Pay off mortgage instead of bond investment

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charriso1973
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Pay off mortgage instead of bond investment

Post by charriso1973 »

Hello everyone, this is my first post (sorry for the length...). I've done my best to search for other posts related to this topic, but most are substantially different from my situation. Sorry if this is covered elsewhere...

My wife and I, both aged 44, have no children. We don't live a frugal lifestyle (current spending ~$140k/yr), but by both of us working lucrative jobs for 20+ years we have amassed a pretty significant nest egg of about $2M, mostly tied up in qualified retirement accounts. Additionally, my wife has recently received an inheritance of over $2.3M, which is currently held in trust with the principal payable to her at points in the future - age 45, 50, 55, and ~70. She has control of the investment allocation in these trusts, but cannot access the principal until the prescribed points. Prior to the principal distribution, she will receive dividend/interest payments on these balances which have historically paid about $35k/yr.

We are seriously considering early retirement within a few years, as our assets are over 30x our currently excessive yearly expenses. I make a good salary of over $200k plus fantastic benefits, and I'm planning on keeping at it until age 50 (but no more!).

Despite most of our money being tied up in qualified accounts or the trust, we do have about $350k in cash. We recognize that this is a stupid amount of cash to be holding, but the market is frighteningly expensive to me at the moment (CAPE ~30)... Considering most of our non-cash assets are invested in equities, I'm wondering: instead of converting cash to stocks (risky) or bonds (weak returns), why not lock in a guaranteed return by paying off our mortgage?

Our current investment allocation including her trust is roughly 80% equities/ 15% bonds / 5% cash. We currently owe roughly $175k on our mortgage at 2.875% for a remaining period of 10 years. Our home is worth roughly $500k, so we have significant equity (and a zero-balance prime+0 $75k HELOC).

My idea is to PAY OFF THE MORTGAGE, treating it as an investment similar to a bond - a hedge vs equity returns. We'll get a "guaranteed rate" of 2.875%, but we'll lose the itemized mortgage interest deduction. So, we'll end up with a return of ~2%. We'll have an additional ~$2k/month to invest when the market (inevitably?) corrects itself. Is that not effective dollar cost averaging? We'll still have ~$150k (12 months) of cash for emergency expenses. Considering the amount of money exposed to the equity market in our retirement accounts and the trust, it seems that paying off the mortgage is an appropriate diversification... 5%ish of our assets at a guaranteed return of 2% seems decent...?

So, what say you? Pay the mortgage off, be immensely happy with being debt free, and (potentially) lose vs. the stock market? Or, be aggressive and dump our excess cash into the (frighteningly expensive) market looking for a better return?

May the wisdom of Bogleheads enlighten me... Thanks!
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mhc
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Re: Pay off mortgage instead of bond investment

Post by mhc »

Welcome to the forum.

I was in a similar situation in 2007. I chose to pay off my mortgage. Looking back, I have no regrets.

From a financial perspective, only time will tell if it is the corrrect decision. From an emotional/comfort perspective, you will benefit every day.

I like a simple life. Removing a mortgage, simplifies life.
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JBTX
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Re: Pay off mortgage instead of bond investment

Post by JBTX »

Typically I'd say for your age I'd hold on to a mortgage that is essentially 2.0% (or less ) after tax mortgage. But given everything else you said and given your financial situation paying off is fine.

I'd still recommend taking your equity portion down to 50/60% equity. At this point you probably have enough savings. I'd concentrate more on preserving the savings vs growing it.
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tc101
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Re: Pay off mortgage instead of bond investment

Post by tc101 »

I would pay off the mortgage and lower percent of equities.
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Re: Pay off mortgage instead of bond investment

Post by Grt2bOutdoors »

Pay off the mortgage!
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Lakeparty
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Re: Pay off mortgage instead of bond investment

Post by Lakeparty »

We just did the same thing... building a house and paid it off-- love it! Pay the mortgage : )
bigred77
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Re: Pay off mortgage instead of bond investment

Post by bigred77 »

I would pay off the mortgage in your case. It's 4% of your investment portfolio and half of your cash. I would just pay it off to simplify your life rather than make it an investment analysis.

Sounds like you have a good plan and if your wife has the ability to control the AA of the trust then it definitely makes sense to consider the overall AA as one even if you can't withdraw principal from the trust for a while. I would probably consider adding more fixed income to your portfolio if you plan to retire in 6 years. Maybe start working your way down to a 70/30 type portfolio over the next few years.
Admiral
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Re: Pay off mortgage instead of bond investment

Post by Admiral »

Welcome to the forum.

What is your net interest savings if you pay off the mortgage tomorrow? It can't be a lot because I have a mortgage that is larger than yours (albeit with a slightly lower rate) and the interest over 15 years is quite low.

Here's what I find a little odd about your situation:

You have $350k in cash. Your wife gets 35k per year in distributions, and next year is going to get (presumably) a lot more once you get the distribution. You have high incomes.

Yet, you're talking about paying off a loan and then investing the saved mortgage payment "when the market corrects itself." Which will be when, exactly?

If you're planning on investing the payment, then why have you been sitting on 350k in cash? It sounds like market timing. Ignore the CAPE and get your money working for you. You should easily be able to beat a 2.x % mortgage rate (hell, you can beat it with bonds alone right now!)

I would not pay it off, at least not right now. Perhaps reevaluate once she gets the distribution of principal. I agree that around 70% equities makes sense now.
CnC
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Re: Pay off mortgage instead of bond investment

Post by CnC »

I just gave this same advise to a younger person.


It makes no sense to lose money to interest and make less money off investing in bonds.


Who in their right mind would pay 3% per year to borrow money so that they can earn 2% interest.
Admiral
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Re: Pay off mortgage instead of bond investment

Post by Admiral »

CnC wrote: Tue Oct 03, 2017 10:28 am I just gave this same advise to a younger person.


It makes no sense to lose money to interest and make less money off investing in bonds.


Who in their right mind would pay 3% per year to borrow money so that they can earn 2% interest.
That is not his situation. He's paying about 2% (effective rate). Vanguard Total Bond has a 10-year after tax yield of about 2.8%. So, he could beat it with bonds...if he cares to.

However, my point is that, while not guaranteed, the market return in a well-diversified portfolio should easily be able to beat his 2%, even with minimal risk. And, has already has so much cash that he doesn't need to bother investing what he would have paid for the mortgage if he pays it off.
inbox788
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Re: Pay off mortgage instead of bond investment

Post by inbox788 »

Great idea, why didn't anyone think of this before? :wink:

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What is your AA?

Cash is not an asset class and wastes away from inflation, but you can consider it a 0% return bond.

1) The best answer is to use the cash and invest it in your AA (thereby maintaining your desired AA).
2a) You can take your 0% bond and buy a higher yielding bond (hopefully it's already in zero risk FDIC savings account or similar with > 0%; consider your risk/reward tolernace).
2b) You can take your 0% bond and sell your negative yielding bond (i.e pay off your mortgage)
3) You can afford to invest it 100% in the market (riskier, but likely most rewarding)

They're all acceptable answers, so choose what makes you feel best. Just realize all but 1) change your AA, but only a small amount because the amount you're considering is a relative small amount of your invested assets.

FWIW, I'd pick 2b) and maybe rebalance, but really it depends if you include cash in your AA.
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Re: Pay off mortgage instead of bond investment

Post by CnC »

Admiral wrote: Tue Oct 03, 2017 10:37 am
CnC wrote: Tue Oct 03, 2017 10:28 am I just gave this same advise to a younger person.


It makes no sense to lose money to interest and make less money off investing in bonds.


Who in their right mind would pay 3% per year to borrow money so that they can earn 2% interest.
That is not his situation. He's paying about 2% (effective rate). Vanguard Total Bond has a 10-year after tax yield of about 2.8%. So, he could beat it with bonds...if he cares to.

However, my point is that, while not guaranteed, the market return in a well-diversified portfolio should easily be able to beat his 2%, even with minimal risk. And, has already has so much cash that he doesn't need to bother investing what he would have paid for the mortgage if he pays it off.
I read the 2.8% and rounded it to 3%. Also, I was considering the income tax he would be paying on $100,000+ in bonds.


But we are not talking about a well diversified portfolio. We are substituting mortgage for bonds. The stock aspect is not relevant he didn't ask if he should avoid investing in the stock market he asked if there was anything wrong with substitution of mortgage payments for bond payments.


Under no circumstances can I see that it is logical to invest in bonds that yield lower interest rates than you are paying on your mortgage/car/student loan/credit cards. If you can find safe bonds that yield higher than your mortgage then yes, buy bonds put off paying for the mortgage. If not pay off the mortgage.
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Re: Pay off mortgage instead of bond investment

Post by Admiral »

CnC wrote: Tue Oct 03, 2017 10:52 am
Admiral wrote: Tue Oct 03, 2017 10:37 am
CnC wrote: Tue Oct 03, 2017 10:28 am I just gave this same advise to a younger person.


It makes no sense to lose money to interest and make less money off investing in bonds.


Who in their right mind would pay 3% per year to borrow money so that they can earn 2% interest.
That is not his situation. He's paying about 2% (effective rate). Vanguard Total Bond has a 10-year after tax yield of about 2.8%. So, he could beat it with bonds...if he cares to.

However, my point is that, while not guaranteed, the market return in a well-diversified portfolio should easily be able to beat his 2%, even with minimal risk. And, has already has so much cash that he doesn't need to bother investing what he would have paid for the mortgage if he pays it off.

... The stock aspect is not relevant he didn't ask if he should avoid investing in the stock market he asked if there was anything wrong with substitution of mortgage payments for bond payments.

Which is why I pointed out that he's looking at the situation incorrectly. He said:
We'll have an additional ~$2k/month to invest when the market (inevitably?) corrects itself.
My point is that it's silly to consider doing that when he currently has $350k doing nothing. He will come out ahead by simply investing that cash while STILL paying a mortgage. He''s asking the wrong question. If nothing else he could take $5k per month and put it into a diversified portfolio and 99 times out of a hundred he will earn more than the $2k per month is costing him.
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Watty
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Re: Pay off mortgage instead of bond investment

Post by Watty »

You have two separate questions. Should you pay off the mortgage and should that affect your asset allocation.

1) On the pay off the mortgage question if you don't pay it off then investing and getting a higher rate of return is harder than it sound since you will have a sequence of returns risk. Here is an example I have posted before.
If you do not pay it off then you will have more sequence of returns risk. For example in rough numbers if you just kept a $100K mortgage and also put $100K into a separate investing account which you also pay a $500 a month mortgage out of then;

a) If you get unlucky and get a modest 10% decline in the portfolio the first year then it would be down to $90K
b) You would also need to pay the $500 a month mortgage($6,000) so your portfolio would be down to $84K
c) To break even the next year you would need to gain back the $16K and another $6,000 for the next years mortgage payments which is $22K. That would take a 25.6% return on the remaining $84K just to break even.
Of course just by random chance your investments could go up 10% the first year.

I would pay it off.

You can then invest your "mortgage payment" each month in more aggressive investments with your normal asset allocation that you will hold for several decades so you will not have the sequence of returns risk. Instead you will get the advantages of dollar cost averaging.

2) On the asset allocation question.

When you pay off the house your mortgage payment will go away so your expenses will go down. This is called "Imputed rent" and you can google that.

If you also count the home equity in your investment asset allocation then you are in effect double counting the home equity as both as asset and as the reduction in your expenses.

Another issue is that if instead of paying off your mortgage you could go out and buy an investment property to rent out. That would be different in that it is clearly an investment asset but there is no way that you would count it as a bond in your asset allocation, it would be counted as a separate real estate investment asset class. You would not count your home equity the same way since you get the imputed rent from it.

People sometimes try oversimplify to fit everything into being a stock or bond but you could easily list a dozen different asset classes.
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Re: Pay off mortgage instead of bond investment

Post by Admiral »

Watty wrote: Tue Oct 03, 2017 11:21 am ...

You can then invest your "mortgage payment" each month in more aggressive investments with your normal asset allocation that you will hold for several decades so you will not have the sequence of returns risk. Instead you will get the advantages of dollar cost averaging.

But the OP is ALREADY losing money (in the form of inflation) on the $350k that is in cash. A 2% mortgage is practically free money. With inflation it's really 1%. I say ignore the mortgage (for now) and invest the $350k.

Look at it another way:

Even if he were to take just $200k of that $350k in cash and buy bonds earning 2.5%, that's $5,000 per year (before taxes). That's probably more than he pays in interest on that loan each year (hard to say exactly since he didn't note his payment).
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Re: Pay off mortgage instead of bond investment

Post by grabiner »

charriso1973 wrote: Mon Oct 02, 2017 10:55 pm Despite most of our money being tied up in qualified accounts or the trust, we do have about $350k in cash.

Considering most of our non-cash assets are invested in equities, I'm wondering: instead of converting cash to stocks (risky) or bonds (weak returns), why not lock in a guaranteed return by paying off our mortgage?

We currently owe roughly $175k on our mortgage at 2.875% for a remaining period of 10 years.
I am guessing from your data that you are in the 28% tax bracket, so the after-tax return on your mortgage is 2.07%. Paying down the mortgage is thus equivalent to buying a bond portfolio with a 2.07% after-tax, risk-free return. And with ten years left on your mortgage, the duration of that bond portfolio would be 5 years.

That makes it a good deal, because the current yield on Vanguard Intermediate-Term Tax-Exempt Admiral shares is only 1.75%; this is a fund with a five-year duration holding low-risk bonds. Since you can get a better rate on the "bond" mortgage payment, you should pay off the mortgage.

The rest of your cash should be invested somehow; putting it in Intermediate-Term Tax-Exempt Admiral shares isn't a bad use if you don't want to take more stock-market risk.
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Re: Pay off mortgage instead of bond investment

Post by grabiner »

Admiral wrote: Tue Oct 03, 2017 10:37 am That is not his situation. He's paying about 2% (effective rate). Vanguard Total Bond has a 10-year after tax yield of about 2.8%. So, he could beat it with bonds...if he cares to.
This is the wrong comparison, as you are looking at a historical return. The current yield on Total Bond Market Index is only 2.37%, which beats the mortgage only if you can invest in an IRA. Since the OP can already max out tax-deferred accounts, it makes sense to compare returns on a taxable account, and earning more than 2.07% in a taxable account involves taking either extra interest-rate risk (long-term munis) or more stock-market risk.
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charriso1973
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Re: Pay off mortgage instead of bond investment

Post by charriso1973 »

From the OP: Thanks to everyone for the very thoughtful and insightful responses. It's clear that mine is not a cut-and-dry situation, and you have eloquently outlined arguments on both sides.

I realize now that I created confusion with some of my statements. Some (probably unnecessary) clarification:
- My comment about waiting to invest until a market downturn was poorly worded - I simply meant to use the money previously earmarked for the mortgage payment as dollar-cost-averaged monthly investments.
- I incorrectly stated that we had $350k in "cash". About $100k of that is invested, but it's non-qualified and highly liquid.
- Yes, I know we still have way too much cash... It's not about trying to time the market: it's more (a) my wife likes a big cash cushion, (b) we had some large lump sum payouts this year (bonuses from each of our jobs, inheritance earnings), and (c) we get caught up in work and other stuff and time gets away from us.

At the moment, I'm leaning towards paying the mortgage off, mainly for peace-of-mind. I realize it's probably not the proper mathematical "A vs. B" option, but it has value that can't be quantified. The only thing holding me back is: what if we want to pull the retirement ripcord SOONER than 50?? In that case, we'll need more non-qualified funds... Another conundrum I'll have to consider!

Again, thanks to you all for your insights. The Bogleheads community is remarkably attentive and much more tolerant of a "noob" than any other forum I've frequented!!
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Re: Pay off mortgage instead of bond investment

Post by Dandy »

I'd pay off the mortgage. I don't think you have made the case or have the risk tolerance for being aggressive especially now. While you haven't identified your "number" it seems as if you will have enough assets to fund a good life style and you can choose when to retire depending on how your current investments perform. Also, for you 350k is a relatively small percentage of your current and future inherited assets.
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Re: Pay off mortgage instead of bond investment

Post by Lafder »

Another vote to pay it off !

Then you can start investing, or saving the equivalent of the mortgage payments each month.

You have enough money that you have a lot of options.

I would be considering retiring now with those assets. But if you like your job, do it as long as you can :)

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Re: Pay off mortgage instead of bond investment

Post by David Scubadiver »

Risk Tolerance is about the ability, need and willingness to take risk. You are clearly not willing to take more risk, and you clearly do not need to take more risk. You have the ability to do so. While important, it is not necessarily enough of a reason to do so.

Your mortgage is the equivalent of a rounding error. Still, were you to dump the cash into a Schwab Intelligent Portfolio, with low risk profile, a good portion of it would be kept in cash as ballast, and, I expect, you could generate returns in excess of the amount you are paying in mortgage interest after taxes. That is exactly what I would do were I in your shoes. If it turns out that the returns are lower and you are not willing to up the risk, then you can always sell and pay off the mortgage.
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Re: Pay off mortgage instead of bond investment

Post by Admiral »

grabiner wrote: Tue Oct 03, 2017 8:41 pm
Admiral wrote: Tue Oct 03, 2017 10:37 am That is not his situation. He's paying about 2% (effective rate). Vanguard Total Bond has a 10-year after tax yield of about 2.8%. So, he could beat it with bonds...if he cares to.
This is the wrong comparison, as you are looking at a historical return. The current yield on Total Bond Market Index is only 2.37%, which beats the mortgage only if you can invest in an IRA. Since the OP can already max out tax-deferred accounts, it makes sense to compare returns on a taxable account, and earning more than 2.07% in a taxable account involves taking either extra interest-rate risk (long-term munis) or more stock-market risk.
As usual, your bonds vs mortgage analysis is spot on. My point was that beating his effective rate could be done not at NO risk, but at absolutely minimal risk. If one does not have confidence that one can beat an effective 2% mortgage (with an assumed 1% rate of inflation, though hopefully higher in the future) then, really, the stock market has little appeal.
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Re: Pay off mortgage instead of bond investment

Post by ThrustVectoring »

CnC wrote: Tue Oct 03, 2017 10:28 am I just gave this same advise to a younger person.


It makes no sense to lose money to interest and make less money off investing in bonds.


Who in their right mind would pay 3% per year to borrow money so that they can earn 2% interest.
You're losing 1% per year, sure, but you have significantly more optionality with a mortgage + owning bonds. To be specific: you can sell bonds, but you can't sell mortgage pre-payment. I suppose you could pay off your mortgage and open a HELOC that you can draw from if you needed the money, but that generally means a higher floating rate if you end up using it.

Like, if the interest rate environment was mortgages at 7% and same-duration treasuries at 6%, if you borrow $100k and invest in those treasuries, and interest rates for both fall by 3%, you can refinance the mortgage or sell the treasuries for a profit and make out like a bandit. There's a reason why mortgages have a spread, and it's not just the lender making money off you.

I'm not saying it's necessarily a good idea, just that there's some upside risk that you're getting compensated for.
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Re: Pay off mortgage instead of bond investment

Post by grabiner »

Admiral wrote: Wed Oct 04, 2017 9:24 am As usual, your bonds vs mortgage analysis is spot on. My point was that beating his effective rate could be done not at NO risk, but at absolutely minimal risk. If one does not have confidence that one can beat an effective 2% mortgage (with an assumed 1% rate of inflation, though hopefully higher in the future) then, really, the stock market has little appeal.
The same argument says that you should invest in stock in preference to any bond fund; if you expect to beat 2.37% on a tax-free investment, you shouldn't be holding Total Bond Market Index in your IRA. However, few investors hold 100% stock. (I don't hold 100% stock myself, although my current portfolio which is 94% stock is riskier than a typical 100% stock portfolio because I overweight riskier stock.)
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Re: Pay off mortgage instead of bond investment

Post by Slothmeister »

Pay it off! Then DCA into nice equity index fund(s) after the minimum (Admiral or Premium). Forget the bonds. Do some high-yield CDs instead. Maybe work a part time job. Forty-four is pretty young.
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Re: Pay off mortgage instead of bond investment

Post by desiderium »

I have a similar time horizon to retirement and would suggest considering this:

You want to retire in 6 years. In reality, your plans are not all that reliable--maybe you will get antsy and decide not to wait that long, or maybe someone else will make the decision for you.

Your projected retirement income is also not so reliable, as it is not a guaranteed pension. You are vulnerable to a sequence of return risk. If it came to this you could mitigate by reducing your lifestyle.

Therefore, it makes sense to reduce your minimum expenses during retirement, and have the mortgage paid within 6 years.

If you try to calculate the financial impacts of keeping or paying the mortgage now or in 6 years, you won't be able to come up with anything reliable, or especially important given your overall portfolio size.

I would pay it off now and be done with it.
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Re: Pay off mortgage instead of bond investment

Post by Admiral »

grabiner wrote: Wed Oct 04, 2017 8:48 pm
Admiral wrote: Wed Oct 04, 2017 9:24 am As usual, your bonds vs mortgage analysis is spot on. My point was that beating his effective rate could be done not at NO risk, but at absolutely minimal risk. If one does not have confidence that one can beat an effective 2% mortgage (with an assumed 1% rate of inflation, though hopefully higher in the future) then, really, the stock market has little appeal.
The same argument says that you should invest in stock in preference to any bond fund; if you expect to beat 2.37% on a tax-free investment, you shouldn't be holding Total Bond Market Index in your IRA. However, few investors hold 100% stock. (I don't hold 100% stock myself, although my current portfolio which is 94% stock is riskier than a typical 100% stock portfolio because I overweight riskier stock.)
That's only true if you hold bonds for return/yield, as opposed to their stability properties/a hedge against volatility, which I would argue should be viewed as their purpose overall (at least in the current interest rate environment). If one has the a great tolerance for risk, no fear of volatility, and either enough money or enough time to recover from a protracted period of loss, then 100% stocks is appropriate. Just ask Warren Buffet.
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Re: Pay off mortgage instead of bond investment

Post by Tamarind »

You have so much that it's almost a moot point. You could also accelerate mortgage payments while also putting some of your cash horde into the market.

At this point whatever gives you peace of mind is probably best. You'll be wanting to trim expenses over the next couple of years anyway to get a feel for when you can call it quits.

Don't worry about the market valuations - just deploy your money where you think it'll do you good, and give each dollar a job so that you aren't building up cash.

Really the only losing thing you could do would be to keep holding cash in excess of your emergency fund needs while neither investing nor paying off the mortgage. Anything with an expected return in excess of inflation is better than what you're doing now. You don't have to plan for the highest return for it to be a good idea.
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Re: Pay off mortgage instead of bond investment

Post by Admiral »

charriso1973 wrote: Tue Oct 03, 2017 10:59 pm From the OP: Thanks to everyone for the very thoughtful and insightful responses. It's clear that mine is not a cut-and-dry situation, and you have eloquently outlined arguments on both sides.

I realize now that I created confusion with some of my statements. Some (probably unnecessary) clarification:
- My comment about waiting to invest until a market downturn was poorly worded - I simply meant to use the money previously earmarked for the mortgage payment as dollar-cost-averaged monthly investments.
- I incorrectly stated that we had $350k in "cash". About $100k of that is invested, but it's non-qualified and highly liquid.
- Yes, I know we still have way too much cash... It's not about trying to time the market: it's more (a) my wife likes a big cash cushion, (b) we had some large lump sum payouts this year (bonuses from each of our jobs, inheritance earnings), and (c) we get caught up in work and other stuff and time gets away from us.

At the moment, I'm leaning towards paying the mortgage off, mainly for peace-of-mind. I realize it's probably not the proper mathematical "A vs. B" option, but it has value that can't be quantified. The only thing holding me back is: what if we want to pull the retirement ripcord SOONER than 50?? In that case, we'll need more non-qualified funds... Another conundrum I'll have to consider!

Again, thanks to you all for your insights. The Bogleheads community is remarkably attentive and much more tolerant of a "noob" than any other forum I've frequented!!
I feel like maybe you're not totally understanding the incredible value of a 2.x% mortgage rate, even over 10 years, and that it's folly to pay it off in current dollars versus letting inflation eat away at the value of your balance and paying with cheaper dollars in the future. DCAing the $2,000 per month versus putting all that payoff money in a reasonable investment just makes no sense (aside from perhaps emotional sense) with that low of a rate. Ignore the amortization sked and how much interest you will be saving with a payoff because that uses current dollars, not inflated future dollars. I would encourage you to read this excellent explanation of how inflation works in terms of a low rate mortgage:

http://www.heracliteanriver.com/?p=478
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