Paying down mortgage instead of buying bonds

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Rinkadink
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Paying down mortgage instead of buying bonds

Post by Rinkadink »

Lets say my budget allows for $1,000 to invest every month. My current asset allocation target is 85/15. So I would invest $850 into a total stock market index fund and $150 into a total bond market index fund.

But what if instead I used the $150 as an extra principal payment on my 4% mortgage? I view that as a guranteed 4% return, which I believe is at least comparable with what I would get in the total bond fund, if not better. I'm investing into a 457B plan, and I don't plan to withdraw for at least 20 years. I also believe that I am fully prepared to watch my account value swing up and down wildly without panicking.

My basic question is... if I choose to use a portion of my monthly surplus to make extra mortgage payments, does it make sense that the remaining portion, which will be invested, could be more heavily weighted toward stocks than it otherwise would have been? Thanks.
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9-5 Suited
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Re: Paying down mortgage instead of buying bonds

Post by 9-5 Suited »

You have zeroed in on the illusion of not treating a mortgage as a "negative bond" in your asset allocation. In reality, you have over 100% allocated to stocks currently assuming your mortgage is larger than your bond holdings. If you pay off part of your mortgage, your net fixed income position will grow and your portfolio as a whole will be less heavily weighted to stocks.

But yes, if you use mental accounting as many do and isolate only stocks and bonds in your asset allocation and ignore the effect of the mortgage, your investment portfolio will become more heavily stock weighted.
HEDGEFUNDIE
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Re: Paying down mortgage instead of buying bonds

Post by HEDGEFUNDIE »

My bonds go up when my stocks go down (like this week). My home equity doesn't.
bryanm
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Re: Paying down mortgage instead of buying bonds

Post by bryanm »

Why are you 85/15 to begin with? If you're in the "bonds are for safety" camp and are concerned that you couldn't stomach a big drop in your investment portfolio value, then don't redirect to a mortgage. If it's because you think 85/15 will get you non-psychological benefits, paying your mortgage might make sense.

Be aware of the difference in liquidity. It is not as easy to pull money out of a property as it is to pull money out of a bond fund. If you might need the money, some bonds may be useful.
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9-5 Suited
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Re: Paying down mortgage instead of buying bonds

Post by 9-5 Suited »

An example that I used on another thread which I think is useful here as well. It shows exactly why investing in bonds and mortgage repayment is the same in terms of its impact on asset allocation and net worth in the event of stock market changes.

Note: This isn't to say there is no difference at all between these approaches, as liquidity is a relevant consideration as well as the differences in the features of the debt. This is just about the asset allocation / net worth part of the discussion.

Imagine two investors:

Investor A: $500K stocks, $250K bonds, $250K mortgage, $500K home
Investor B: $500K stocks, $0K bonds, $0K mortgage, $500K home

If stocks crash by 40%, explain how these two investors' net worth are not impacted equally? Bonds and debt of similar risk and duration offset one another on the balance sheet.

The same is true of a combined RE/stock downturn. You'll see from the above example that you could take the house value in any direction, by any amount, and again both investor A and B are subject to the same stock and real estate risk regardless of debt vs. bond allocation.
Admiral
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Re: Paying down mortgage instead of buying bonds

Post by Admiral »

9-5 Suited wrote: Thu Feb 27, 2020 12:47 pm An example that I used on another thread which I think is useful here as well. It shows exactly why investing in bonds and mortgage repayment is the same in terms of its impact on asset allocation and net worth in the event of stock market changes.

Note: This isn't to say there is no difference at all between these approaches, as liquidity is a relevant consideration as well as the differences in the features of the debt. This is just about the asset allocation / net worth part of the discussion.

Imagine two investors:

Investor A: $500K stocks, $250K bonds, $250K mortgage, $500K home
Investor B: $500K stocks, $0K bonds, $0K mortgage, $500K home

If stocks crash by 40%, explain how these two investors' net worth are not impacted equally? Bonds and debt of similar risk and duration offset one another on the balance sheet.

The same is true of a combined RE/stock downturn. You'll see from the above example that you could take the house value in any direction, by any amount, and again both investor A and B are subject to the same stock and real estate risk regardless of debt vs. bond allocation.
This has been posited countless times and is simply not true (in my opinion, of course).

First, net worth is irrelevant to the discussion. Net worth is some paper # that changes with the breeze. My house could fall (or rise) in "market value" by $50k per year. This has absolutely zero effect on my day to day finances, investment choices, or asset allocation. None. Unless I borrow against that equity, it's nothing but a number in my head.

Second, how will you invest your home equity if stocks fall and you want to buy more of them? Will you take out a HELOC?

My bond portfolio throws off more interest each month than my mortgage costs me. If I pre-pay my mortgage, my monthly obligation does not change. If I buy more bonds, I make actual money (which is then reinvested, so I can make interest on the interest, and eventually interest on that interest.) Meanwhile, due to inflation, each dollar that I pre-pay saves me only a fraction of that dollar when my loan is eventually paid off in 20 years (or whenever). My bond portfolio, by contrast can grow through contributions (which then cause coupon payments to rise) or as NAV/interest rates increase).

A mortgage is not a "reverse bond." It's not something that can be bought or sold, and it's not marked to market. It's a fixed-rate (in most cases) non-callable debt.
My basic question is... if I choose to use a portion of my monthly surplus to make extra mortgage payments, does it make sense that the remaining portion, which will be invested, could be more heavily weighted toward stocks than it otherwise would have been? Thanks.
Could it be? Yes. Are you any better off? No.
cost.basis
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Re: Paying down mortgage instead of buying bonds

Post by cost.basis »

I think you are better off, since, you can live in your home.
vipertom1970
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Re: Paying down mortgage instead of buying bonds

Post by vipertom1970 »

OP, pay off or pay down the mortgage then invest in 100% equities. Why pay 3%+ mortgage interest when bond yield is on 1%+ and I guarantee you and your family sleep better.
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9-5 Suited
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Re: Paying down mortgage instead of buying bonds

Post by 9-5 Suited »

Admiral wrote: Thu Feb 27, 2020 1:09 pm This has been posited countless times and is simply not true (in my opinion, of course).
A few thoughts, as this is a case where multiple things can be true at once. I think that's why it gets so needlessly contentious.

1. It's undoubtedly true that the ability to re-balance is a beneficial feature of bonds vs. debt paydown, very much related to the liquidity caveat above.

2. In reality, very few bonds have exactly the same features as a mortgage, so the world is complex as are the decisions we all make. We use some generalizations to roughly equate things to make decisions easier.

3. Balance sheets (i.e. statements of net worth) are not irrelevant. They not only are an important picture of financial health, but more importantly they highlight the risks your portfolio is exposed to. In the example I note above of the two investors, both are equally exposed to stock market and real estate risk.

4. Increases in home equity are not irrelevant either. Imagine a case where you get lucky and your home value goes from $100,000 to $500,000. You now have a portfolio whose value is unbelievably tied to one undiversified asset. You may well want to consider selling the home based on that appreciation if you don't prefer that risk profile.

5. For the OP's decision, I still think he should think about bond and debt paydown as reasonably similar choices assuming he has sufficient liquidity. If bonds pay 1% I'd go to the mortgage and if they pay 5% I'd be inclined toward the bonds. If about the same rates, then either is fine.
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Re: Paying down mortgage instead of buying bonds

Post by Admiral »

9-5 Suited wrote: Thu Feb 27, 2020 5:28 pm
Admiral wrote: Thu Feb 27, 2020 1:09 pm This has been posited countless times and is simply not true (in my opinion, of course).
A few thoughts, as this is a case where multiple things can be true at once. I think that's why it gets so needlessly contentious.

1. It's undoubtedly true that the ability to re-balance is a beneficial feature of bonds vs. debt paydown, very much related to the liquidity caveat above.

2. In reality, very few bonds have exactly the same features as a mortgage, so the world is complex as are the decisions we all make. We use some generalizations to roughly equate things to make decisions easier.

3. Balance sheets (i.e. statements of net worth) are not irrelevant. They not only are an important picture of financial health, but more importantly they highlight the risks your portfolio is exposed to. In the example I note above of the two investors, both are equally exposed to stock market and real estate risk.

4. Increases in home equity are not irrelevant either. Imagine a case where you get lucky and your home value goes from $100,000 to $500,000. You now have a portfolio whose value is unbelievably tied to one undiversified asset. You may well want to consider selling the home based on that appreciation if you don't prefer that risk profile.

5. For the OP's decision, I still think he should think about bond and debt paydown as reasonably similar choices assuming he has sufficient liquidity. If bonds pay 1% I'd go to the mortgage and if they pay 5% I'd be inclined toward the bonds. If about the same rates, then either is fine.
1. You are not at "risk" unless you stop paying your mortgage. It's a place to live. If you want to include it in your balance sheet, I have no issue with that. However, I don't think people buy and sell stocks and bonds based on their (highly variable and always fluctuating) home value.

2. Bond returns fluctuate. Your paydown rate is fixed. This means that (to take early 2019 as an example) your bonds may sometimes pay out much more that your mortgage rate. When they pay less, you can swap them for stocks (with the attendant risk and return). Neither of these things are true or possible with mortgage paydown. What's more, even when bonds pay less than your rate, once you have enough of them, this delta is irrelevant, since it's a smaller interest rate on a higher amount. The coupons thus pay more than the mortgage costs.

3. My home value has gone up 40%. Are you suggesting that I sell it because I'm now "overweight" in real estate? I'd have to buy a much cheaper home to capture that gain, otherwise it will simply go toward another home that has also appreciated by the same amount.

What you're saying above may make sense in theory but it's not how people make (or should make) investing choices in real life. I don't disagree that there are situations where accelerated payment (or payoff) may make sense, but that's mostly for those nearing retirement, to reduce sequence of return risk. For those with high mortgage rates, the solution is to refinance, not to pre-pay.

You also failed to address the inflation issue, which eats away at the dollar value of any future savings in a paydown strategy. (And, yes, I realize that inflation also affects bond returns as well. The difference is bonds are liquid, home equity is not.)
annu
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Re: Paying down mortgage instead of buying bonds

Post by annu »

At 4% rate, definitelynpay it off, with changes in tax laws mortgage is a lot more expensive now search for a thread about before tax equivalent mortgage rate, depending upon on your tax 4% can be close to 7% tax equivalent rate...and makes sense to pay off
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Re: Paying down mortgage instead of buying bonds

Post by whodidntante »

I decided some time ago that I need to reduce the risk of my portfolio, but that I didn't want to own more bonds at these putrid yields. So I redirected money that would have gone to taxable equities to prepay my mortgage. The effect on my portfolio risk is the same as buying more bonds, since a loan is a short position on fixed income. However, the spread of prepaying my mortgage is favorable versus buying more bonds with putrid yields. However, I would first make sure I'm on track to max all tax-advantaged accounts before considering spending $1 to prepay a mortgage.
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AerialWombat
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Re: Paying down mortgage instead of buying bonds

Post by AerialWombat »

Bonds are for safety. You can't eat home equity.
petulant
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Re: Paying down mortgage instead of buying bonds

Post by petulant »

As whodidntante and 9-5 Suited pointed out, paying down the mortgage can be a good strategy to compared to buying bonds in the right circumstances. The key drawbacks to the mortgage paydown are that you can't do it with retirement account money and the home equity is less liquid than bond assets.

On the second drawback, thanks to their improved liquidity, bonds in taxable can be easily rebalanced into stocks during a downturn. They can also be sold with a relatively safe assumption that the principal is safe for paying bills, particularly when using short-term or intermediate-term bonds.

So, if an investor can minimize these drawbacks--ensuring adequate liquidity and exhausting all advantageous retirement account contributions--then paying down a mortgage with a higher rate than prevailing bond rates can be a great plan. The key for adequate liquidity is probably some combination of a large emergency fund and an existing bond allocation.
Last edited by petulant on Thu Feb 27, 2020 8:15 pm, edited 2 times in total.
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9-5 Suited
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Re: Paying down mortgage instead of buying bonds

Post by 9-5 Suited »

Admiral wrote: Thu Feb 27, 2020 7:32 pm 1. You are not at "risk" unless you stop paying your mortgage. It's a place to live. If you want to include it in your balance sheet, I have no issue with that. However, I don't think people buy and sell stocks and bonds based on their (highly variable and always fluctuating) home value.

The risk I'm referencing there is the risk that your real estate loses value, not the risk of losing the property. It may be a place to live, but there are many reasons people may want to sell/leave the property of their own choosing, and that lost value can be a real, tangible thing. And you incur that loss when you sell whether or not you hold a mortgage.[/color]

2. Bond returns fluctuate. Your paydown rate is fixed. This means that (to take early 2019 as an example) your bonds may sometimes pay out much more that your mortgage rate. When they pay less, you can swap them for stocks (with the attendant risk and return). Neither of these things are true or possible with mortgage paydown. What's more, even when bonds pay less than your rate, once you have enough of them, this delta is irrelevant, since it's a smaller interest rate on a higher amount. The coupons thus pay more than the mortgage costs.

That is indeed a difference with bonds that sometimes works in your favor and sometimes not. If you have a 3% mortgage and bonds are paying 1.5%, you are probably making a mistake buying bonds due to the negative carry.[/color]

3. My home value has gone up 40%. Are you suggesting that I sell it because I'm now "overweight" in real estate? I'd have to buy a much cheaper home to capture that gain, otherwise it will simply go toward another home that has also appreciated by the same amount.

I'm not saying you SHOULD, I'm saying you COULD make that choice and it would be a legitimate reason for doing so. SHOULD is a personal decision, but many people make that choice every day to move down in house and invest the balance.[/color]

What you're saying above may make sense in theory but it's not how people make (or should make) investing choices in real life. I don't disagree that there are situations where accelerated payment (or payoff) may make sense, but that's mostly for those nearing retirement, to reduce sequence of return risk. For those with high mortgage rates, the solution is to refinance, not to pre-pay.

I actually agree with this. As long as the investor isn't taking more risk than they really intend to by leveraging into stocks accidentally.[/color]

You also failed to address the inflation issue, which eats away at the dollar value of any future savings in a paydown strategy. (And, yes, I realize that inflation also affects bond returns as well. The difference is bonds are liquid, home equity is not.)

You addressed it, cuts both ways.[/color]
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Re: Paying down mortgage instead of buying bonds

Post by grabiner »

HEDGEFUNDIE wrote: Thu Feb 27, 2020 12:24 pm My bonds go up when my stocks go down (like this week). My home equity doesn't.
Your home equity is not the right number to use for comparison, because the home equity cannot be converted to cash unless you sell the house or refinance the mortgage. Rather, you have a home (which is worth its market value) and a mortgage (which has a negative value to you, but that may not be equal to the remaining principal).

For example, suppose that you have ten years left on your 3% mortgage, and you sell a $1000 ten-year bond yielding 2% to pay down your mortgage. The bond would have been worth $1219 in ten years, while you reduce your final mortgage payment by $1344. Thus you are guaranteed to gain $125 in ten years. (Inflation is irrelevant here because it affects both numbers).

This does not necessarily mean that paying down the mortgage is the right strategy. You give up the liquidity, and if the bond money could have been invested in your IRA, you also give up the tax deferral. And you give up the option of refinancing the mortgage if rates fall, or of keeping the mortgage if rates rise.

I just made exactly this decision. I sold stocks (tax loss harvesting) in my taxable account, and sold bonds to buy stocks in my employer plan, so I kept my stock allocation. Now, rather than buying a bond portfolio in my taxable account, I will use the money to pay down my mortgage from nine years to one year, getting a higher guaranteed return (1.78% after tax on my 2.625% mortgage, versus 1.15% after state tax on Vanguard Intermediate-Term Tax-Exempt Admiral Shares). This is right for me because I do not need the liquidity, and have no benefit from refinancing (I paid a lot of points to get that rate); the only option I lose is the right to keep the 1.78% after-tax mortgage if muni yields go above 1.78%.

(edited to fix typo)
Last edited by grabiner on Sat Feb 29, 2020 12:12 am, edited 1 time in total.
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annu
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Re: Paying down mortgage instead of buying bonds

Post by annu »

grabiner wrote: Fri Feb 28, 2020 11:54 pm
HEDGEFUNDIE wrote: Thu Feb 27, 2020 12:24 pm My bonds go up when my stocks go down (like this week). My home equity doesn't.
Your home equity is not the right number to use for comparison, because the home equity cannot be converted to cash unless you sell the house or refinance the mortgage. Rather, you have a home (which is worth its market value) and a mortgage (which has a negative value to you, but that may not be equal to the remaining principal).

For example, suppose that you have ten years left on your 3% mortgage, and you sell a $1000 ten-year bond yielding 2% to pay down your mortgage. The bond would have been worth $1219 in ten years, while you reduce your final mortgage payment by $1344. Thus you are guaranteed to gain $125 in ten years. (Inflation is irrelevant here because it affects both numbers).

This does not necessarily mean that paying down the mortgage is the right strategy. You give up the liquidity, and if the bond money could have been invested in your IRA, you also give up the tax deferral. And you give up the option of refinancing the mortgage if rates fall, or of keeping the mortgage if rates rise.

I just made exactly this decision. I sold stocks (tax loss harvesting) in my taxable account, and sold bonds to buy stocks in my employer plan, so I kept my stock allocation. Now, rather than buying a bond portfolio in my taxable account, I will use the money to pay down my mortgage from nine years to one year, getting a higher guaranteed return (1.78% after tax on my 2.625% mortgage, versus 1.15% after state tax on Vanguard Intermediate-Term Tax-Exempt Admiral Shares). This is right for me because I do not need the liquidity, and have no benefit from refinancing (I paid a lot of points to get that rate); the only option I lose is the rate to keep the 1.78% after-tax mortgage if muni yields go above 1.78%.
Mr. Grabiner, I am somewhat drunk, but all you said still made clear sense to me. Thanks for always replying in so clear terms...if toubtweet please share, I will sure sign up for you tweets...plan on doing the same in next few weeks, sell most of bonds in 401k and buy stocks.....
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