits are figured AFTER the appropriate level of taxation is determined, which is after the standard/itemized deduction choice.

 

[DJScrib]

Hi all, long time lurker, first time poster.

One aspect of the pay-off mortgage argument I haven't seen addressed is the "**** hits the fan" scenario for a person who is in the early stages of paying off a mortgage.

The scenario is for a 300K house, person #1 has paid 50k of it off, so has a 250k mortgage and 50k equity. person #2 has paid off 5k, and has a 295k mortgage and 5k equity.

If they wreck their car while drunk and get fired, and wind up in deep trouble for a year or so which one can survive the situation? Assuming no other appreciable buckets of money.

Person 1 can't get a home equity loan (since no job), and may be forced to sell their house and lose 6% in the process. While person 2 can dip into their savings, to survive much longer before biting the bullet.

Lastly, in the above scenario, a mortgage lender is going to foreclose person #1 first (becuase they can get some money out of it), while being more likely to work something out with person #2 since it would be an unprofitable foreclosure. In a cruel twist, the "better" mortgage holder gets penalized.

Anyhow, I've heard the above scenario outlined before and are curious if any variation of this theme enters into people's equations. Basically are you willing to sacrifice a percent or so of overall profit, in exchange for "peace of mind" in a sticky situation.

Now obviously people closer to ER probably have a large enough nest egg to raid, but again, even in that situation raiding the 401k and taking a tax penalty is not an ideal situation.

 

[myself]

I think the explanation is - the whole thing is based on arbitrage of the mortgage. But, we need to go near full term for that arbitrage to 'work', because a mortgage is front-end loaded with interest, while the fixed-income loans that personal investors make are interest-only loans. Does that explain it? Help, my brain hurts!

Regards - ERD50

Actually, ANY loan is front-loaded with interest. Whether it's a mortgage, or a credit card.
Why?
Simple. The interest is basically calculated off of the principle at that given moment in time. Mortgages are merely different in that they have fixed payment schedule, whereas other borrowing like on credit cards, etc., work on a fluctuating payment (i.e. 1%-4% of the principle).
Don't believe me, try this mortgage (although the rate is intentionally high).
$100,000 @ 12% for 30 years = payments of $1,028.61
First payment breakdown:
Interest: $1,000
Principle: $28.61

Since 1%/month is what is being charged, the first interest payment is 1% of the principle. So $100,000 x .01 = $1,000
Wow, amazing.

Try it for a 15 year mortgage, and you'd find the same thing. The only difference is that the person is paying a higher payment which is only due to the additional principle being paid (to get it paid off in a shorter timeframe).

 

[clifp]

Hi all, long time lurker, first time poster.

One aspect of the pay-off mortgage argument I haven't seen addressed is the "**** hits the fan" scenario for a person who is in the early stages of paying off a mortgage.

The scenario is for a 300K house, person #1 has paid 50k of it off, so has a 250k mortgage and 50k equity. person #2 has paid off 5k, and has a 295k mortgage and 5k equity.

If they wreck their car while drunk and get fired, and wind up in deep trouble for a year or so which one can survive the situation? Assuming no other appreciable buckets of money.

Person 1 can't get a home equity loan (since no job), and may be forced to sell their house and lose 6% in the process. While person 2 can dip into their savings, to survive much longer before biting the bullet.

Lastly, in the above scenario, a mortgage lender is going to foreclose person #1 first (becuase they can get some money out of it), while being more likely to work something out with person #2 since it would be an unprofitable foreclosure. In a cruel twist, the "better" mortgage holder gets penalized.

Anyhow, I've heard the above scenario outlined before and are curious if any variation of this theme enters into people's equations. Basically are you willing to sacrifice a percent or so of overall profit, in exchange for "peace of mind" in a sticky situation.

The flexibility arguement is one fairly compelling argument for not paying off a mortgage. In fact, I'd argue that you don't even want to think about paying off your mortgage early until you have a sizable emergency fund in place. So in the example you give I wouldn't think it would be prudent to be accelerating the paying off of a mortgage.

On the other hand in the situation you describe where do something really stupid like being drunk and getting into an accident. If one person has $50K emergency fund and the other other has $50K in equity but no other money, in many/most? state home equity is fairly judgement proof so if you hit somebody while driving drunk better to only have home equity.

God protects fools, drunks, and children, and the law protects home owners.

 

[OAG]

IMO the example is extreme and these types of factors could be applied to any financial picture. Hurricane coming and comes and you forgot to pay the insurance bill on your fully paid for home. Your kid shoots the neighbors horse, you get sued. It would not be financially prudent for anyone to pay down the mortgage without access to other funds and/or an emergency fund. IMHO people who do pay down the mortgage and for that matter pay off the CC each month or pay down the car loan quickly are financial prudent.

Besides clifp makes the point well regarding the safety of the "homestead". Why do most all of the recently charged CEO, CFO, etc., all have LARGE FLORIDA estates? To protect large sums of money from law suits is why.

 

[DJScrib]

I may have poisoned my argument a bit with a overly extreme example. Better examples would be Mortgage Brokers in 2008, IT Workers in 2001, Boiler Room works in 2000, Auto Workers in the 80s, Steel workers in the US. People who were at the peak of their earning potential, and then had the rug yanked completely out from underneath them and were forced to retrain and shift industries in many cases.

I think it's been properly addressed, but having a nicely funded emergency fund + other liquid assets probably comes before paying down your mortgage, and maybe a 6 month emerency cash fund, and another 6 months in some non-retirement investment would be a good starting point.

The main point I was getting at is the irony in that come foreclosure time, the banks will hit the people who have diligently paid their principal down first.

 

[JohnDoe]

That Pen Fed H/E is looking pretty good these days. 4.99% for 10 years with 0 costs.

 

[JohnDoe]

Keep an eye open next week. I think 15yr will be under 5%.

 

[cardude]

Wasn't the 15 year conventional fixed 4.75% not too long ago?

 

[jazz4cash]

Wasn't the 15 year conventional fixed 4.75% not too long ago?

If you go back to post #20 around 1/22/08, it was actually even lower than that at some institutions.

 

[JohnDoe]

Wasn't the 15 year conventional fixed 4.75% not too long ago?

4.625 for 1 day...next day 5.125

 

[jblack]

Keep an eye open next week. I think 15yr will be under 5%.

I wish....I'm wondering if PenFed is not trying to be as competitive as it was a few weeks ago. Their rates have gone back up quite a bit this week. 15yr is now 6.125 (?!?!) and the 30yr is 6.5%. Huh?