Chp 14: Paying down the mortgage
To pay or not pay down a home mortgage.
Chapter 14 had some extremely interesting perspectives on paying off the balance, but I’ve been operating on the view beforehand that if I invest in assets that are getting traditionally higher return rates than my mortgage rates then I’m ahead of the game.
Yes, I recognize that I am creating higher risks by leverage the home in more volatile like investments, such as index stock funds, but over time, I should come out ahead. (Yes, there are some extreme examples where this could turn bad with many consecutive years of bad returns.)
I’m not advocating high leverage, but if given the choice of putting money in my 401k plan (no company matching) and making extra mortgage principal payments, I’ve been going with the 401k (with the bonus of some income tax sheltering, which may haunt me later in life with higher tax brackets).
Like my previous post, I’m still struggling with the books contention that the long term variability of stock returns may not justify their use.
Am I way off base investing in my 401k versus paying down the mortgage? There is a x% risk, but I guess life is not filled with certainty and I’m willing to live with a 5-10% risk of things not playing out as calculated.
RSS
I don't know that you are way off base here, but it does seem that the book makes a good point that if you want to be honest about the choice of paying down a mortgage or reinvesting, then you have to compare, not just interest rates, but the risk as well. It's easy to see when taken to more extremes: should I pay down the mortgage or should I go buy IPOs and extreme tech stocks? The latter has the potential to provide a very high return that far outpaces the mortgage interest . . . but !
The point I like about this chapter is that risk, when viewed as some future event is much easier to live with than when it's put in a more immediate context. Look at the bottom of page 138. There they make this point: say your mortgage interest is at 6%. Say your house was paid off and you could could borrow a hundred thousand against the house at 6% to invest in that 401(k) would you do it? If so, then you are not off base at all. If you would not, then it would seem you are inconsistent in doing so now.
I don't know that this is all there is to say about the matter, but that's part of the point being made there I believe.
Dan
Am fortunate to have a 30 year 5.125% loan with a $150,000 balance and $887 Principle and Interest each month.
As suggested by the book have put a 100% TIP fund in the retirement accounts and a 50% stock and 50% TIP portfolio in the taxable account. NOT an aggressive portfolio.
Compared my consumption with the mortgage vs consumption after spending $150,000 to pay off the mortgage.
Paying off the mortgage reduced my consumption by about $1500/year and increased the distribution report "spread" (or variance) as shown on the explanations of Monte Carlo Reports as shown on page 45 of the help manual. Probably due to the reduction in assets?
I agree that doing the ESPlanner analysis is the best way since everyone will have a different interest rate, asset funds and loan balance.
A dedicated number cruncher, my age and circumstances have given me a different perspective.
I've come to the conclusion that there IS a time when the "crunched numbers" give way to the desire to reduce your mandatory retirement income level.
This reflects Scott Burns' thoughts that it's often best to pay down your debt as you approach retirement years.
So this years downs and ups have started me on a "pay down" path, despite a 5.125% mortgage.
It turns out that the peace of mind outweights the marginal numbers in the spreadsheets.
The old saw about holding a 5% mortgage and investing the money in the market to earn 8% is flawed. It assumes that both the mortgage and the stock market have the same risk.
Here's my view on holding a mortgage so you can invest in stocks. Say stocks return 8% with a standard deviation (risk) of 12%. Money market funds, much safer, return 3% with a standard deviation (risk) of only 3%.
My fixed rate mortgage costs 5%, but while stocks are a random variable with a mean of .08 and std dev of .12, the mortgage payments are pretty much constant year after year.
My net return will be the earnings on the stocks less the cost of the mortgage. When you subtract a constant like mortgage payments from a random variable like stock returns, the difference is another random variable. You subtract the means, but the std dev (risk) of the new random variable is the same as the old.
In this case, by holding a mortgage and investing in stocks, I have created a hybrid investment with an expected return of 3% (8-5) and a std dev (risk) of .12. In other words, I have created a hybrid investment with the expected returns of a money market fund but the risk of the stock market. Sound attractive?
In less statistical terms, my stocks must now return the 5% cost of the mortgage just to break even, whereas I used to break even when stocks returned 0%. If the market has losses, I will worsen them by 5%. Only when the market does better than average will I improve my overall returns at all, and that is when I least need better returns.
A fixed rate mortgage is a great hedge against inflation, which is a real concern after retirement, when a greater percentage of assets are invested in fixed income securities. All of my ESP runs so far show me to be better off with a mortgage than without in retirement, even when considering the risks that are calculated with Monte Carlo.
After further thought, the explanation of our differing results is probably simpler. I'm not borrowing-constrained.
If you are borrowing-constrained without a mortgage, then holding a mortgage will increase your standard of living by borrowing against future surpluses. If you don't need to borrow, paying off the mortgage will increase SofL because it's a great investment (high return for a risk-free investment).
ESPlanner shows a substantial improvement in my SofL if I pay off my mortgage. But if I start reducing the savings I input, I will eventually reach a point where paying off the mortgage worsens the SofL.
Mortgages are great if you need them to buy a home; they're expensive when you could pay them off and still have plenty of cash. I recommend to all my retired friends and clients that they pay off their mortgage if they can afford it; hardly any can.
All mine are considerably better off paying off a mortgage. I'm assuming a 6% return on stocks and 4.5% return on real estate (nominal). Of course, it could be any number of things that cause the difference.
A fixed rate mortgage is an inflation hedge assuming your home price appreciates. People with homes and mortgages underwater aren't getting inflation protection.
One other very good reason to pay off a mortgage-- hardly any of the millions of people recently foreclosed owned their homes free and clear.
No, I'm using 0% real return on real estate. The fixed rate mortgage is an inflation hedge because the real value of the mortgage decreases over time, not because the value of the home increases.
John, I don't use monte carlo simulation with ESPlanner, so not sure what the output looks like. Are you saying that your AVERAGE total spending can increase when you keep the mortgage or are you looking at a distribution of total spending that can increase?
Because if it's the former, that's what I'm saying: the average will look better, but there is no certainty that you won't earn less than average on the investments.
Thanks.
I'm saying the latter. I also would expect the mean total spending to increase, but even when I take into account the distribution of SofL (which is, of course, a subjective decision about acceptable risk), I seem to be better off with a mortgage. I have not really tried to analyze why, however - I assumed it was the inflation effect. But if you're getting the opposite results, I may take a closer look to try to see what's up.