Pay off mortgage or put money into bond fund?

[Gone4Good]

The question isn't whether to be a borrower or a lender, because right now you are both. You are borrowing at ~5% and simultaneously lending at <2%. There are only a few instances where that makes sense 1) You need the liquidity 2) You're speculating on higher interest rates. Considering that you're starting your bet more than 300bp out of the money, you need a pretty sizable increase in interest rates to make this gamble pay off. How much? Here's one simple model . . .

Assume a 30yr fixed rate mortgage at 5.125% is amortized monthly with a cash balance invested at 1.75%. After 10yrs, you pay $34K more in interest than you earn per $100K of mortgage. Just to reach breakeven, short-term interest rates need to climb 78bp per year and reach 9.45% after 10 years. Not likely, in my view.

 

[target2019]

The wild card is itemized deductions. How much do you benefit from the interest deduction?

 

[Tesaje]

The wild card is itemized deductions. How much do you benefit from the interest deduction?

It does reduce the effective interest rate but it is still essentially spending 2/3rds to get only 1/3 back. You won't make any money that way.

 

[Meadbh]

It should be possible to input this information in a spreadsheet, allowing sensitivity analysis, no?

 

[freebird5825]

Who is sorry he/she paid off the mortgage?

I'm not.

We paid that puppy off yeas and years ago when folks told us it would be better to put the cash saved up (originally destined for a new car) into the market because it was going up, up, up.
The year we paid it off was 1998 or 1999. I'm too lazy to go look that up.
The freed up mortgage payment money was then used to go into the market slowly and carefully, not in a lump sum.
No regrets!

 

[target2019]

It does reduce the effective interest rate but it is still essentially spending 2/3rds to get only 1/3 back. You won't make any money that way.

Not about making money, about itemizing deductions, the big picture, tax bracket, etc.

 

[megacorp-firee]

There are a lot of reasons to pay it off or not to pay it off.

Here is why DW and I are going to pay ours off (lining up the ducks now).
The mortgage is about 30% of our monthly 'nut'.
This will take a lot of stress off of budget (which is already pretty conservative and unstressful).
It will provide PEACE OF MIND (lots of it)

The other stuff (for us) is 'noise'.

 

[dizzy]

There are a lot of reasons to pay it off or not to pay it off.

Here is why DW and I are going to pay ours off (lining up the ducks now).
The mortgage is about 30% of our monthly 'nut'.
This will take a lot of stress off of budget (which is already pretty conservative and unstressful).
It will provide PEACE OF MIND (lots of it)

The other stuff (for us) is 'noise'.

I have to agree with this. After all the due-diligence analysis, my conclusion was that it was a nearly statistical wash for us. In that case, paying off, and reducing the monthly nut was a clear psychological win. Plus, the less the monthly nut, the more room in the budget for all that fun discretionary stuff!

 

[jdw_fire]

I've been agonizing for months over getting the bond side of my AA set up in this uncertain environment. I'm worried that bond funds NAVs are due to fall as rates gradually increase sometime in the future. So, a huge part of my portfolio (35%) currently sits in cash earning about 1.75% pre tax.

Why don't I just pay off my mortgage instead of worrying about investing the money into bond funds right now? I didn't really wannt to do that because I wanted to take advantage of paying my mortgage down with inflated dollars eventually. Plus, I really didn't want to tie that much money up in an illiquid asset (would take about 12% of my portfolio if I paid it off), but when I plug the numbers into my SWR spreadsheet my SWR rate drops from 2.8% to 2.23% if I pay it off.

Long term am I better off with a guaranteed 5.12 after tax return by paying off the house or should I just hold onto the cash and wait for the bond market to "correct"? What am I missing here?

My mortgage is 5.12%, I'm in the 25% federal tax bracket this year, and I'm retired but DW is working for the next couple of years. We plan on staying in this house for about 10 years until the kids get out of school.

if a 5.12% FDIC insured CD was available would you invest in it? at present the US 30yr (as are all shorter terms) bond rate is lower then that.

 

[cardude]

The wild card is itemized deductions. How much do you benefit from the interest deduction?

It looks like the PV of the mortgage deduction over the standard deduction, over 26 years, will be about $24000. Not that much. The FV came out to 88K, and I discounted it back to today using a 5% rate.

I'm not sure how to calculate the the inflation advantage over 30 years-- paying with inflated dollars. Not that analytical, or maybe not enough coffee yet.

Is your mortgage payment fixed? If so, be sure to model it as a non-inflation adjusted expense. This usually makes the payoff picture a little closer call in terms of SWR, since your expenses will decline in real terms. e.g. if your yearly mortgage expense is 20k, in 30 years of 3% inflation that will equivalent to an 8k expense today.

You can model this in firecalc by using a non-inflation adjusted expense to represent your mortgage, offset by a non-inflation adjusted pension of the same amount starting the year your mortgage is paid off.

Or, looking at it another way, the conventional portfolio survivability SWR targets (4%, 3%, whatever) typically assume all expenses grow inflation adjusted. For a scenario where some expenses do not increase with inflation, initial SWR can actually be higher at the same level of survivability risk.

Ahh, good point. I was not doing that. When adjusting for this, and adjusting for the mortgage deduction, I get about a 10% difference in firecalc"s possible ending portfolio values for both the low and high side. That's 10% higher for each value by NOT paying off the fixed 30 year 5.15 mortgage.

That would seem to make the case to keep the mortgage, but of course that's if the future looks like the past. If the future turns out to be worse than the past-- more volatile, or have bigger fat tail events-- then maybe a 10% difference does not mean that much.

OK, all that didn't really tell me anything................

 

[audreyh1]

Cardude - you are so way under even a very conservative SWR, I don't think you need to worry about what difference paying off the mortgage makes to your SWR.

Also, even if bond fund NAVs go down after a while, the NAVs don't usually drop that much due to the Fed raising interest rates, and the bond funds usually recover over the next year or two in terms of total return - usually because they are rolling over to higher yielding bonds thus paying out higher dividends. So it really is more of a temporary situation if you are planning to hold the bond funds for a decade or more.

Now if you are convinced that inflation will cause interest rates to go way higher (7%+) in the future, that's another matter. I'm not convinced of that outcome, but I don't know any better than the next guy does.

This article indicates that short-term bond rates may stay excessively low for quite a while. FT.com / The long view - Yield curve watchers divided over bank power . I'm still reading/mulling over this article.

Audrey

 

[ERD50]

Who is sorry he/she paid off the mortgage?

I'm not.

I don't think that a few random self-selected anecdotes lead to an informed decision. It can be a good way hear some confirmation from the choir, if that is what you are seeking.

So, a few anecdotes from the other side:

I was pre-paying my 1981 mortgage. A few years later, I wish I hadn't. It was an ARM and the rates/payment dropped each and every month, and since it was a "blend" it was below market rates, ended up being really, really cheap money, and all I did was lock it up in my house. When I moved in 1992, I took out a slightly larger mortgage on a house of ~ same cost. Which allowed me to keep more money invested throughout the 1990's boom. I don't regret the mortgage at all.

And here's one from an unlikely source:

...

August 29th, 2005: Katrina devastated New Orleans and the Gulf Coast while Frank and I watched from a motel room in Huntsville. Being broke during an extended evacuation due to liquidating my emergency fund, in order to pay off my house, qualifies as a stupid money mistake IMO.

When adjusting for this [inflation], and adjusting for the mortgage deduction, I get about a 10% difference in firecalc"s possible ending portfolio values for both the low and high side. That's 10% higher for each value by NOT paying off the fixed 30 year 5.15 mortgage.

That would seem to make the case to keep the mortgage, but of course that's if the future looks like the past. If the future turns out to be worse than the past-- more volatile, or have bigger fat tail events-- then maybe a 10% difference does not mean that much.

OK, all that didn't really tell me anything................

As I've said, I don't think it is a big deal either way. I prefer the liquidity and options available to me by holding the mortgage. Something tells me that if FIRECALC showed a 10% decline in keeping the mortgage, that you might have thought that was significant? Maye not, just a guess.

I'm not sure that I agree that a 'different' future would necessarily lessen the benefit of holding a mortgage. How can we know? It might increase the benefit, no? After all, it helped in the worst of the past years - so isn't it reasonable to think it may help if the future was a bit worse? I could understand if it helped in good years and hurt in bad years, but that is not what you discovered.

Also, while you accounted for the tax deduction, that might be offset somewhat by higher withdraws to pay the monthly mortgage (if those WDs increase your tax burden). If that is the case, it would reduce the 10% somewhat. OTOH, taxes may have been incurred during the pre-pay phase also. It really depends on individual circumstances.

I think it's good that you have run the numbers. Since it is unlikely to make a big difference either way, you can do as you please, knowing that there are probably far more important decisions for you to concentrate on. But I would definitely consider liquidity in all this.

-ERD50

 

[cardude]

Thanks to all for all the great responses!

After running the numbers, and since there does not seem a big reason to pay it off other than the "feel good" aspect, I've decided to just keep the mortgage for now and keep my liquidity. Even though I really don't like the current environment, I'm gritting my teeth and slowly averaging into a couple of bond funds (very, very slowly). Plus, I keep getting the strange feeling I may have the chance to put a chunk of cash to work in the near future if something happens to shock the market. That's just a WAG obviously.

 

[Gone4Good]

Ally Bank; the old GMAC bank. Very easy to set up and direct deposit..

I've got some cash at various other online banks (Capital One, FNBO) but they have recently dropped their rates to 1.6 and 1.5%, and their transfers are much slower.

What has been your experience with these various online banks (Ally in particular). I'm going to be looking at moving some cash out of 0% money market funds and these look like a good option. Discover Bank is paying 2% but I've heard horrible things about them. ING gets good reviews, but is paying 1.3%.

Any recommendations?

 

[cardude]

The best of the bunch IMO so far has been Ally. Fastest transfers and good rates. Just opened an account at Discover for the 2pct rate but no real experience there yet.

 

[Gone4Good]

The best of the bunch IMO so far has been Ally. Fastest transfers and good rates. Just opened an account at Discover for the 2pct rate but no real experience there yet.

Thanks.

 

[mf15]

This is a good thread hope you dont mind me putting in my problem
I am having the same type of debate with myself, retired 61 1552 month with taxes and insurance, 9 years left @5% around 96k. Wife is on SS I have a pension but no
SS until 62. Thats a whopping 45% of monthly cash flow before my SS, and 30% after I start SS. The percent of cash flow will of course lower if I compute not counting
taxes and insurance. I can pay it off, but would use all liquid non sheltered cash, plus
my wifes sheltered funds.
Any thoughts on this problem
Thanks
Old Mike

 

[brewer12345]

Plus, the less the monthly nut, the more room in the budget for all that fun discretionary stuff!

Ah, but that is one of my worries, at least in the accumulation stage. I do best when things are automated and I cannot get my filthy hads on the money for discretionary purposes. It is who I am and I know it. So in part, a 15 year fixed mortgage is enforced savings that soaks up a bunch of my otherwise free cashflow.

 

[Gone4Good]

This is a good thread hope you dont mind me putting in my problem
I am having the same type of debate with myself, retired 61 1552 month with taxes and insurance, 9 years left @5% around 96k. Wife is on SS I have a pension but no
SS until 62. Thats a whopping 45% of monthly cash flow before my SS, and 30% after I start SS. The percent of cash flow will of course lower if I compute not counting
taxes and insurance. I can pay it off, but would use all liquid non sheltered cash, plus
my wifes sheltered funds.
Any thoughts on this problem
Thanks
Old Mike

I'd be very reluctant to repay a fixed rate mortgage if it would drain all of my liquid reserves. I don't think 5% interest is too much to pay for a solid liquidity cushion. The only reason you should be considering paying down the mortgage is if you have more than enough in cash and bonds to repay the mortgage and still have enough emergency money left over.

As far as your analysis goes, I wouldn't factor taxes and insurance into your consideration because these payments won't change regardless of weather you pay down the mortgage or not. I also don't think you should look at the payment as a % of monthly cash flow if you are in the position to pay off the mortgage. Just view those monthly mortgage payments as coming from your cash balances if it makes you feel better. After all, that's where the money would come from if you decided to repay the mortgage all at once.

 

[mf15]

Yrs to Go:
Looking at it as you suggest makes me feel better about keeping the mortgage.
Many things to ponder, such as if one of us dies then we only get one SS check,
which if we have a mortgage the cash flow is negative by about 1k month. Of course the mortgage can be covered by insurance.
Accountant says, don't buy life insurance, if one dies sell vacation home
to cover the primary mortgage.
Going Crazy now since I only have two paychecks left from ER package.

Thanks
Old Mike

 

[rayvt]

I don't think 5% interest is too much to pay for a solid liquidity cushion. The only reason you should be considering paying down the mortgage is if you have more than enough in cash and bonds to repay the mortgage and still have enough emergency money left over.

I fully agree with the first part. Liquidity is too valuable to squander unless you're getting a LOT more than 5%.

I've always thought that there is really only one situation where it arguable makes sense to pay off the mortgage.

If you don't have enough cash/investments to pay it off, then of course you should keep it.

If you have a large portfolio, there is no real advantage to paying it off. If you can (figuratively) pay it off out of pocket change, then you clearly will never have any problem with making the payments, and you probably have a portfolio that is safely diversified and therefore earns you much more than the 5% you're paying to the mortgage company.

The only situation I can see where it might makes sense to pay it off is if you have a smallish portfolio, where paying off the mortgage will take a significant bite out of the portfolio.

 

[brewer12345]

I fully agree with the first part. Liquidity is too valuable to squander unless you're getting a LOT more than 5%.

I've always thought that there is really only one situation where it arguable makes sense to pay off the mortgage.

If you don't have enough cash/investments to pay it off, then of course you should keep it.

If you have a large portfolio, there is no real advantage to paying it off. If you can (figuratively) pay it off out of pocket change, then you clearly will never have any problem with making the payments, and you probably have a portfolio that is safely diversified and therefore earns you much more than the 5% you're paying to the mortgage company.

The only situation I can see where it might makes sense to pay it off is if you have a smallish portfolio, where paying off the mortgage will take a significant bite out of the portfolio.

*Sigh*

We live in an uncertain world. Over the years, I have come to the conclusion that we should behave like the smartest of the commodity producers, who successfully navigate brutally cyclical industries (think Exxon): when times are good you improve your balance sheet by piling up liquidity and paying off debt, that way when times are bad you have the wherewithal to stay in one piece and hopefully clean up at the expense of the improvident. So I would suggest that even if you give up some positive spread, if you can pay down your debt without significantly impairing your liquidity profile, it is a good thing to do.

 

[rayvt]

*Sigh*

We live in an uncertain world. Over the years, I have come to the conclusion that we should behave like the smartest of the commodity producers, who successfully navigate brutally cyclical industries (think Exxon): when times are good you improve your balance sheet by piling up liquidity and paying off debt, that way when times are bad you have the wherewithal to stay in one piece and hopefully clean up at the expense of the improvident. So I would suggest that even if you give up some positive spread, if you can pay down your debt without significantly impairing your liquidity profile, it is a good thing to do.

I completely agree. The problem I have with so many of these threads is that IMHO the people are significantly impairing their liquidity, by either paying off the portgage or making extra principal payments. Also, paying extra reduces your liquidity without lowering your risk one iota. (It actually increases your risk, since you have more equity in the house that can be lost to foreclosure.)

Question: what is your criteria for "significantly impairing one's liquidity profile"? This is where I have a problem because I can't decide. 1% of your investment (that is, excluding the house) portfolio? 10%?

For example, if you have a $200K mortgage ($1700 monthly P&I), and a $1,000,000 portfolio, should you pay off the mortgage? That would take 20% of your portfolio (assuming you consider the entire portfolio as liquid assets). That seems rather high to me. And of your total net worth of $1,200,000, 17% of it is locked up in one single piece of illiquid, non- income-producing real-estate. Your diversification is all lopsided.

How about a $2M portfolio? That would take only 10% of the portfolio to pay off. That still seems like a lot to me.

A $4M portfolio? That would take only 5% of the portfolio. But......a 4% SWR of $4M is $13,300/mo. Why even bother paying off the mortgage? Out of $13K coming in each month, you'll barely notice the $1700 mortgage payment.

Emitionally, I can see paying off the mortgage. Financially, not so much.

 

[Bikerdude]

For example, if you have a $200K mortgage ($1700 monthly P&I), and a $1,000,000 portfolio, should you pay off the mortgage? That would take 20% of your portfolio (assuming you consider the entire portfolio as liquid assets). That seems rather high to me. And of your total net worth of $1,200,000, 17% of it is locked up in one single piece of illiquid, non- income-producing real-estate. Your diversification is all lopsided.

Another positive point is if your house appreciates by 10% you get the full amount, mortgage or not. Leverage can be good.

 

[dizzy]

A $4M portfolio? That would take only 5% of the portfolio. But......a 4% SWR of $4M is $13,300/mo. Why even bother paying off the mortgage? Out of $13K coming in each month, you'll barely notice the $1700 mortgage payment.

This may be a valid argument for a $10-20M portfolio, but at $4M a 13% expense reduction is hardly "in the noise" to many LBYM types. I think there is a significant gray zone between the "liquidity impairment" argument and the "I have so much that I don't care" argument, where paying off can make sense. If you have enough that you are not concerned about rainy day liquidity, the next priority should be portfolio survivability, and there the expense reduction argument can have merit.

Take your 4M scenario. Suppose you don't think 4% SWR is safe enough these days, and you want to target 3%, perhaps because you have 40-50 yrs to go. Now you are looking at 10k/month @ 3% SWR. Without the mortgage you are looking at 8.3k/month on a $3.8M portfolio for an implied SWR of 2.6%. That is a significant reduction in SWR, when it matters most in the first few years of retirement. (The real picture is somewhat more complicated due to the fact the mortgage payment is not subject to inflation, see my other posts). Nonetheless, if portfolio survivability and not liquidity is your main concern, paying-off can indeed make financial (not just emotional) sense.