Why Buy Bonds If You Have A Mortgage?

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pezblanco
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Why Buy Bonds If You Have A Mortgage?

Post by pezblanco » Mon Jan 01, 2018 1:50 pm

Suppose you have a too heavy stock allocation ... (my own situation given the last couple of years without rebalancing). I also have a mortgage at 2.625 %. I could/should rebalance by selling some stock and purchasing bonds/cds but my question is more what should I do with future/present extra income. The two options that I consider are

1) Rebalance by purchasing bonds (or CDs).
2) Prepay some principal on mortgage.

Both options see to be more or less the same idea. With option 2, during the life of the mortgage, I'm purchasing a bond paying 2.625 % tax free (due to the new tax law, I will not itemize). No conservative bond fund that I can purchase will have an SEC yield of greater than that even taxable. Isn't it a no-brainer to do option 2?

Am I missing something here? I would appreciate your thoughts.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by simplesimon » Mon Jan 01, 2018 1:54 pm

Not missing anything...how much do you value liquidity?

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Re: Why Buy Bonds If You Have A Mortgage?

Post by EddyB » Mon Jan 01, 2018 3:54 pm

How long is your mortgage term? Is it a fixed rate? Are you convinced that prepaying is still going to be advantageous vs. bond rates later in the term of your mortgage?

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Re: Why Buy Bonds If You Have A Mortgage?

Post by TinkerPDX » Mon Jan 01, 2018 4:09 pm

pezblanco wrote:
Mon Jan 01, 2018 1:50 pm
Suppose you have a too heavy stock allocation ... (my own situation given the last couple of years without rebalancing). I also have a mortgage at 2.625 %. I could/should rebalance by selling some stock and purchasing bonds/cds but my question is more what should I do with future/present extra income. The two options that I consider are

1) Rebalance by purchasing bonds (or CDs).
2) Prepay some principal on mortgage.

Both options see to be more or less the same idea. With option 2, during the life of the mortgage, I'm purchasing a bond paying 2.625 % tax free (due to the new tax law, I will not itemize). No conservative bond fund that I can purchase will have an SEC yield of greater than that even taxable. Isn't it a no-brainer to do option 2?

Am I missing something here? I would appreciate your thoughts.
Have thought a lot about this too.

Liquidity is an issue - if the market tanks, you can use bonds to quickly rebalance and buy the bargain. With time, you could do this with your mortgage balance with an additional refinance, or with a HELOC, but that probably takes time, requires an adjustable rate, or both.

Comfort with your AA is also an issue - if the market tanks by 50% but you’re 50% bonds, maybe it’s a 25% portfolio drop that doesn’t freak you out into breaking your AA/IPS rules; but if you’re counting your mortgage somehow in your AA, it likely won’t provide the same mental comfort. (Though if you have nerves of steel/sufficient discipline, perhaps you don’t need this kind of help to “sleep at night.”)

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Re: Why Buy Bonds If You Have A Mortgage?

Post by WarChest » Mon Jan 01, 2018 4:50 pm

Exactly. This is the same question I had when I started a similar thread.

viewtopic.php?f=2&t=223498#p3451569

The new tax rules combined with this long equity bull run we've had are going to make paying off a mortgage more attractive (as long as you have a good liquid emergency fund and ongoing savings rate).

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Re: Why Buy Bonds If You Have A Mortgage?

Post by lack_ey » Mon Jan 01, 2018 5:05 pm

There's some optionality favorable to you with a mortgage because you control when you make any payments beyond the minimum required. It's possible that rates could rise above the mortgage rate, so at some point you would simply earn more investing in bonds than you're losing in mortgage interest. On the other hand if rates fall, it's more clearly better to prepay the mortgage.

And as stated there is the liquidity issue.

But sure, a lot of people probably incorrectly are (over)investing in bonds while having a mortgage, generally speaking. Borrowing long at high rates to invest short at lower rates isn't exactly a great way to make money. In fact, there are other, cheaper ways to access leverage, though with short-term rates rising this is becoming increasingly less true. Back when yields were lower overall and short rates at zero, it was probably a clearer choice for many situations.

I guess you could also make arguments in favor, touching on behavioral economics.

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pezblanco
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Re: Why Buy Bonds If You Have A Mortgage?

Post by pezblanco » Mon Jan 01, 2018 8:46 pm

OK ... awesome ... thank you guys! It's great to be able to pass thoughts by such an erudite group as BHs. Yes, I'm giving up liquidity which I suppose I should take care of via an emergency fund but otherwise my plan right now is that I'm paying down that beast ....

thanks again!

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Re: Why Buy Bonds If You Have A Mortgage?

Post by jalbert » Mon Jan 01, 2018 9:00 pm

Both options see to be more or less the same idea. With option 2, during the life of the mortgage, I'm purchasing a bond paying 2.625 % tax free (due to the new tax law, I will not itemize). No conservative bond fund that I can purchase will have an SEC yield of greater than that even taxable. Isn't it a no-brainer to do option 2?
If, hypothetically, you expect to hold the mortgage another 15 years, then paying down the mortgage is equivalent to buying a 15 year bond at 2.625%. Given that this would be the approxinate rate today of a treasury note with 15 years to maturity, it would not be a good deal to pay down the mortgage at this term.

On the other hand, if you plan to sell the house next year, paying down the mortgage in lieu of buying a bond would be a good deal in comparison to 1-year rates. This also illuminates the value of the prepayment ootion to you.
Risk is not a guarantor of return.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Mon Jan 01, 2018 9:06 pm

jalbert wrote:
Mon Jan 01, 2018 9:00 pm
Both options see to be more or less the same idea. With option 2, during the life of the mortgage, I'm purchasing a bond paying 2.625 % tax free (due to the new tax law, I will not itemize). No conservative bond fund that I can purchase will have an SEC yield of greater than that even taxable. Isn't it a no-brainer to do option 2?
If, hypothetically, you expect to hold the mortgage another 15 years, then paying down the mortgage is equivalent to buying a 15 year bond at 2.625%. Given that this would be the approxinate rate today of a treasury note with 15 years to maturity, it would not be a good deal to pay down the mortgage at this term.
Except that the Treasury return is taxable, while the mortgage return is not deductible. Therefore, it is a better deal to buy more bonds in your 401(k) or IRA if you aren't maxing them out, but it is a better deal to pay down the mortgage rather than earn a taxable 2.6% return which would be only 2% after tax.

I make this decision every year. My mortgage rate is the same as yours, 2.625%, with 11 years left. But I can still deduct the mortgage interest, so it's only 2.00% after 24% federal tax, and at that rate, I would rather invest in my taxable account. I still count the mortgage as a negative bond; I hold $X in bonds, -$Y in mortgage, and $Z in stock, and I compute my bond allocation as (X-Y)/(X-Y+Z).
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Re: Why Buy Bonds If You Have A Mortgage?

Post by jalbert » Mon Jan 01, 2018 9:23 pm

while the mortgage return is not deductible.
It may or may not be depending on circumstance.
Risk is not a guarantor of return.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by pezblanco » Mon Jan 01, 2018 9:27 pm

grabiner wrote:
Mon Jan 01, 2018 9:06 pm
jalbert wrote:
Mon Jan 01, 2018 9:00 pm
Both options see to be more or less the same idea. With option 2, during the life of the mortgage, I'm purchasing a bond paying 2.625 % tax free (due to the new tax law, I will not itemize). No conservative bond fund that I can purchase will have an SEC yield of greater than that even taxable. Isn't it a no-brainer to do option 2?
If, hypothetically, you expect to hold the mortgage another 15 years, then paying down the mortgage is equivalent to buying a 15 year bond at 2.625%. Given that this would be the approxinate rate today of a treasury note with 15 years to maturity, it would not be a good deal to pay down the mortgage at this term.
Except that the Treasury return is taxable, while the mortgage return is not deductible. Therefore, it is a better deal to buy more bonds in your 401(k) or IRA if you aren't maxing them out, but it is a better deal to pay down the mortgage rather than earn a taxable 2.6% return which would be only 2% after tax.

I make this decision every year. My mortgage rate is the same as yours, 2.625%, with 11 years left. But I can still deduct the mortgage interest, so it's only 2.00% after 24% federal tax, and at that rate, I would rather invest in my taxable account. I still count the mortgage as a negative bond; I hold $X in bonds, -$Y in mortgage, and $Z in stock, and I compute my bond allocation as (X-Y)/(X-Y+Z).
Grabiner, I wonder why BHs don't do this sort of calculation and advice for so many people that are starting these perennial "Should I pay down my mortgage or invest?" threads? Shouldn't BHs advise people to look at their AA and decide what percentage of new money should go to the purchase of the "mortagage prepayment bond" and what percentage should go to the purchase of new stock funds based on their AA? This never seems to be addressed or given and I've always wondered why this isn't a standard BH response to this sort of question.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Mon Jan 01, 2018 9:38 pm

pezblanco wrote:
Mon Jan 01, 2018 9:27 pm
grabiner wrote:
Mon Jan 01, 2018 9:06 pm
I make this decision every year. My mortgage rate is the same as yours, 2.625%, with 11 years left. But I can still deduct the mortgage interest, so it's only 2.00% after 24% federal tax, and at that rate, I would rather invest in my taxable account. I still count the mortgage as a negative bond; I hold $X in bonds, -$Y in mortgage, and $Z in stock, and I compute my bond allocation as (X-Y)/(X-Y+Z).
Grabiner, I wonder why BHs don't do this sort of calculation and advice for so many people that are starting these perennial "Should I pay down my mortgage or invest?" threads? Shouldn't BHs advise people to look at their AA and decide what percentage of new money should go to the purchase of the "mortagage prepayment bond" and what percentage should go to the purchase of new stock funds based on their AA? This never seems to be addressed or given and I've always wondered why this isn't a standard BH response to this sort of question.
It is discussed on the wiki: Paying down loans versus investing, which is frequently cited on these threads, and Mortgage as a negative bond.

However, the psychological issue of the portfolio allocation adds to the complication, particularly if you don't count the house in your asset allocation. If you have a $200K house, a $150K mortgage, $50K in bonds, and $200K in stocks, your investment portfolio is 200% stock after counting the negative bond. While the house is an asset, it is an illiquid and undiversified asset, so its value is not primarily as an asset. I prefer to think of a house as more like a pension, which increases your risk tolerance; the house will pay your rent every month, so losing 20% of your portfolio does not result in a 20% reduction in your standard of living.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by watchnerd » Tue Jan 02, 2018 3:19 am

pezblanco wrote:
Mon Jan 01, 2018 1:50 pm

Am I missing something here? I would appreciate your thoughts.
In a downturn, how will you buy stocks on the cheap / rebalance if you have all your 'bond' allocation devoted to paying down the mortgage?
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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Tue Jan 02, 2018 4:57 am

I was thinking about this question recently and ran across an interesting series of articles about whether or not to pay off one's mortgage or invest the money in savings instead:

http://www.theretirementcafe.com/2014/0 ... tgage.html
http://www.theretirementcafe.com/2014/0 ... tgage.html
http://www.theretirementcafe.com/2014/0 ... right.html

The series starts off discussing the (ill advised) idea that a lot of people have to borrow extra money on their house at low rates and invest it in equities, under the assumption that if the market pays 7% or 8% or 10% or whatever people like to assume and they are borrowing money at 3% then that are coming out ahead. This is obviously a bad idea and not as simple as it seems and the article goes into the reasons why.

But in the course of discussing this question, the author makes a point that I hadn't seen before. If you have a mortgage and are making your regular mortgage payments, but are simultaneously using extra income to save for retirement in equities, you are effectively borrowing money to invest in equities. The money that goes to equities could go to simply pre-paying the mortgage. In fact, you could even take whatever money you have already in equities out to pay off your mortgage (tax consequences notwithstanding).

The problem he says, with having equity investements, when you are paying off a mortgage (especially if you have not paid off your mortgage by the time you retire) is that if you assume that the market is going to return say 7% and your mortgage has a 3% rate, then effectively you are taking all the market risk to get an expected return of 4%. In other words, equity type of risk to get something more like bond type of returns.

In the end, he says that it does depend a lot of your personal situation whether you really should take money out of your equity investments to pay off your mortgage and tie up your wealth in an illiquid asset (the house). And he discusses different scenarios.

So I'm not suggesting what people should do. However, I think the point is intersting that it's not just about whether one should be putting money in bonds or one's mortgage, but whether one should have equity investments at all, if one has a mortgage--since one is taking equity risk for much lower expected returns than one thinks.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by saveinvestbecomefree » Tue Jan 02, 2018 8:17 am

There are some other advantages of paying down your mortgage as well. For one, it reduces the income you need for your desired standard of living. For example, if you're retired and need to generate income from you investments, you need to generate more income to cover your mortgage payments. This can put you in a higher tax bracket vs if you had paid off your mortgage and reduce things like health care subsidies due to a higher MAGI.

Generally though, I agree with the main BH advice of comparing your mortgage rate to an equally "safe" treasury rate and then decide if it makes sense to pay down the mortgage (including the various tax considerations mentioned earlier). Usually it does (after all, banks make a lot of money off mortgage loans). Comparing your mortgage rate to average equity returns is a false comparison because they are very different risk profiles.

Lastly, there is a psychological benefit of a paid-off house that even the most rational among us enjoy. Studies show very few people regret paying off their mortgage (e.g. how many take out a new loan on their paid-off house to buy stocks or bonds?).

I have always allocated more to my mortgage after a good run-up in equities and focused on buying more equities after stocks dropped. This has worked well even though you'll of course never get the timing perfect (now is a good time to focus on paying down debt for example).

I paid off my home early, then moved to a higher cost location and took out a new mortgage. After one large monthly payment I realized I really didn't want to go back to a mortgage and paid if off. In hindsight we would have been better having it in stocks but we still are ahead of our net worth goals given the strong bull market so no regrets. And zero desire to take out a loan on our house to invest in equities or bonds.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by oldcomputerguy » Tue Jan 02, 2018 8:36 am

pezblanco wrote:
Mon Jan 01, 2018 1:50 pm
1) Rebalance by purchasing bonds (or CDs).
2) Prepay some principal on mortgage.

Both options see to be more or less the same idea. With option 2, during the life of the mortgage, I'm purchasing a bond paying 2.625 % tax free (due to the new tax law, I will not itemize). No conservative bond fund that I can purchase will have an SEC yield of greater than that even taxable. Isn't it a no-brainer to do option 2?

Am I missing something here? I would appreciate your thoughts.
What happens when stocks take a dive? Will you take out a second mortgage to rebalance into stocks?
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Re: Why Buy Bonds If You Have A Mortgage?

Post by pezblanco » Tue Jan 02, 2018 11:38 am

oldcomputerguy wrote:
Tue Jan 02, 2018 8:36 am
pezblanco wrote:
Mon Jan 01, 2018 1:50 pm
1) Rebalance by purchasing bonds (or CDs).
2) Prepay some principal on mortgage.

Both options see to be more or less the same idea. With option 2, during the life of the mortgage, I'm purchasing a bond paying 2.625 % tax free (due to the new tax law, I will not itemize). No conservative bond fund that I can purchase will have an SEC yield of greater than that even taxable. Isn't it a no-brainer to do option 2?

Am I missing something here? I would appreciate your thoughts.
What happens when stocks take a dive? Will you take out a second mortgage to rebalance into stocks?
watchnerd wrote:
Tue Jan 02, 2018 3:19 am
pezblanco wrote:
Mon Jan 01, 2018 1:50 pm

Am I missing something here? I would appreciate your thoughts.
In a downturn, how will you buy stocks on the cheap / rebalance if you have all your 'bond' allocation devoted to paying down the mortgage?
Good points. I'm heavy on stocks right now 75% or so ..... i.e. I'm not 100 % and so could still rebalance with even a reasonable sized drop in the market.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by pezblanco » Tue Jan 02, 2018 11:42 am

cb474 wrote:
Tue Jan 02, 2018 4:57 am
I was thinking about this question recently and ran across an interesting series of articles about whether or not to pay off one's mortgage or invest the money in savings instead:

http://www.theretirementcafe.com/2014/0 ... tgage.html
http://www.theretirementcafe.com/2014/0 ... tgage.html
http://www.theretirementcafe.com/2014/0 ... right.html

The series starts off discussing the (ill advised) idea that a lot of people have to borrow extra money on their house at low rates and invest it in equities, under the assumption that if the market pays 7% or 8% or 10% or whatever people like to assume and they are borrowing money at 3% then that are coming out ahead. This is obviously a bad idea and not as simple as it seems and the article goes into the reasons why.

But in the course of discussing this question, the author makes a point that I hadn't seen before. If you have a mortgage and are making your regular mortgage payments, but are simultaneously using extra income to save for retirement in equities, you are effectively borrowing money to invest in equities. The money that goes to equities could go to simply pre-paying the mortgage. In fact, you could even take whatever money you have already in equities out to pay off your mortgage (tax consequences notwithstanding).

The problem he says, with having equity investements, when you are paying off a mortgage (especially if you have not paid off your mortgage by the time you retire) is that if you assume that the market is going to return say 7% and your mortgage has a 3% rate, then effectively you are taking all the market risk to get an expected return of 4%. In other words, equity type of risk to get something more like bond type of returns.

In the end, he says that it does depend a lot of your personal situation whether you really should take money out of your equity investments to pay off your mortgage and tie up your wealth in an illiquid asset (the house). And he discusses different scenarios.

So I'm not suggesting what people should do. However, I think the point is intersting that it's not just about whether one should be putting money in bonds or one's mortgage, but whether one should have equity investments at all, if one has a mortgage--since one is taking equity risk for much lower expected returns than one thinks.
Thanks for the articles .... they were very interesting. I think that the idea that if you have a mortgage and have stock holdings means that you are automatically leveraged is provocative ... but I'm not completely convinced. If we have more bond holding than mortgage value .... then we're not leveraged at all, are we? Regardless of our stock holdings.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by Earl Lemongrab » Tue Jan 02, 2018 2:19 pm

I don't include any home loans in my asset allocation at all. The investments are their own thing, with a balance chosen between bonds and stocks, not stocks and loans or stocks and Social Security, or pension or cash-flow from a job or anything else.

And of course a mortgage is leverage. That's one of the great things about it. You get leverage at a low cost, with no margin calls (or calls of any sort) with the only requirement meeting the monthly debt service. There's usually a free put whenever you want. It also hedges against future increases in interest rates and inflation.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by mikep » Tue Jan 02, 2018 3:00 pm

All my investments are in tax advantaged accounts. I can buy bonds in my IRA/401k, but can't pay down my mortgage with that money, is why I own bonds and have a mortgage. I suppose I could borrow from my 401k to pay down my mortgage 50k and treat the 401k loan as part of my bond AA but that has other risks tied to my employment.

For taxable accounts, it somewhat makes sense especially if you can't deduct mortgage interest.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by seychellois_lib » Tue Jan 02, 2018 9:31 pm

mikep wrote:
Tue Jan 02, 2018 3:00 pm
All my investments are in tax advantaged accounts. I can buy bonds in my IRA/401k, but can't pay down my mortgage with that money, is why I own bonds and have a mortgage. I suppose I could borrow from my 401k to pay down my mortgage 50k and treat the 401k loan as part of my bond AA but that has other risks tied to my employment.

For taxable accounts, it somewhat makes sense especially if you can't deduct mortgage interest.
My situation exactly. Short of a massive tax bill, I can not pay off.

After accounting for RE taxes, insurance, maintenance, and mortgage payment I pay about 3800.00 per month for my home. Of this sum, $800 is going to principle payoff and is essentially being saved. Another $300 would go out the door in taxes if I did not own the home (or it was paid off). I will still itemize under new tax law.

So my net expenditure aka rent, is $2700. I live in California, RE Taxes increases are limited to 2% per year. The Mortgage is fixed rate. This means my unlimited inflation exposure is insurance and maintenance. These are budgeted at $650 per month, taxes another $650. I live in a small home on the water so no back yard yard and only 1550 square feet of downsized house to maintain.

I look at the $2700 rent as having $1400 inflation free component, a $650 2% max inflation component and a $650 "whatever" inflation component.

Given I like where I live, I am comfortable with the "rent" and the fact I am reasonably well protected from rent inflation.

There might be some debate regarding whether I can fairly account my principle payment as "savings" but I think it's reasonable given I am slowly reducing the "rent" and consequently increasing my equity.

BTW, the RE tax inflation will only be realized if the value of my home goes up so I think I am being conservative looking at RE taxes as exposed to inflation.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Sun Jan 07, 2018 4:54 am

pezblanco wrote:
Tue Jan 02, 2018 11:42 am
Thanks for the articles .... they were very interesting. I think that the idea that if you have a mortgage and have stock holdings means that you are automatically leveraged is provocative ... but I'm not completely convinced. If we have more bond holding than mortgage value .... then we're not leveraged at all, are we? Regardless of our stock holdings.
I don't think I understand how the amount of bond holding would effect the argument in the articles. You are still in effect borrowing money in order to be able to hold equities, if you have any equities.

I know this is in fact what a lot of people do. And the articles are mostly arguing that holding a mortgage in retirement and expecting to make the payments from a portfolio with equities is much riskier than it might seem. But, putting that aside, it seems like the logic of the argument still holds for anyone with a mortgage and equity investments, regardless of other bond holdings (assuming those bonds are "riskless" treasuries--otherwise the argument would apply to one's bond holdings as well).

I'm not taking a position on what people should do. But it was an interesting point that has made me think about all this in a way I had not before.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by pezblanco » Sun Jan 07, 2018 11:08 am

cb474 wrote:
Sun Jan 07, 2018 4:54 am
pezblanco wrote:
Tue Jan 02, 2018 11:42 am
Thanks for the articles .... they were very interesting. I think that the idea that if you have a mortgage and have stock holdings means that you are automatically leveraged is provocative ... but I'm not completely convinced. If we have more bond holding than mortgage value .... then we're not leveraged at all, are we? Regardless of our stock holdings.
I don't think I understand how the amount of bond holding would effect the argument in the articles. You are still in effect borrowing money in order to be able to hold equities, if you have any equities.

I know this is in fact what a lot of people do. And the articles are mostly arguing that holding a mortgage in retirement and expecting to make the payments from a portfolio with equities is much riskier than it might seem. But, putting that aside, it seems like the logic of the argument still holds for anyone with a mortgage and equity investments, regardless of other bond holdings (assuming those bonds are "riskless" treasuries--otherwise the argument would apply to one's bond holdings as well).

I'm not taking a position on what people should do. But it was an interesting point that has made me think about all this in a way I had not before.
But you have to look at the total portfolio. You can't just look at the mortgage part and the stock part. There is also a bond part. If you think of the mortgage as a negative bond and you have more "positive" bond than negative bond, then you have a net positive bond allocation ... whether or not you have equities means (at least to my mind) that you're not leveraged at all.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by willthrill81 » Sun Jan 07, 2018 11:21 am

Aside from liquidity, the after-tax conclusion for many should be to pay down their mortgage rather than buy bonds. This is more likely to be the correct conclusion for many since it is projected that the new tax law will reduce the number of taxpayers who itemize by around half. If you aren't itemizing, then you should just compare your mortgage interest rate to the current yield of bonds and allocate toward whichever is higher.

Some value liquidity, others value allocating towards peak efficiency (as above), and still others value having no mortgage. I am in the last camp.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by aristotelian » Sun Jan 07, 2018 12:34 pm

I also see mortgage as a negative bond and paid mine off this year using market gains, but I had the liquidity to do so. In addition to liquidity, one other reason to continue holding bonds would be a long term bet that interest rates will rise, so you lock in your 3% mortgage and hope that bond returns will eventually yield higher than that.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by randomizer » Sun Jan 07, 2018 12:39 pm

I like the negative bond model. When I got a mortgage, this showed that I was at 107% stocks (ie. leveraged) despite my nominal 25% allocation to bonds. I think this is a useful heuristic that shows the actual level of risk that I was exposed to (and fortunately, was comfortable with).

I still keep my nominaI 25% in bonds. I don't prepay because the rate is low and fixed.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by Admiral » Sun Jan 07, 2018 1:51 pm

Three reasons to hold a mortgage AND bonds:

1. Liquidity
2. Liquidity
3. Liquidity

Short of a loan backed by your equity, you cannot eat your house. You cannot put a new roof on your house using your house. You cannot pay for schooling with your house. Et cetera.

And if your answer to this problem is "HELOC" then that begs the question: If you intend to use a variable-rate HELOC in an emergency, then why would you not hold a fixed rate mortgage in the first place? And note also that home equity loan interest is no longer deductible.

I would sooner put extra money into a Roth IRA than pay off a low-rate mortgage.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by Admiral » Sun Jan 07, 2018 2:04 pm

willthrill81 wrote:
Sun Jan 07, 2018 11:21 am
If you aren't itemizing, then you should just compare your mortgage interest rate to the current yield of bonds and allocate toward whichever is higher.
This is an oversimplification and, in my view, not true in many cases. Aside from the liquidity argument (which we disagree on) you're ignoring the diversification argument. A home--mortgaged or paid off--is an illiquid asset. Aside from imputed rent, it does not act like a bond.

Let's say I have $100k to pay off my fixed 2.5% mortgage or buy bonds at 2.3%. I choose to pay it off. A year later, rates rise to 3%, and something happens that causes me to need cash: let's say 50k. I've "saved" the interest, but it's no where near the money I now require.

What do I do? I have a paid off house, but my 100k is in it. So, I get a HELOC. Except that now rates are 3%...and perhaps on the rise. And that's assuming one is comfortable with using one's house as a piggybank (which is ill advised in my view in most cases.)

How is this situation better than having 100k in bonds?

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Re: Why Buy Bonds If You Have A Mortgage?

Post by DoubleDraw » Sun Jan 07, 2018 3:15 pm

What kinds of events require such large amounts of cash or liquidity? I have yet to run into any situation other than buying a home or car that requires more than $10k or so at a clip. We have great health insurance, home insurance and car insurance.

I understand the value of liquidity in order to rebalance when there are large shifts in the markets but don’t understand what people need $50k at a time for that is unplanned.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by willthrill81 » Sun Jan 07, 2018 4:04 pm

Admiral wrote:
Sun Jan 07, 2018 2:04 pm
willthrill81 wrote:
Sun Jan 07, 2018 11:21 am
If you aren't itemizing, then you should just compare your mortgage interest rate to the current yield of bonds and allocate toward whichever is higher.
This is an oversimplification and, in my view, not true in many cases. Aside from the liquidity argument (which we disagree on) you're ignoring the diversification argument. A home--mortgaged or paid off--is an illiquid asset. Aside from imputed rent, it does not act like a bond.

Let's say I have $100k to pay off my fixed 2.5% mortgage or buy bonds at 2.3%. I choose to pay it off. A year later, rates rise to 3%, and something happens that causes me to need cash: let's say 50k. I've "saved" the interest, but it's no where near the money I now require.

What do I do? I have a paid off house, but my 100k is in it. So, I get a HELOC. Except that now rates are 3%...and perhaps on the rise. And that's assuming one is comfortable with using one's house as a piggybank (which is ill advised in my view in most cases.)

How is this situation better than having 100k in bonds?
Fair point. Paying off the mortgage is effectively locking in a a fixed rate. If bond rates rise above where your mortgage interest rate was, you would have been better off with the bonds. But that pendulum swings both ways. If bond rates fall even more, then paying off the mortgage was a slam dunk. And people talk about interest rates rising as being a sure thing, but look at Japan. Interest rates have been very low there for decades. Nothing is certain.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by DallasGuy » Sun Jan 07, 2018 4:40 pm

pezblanco wrote:
Mon Jan 01, 2018 1:50 pm
Suppose you have a too heavy stock allocation ... (my own situation given the last couple of years without rebalancing). I also have a mortgage at 2.625 %. I could/should rebalance by selling some stock and purchasing bonds/cds but my question is more what should I do with future/present extra income. The two options that I consider are

1) Rebalance by purchasing bonds (or CDs).
2) Prepay some principal on mortgage.

Both options see to be more or less the same idea. With option 2, during the life of the mortgage, I'm purchasing a bond paying 2.625 % tax free (due to the new tax law, I will not itemize). No conservative bond fund that I can purchase will have an SEC yield of greater than that even taxable. Isn't it a no-brainer to do option 2?

Am I missing something here? I would appreciate your thoughts.
OP - for what it’s worth, I have been considering the same question lately and plan to pursue option #2. I figure at a minimum we will wind up with a paid off house and if we are lucky once it is paid off stock prices will be more attractive and we can throw money at them.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by abuss368 » Sun Jan 07, 2018 5:37 pm

In my opinion over time one builds their Balance Sheet. That is by increasing assets and decreasing liabilities. Specifically, bonds and your mortgage serve two different purposes. On one hand your bonds provide safety to an investment portfolio as well as offering future rebalancing when the next stock market downturn occurs. Your mortgage is a very low rate and thus more of your payment may be going to principal as you build equity over time.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by abuss368 » Sun Jan 07, 2018 5:39 pm

pezblanco wrote:
Mon Jan 01, 2018 1:50 pm
Suppose you have a too heavy stock allocation ... (my own situation given the last couple of years without rebalancing). I also have a mortgage at 2.625 %. I could/should rebalance by selling some stock and purchasing bonds/cds but my question is more what should I do with future/present extra income. The two options that I consider are

1) Rebalance by purchasing bonds (or CDs).
2) Prepay some principal on mortgage.

Both options see to be more or less the same idea. With option 2, during the life of the mortgage, I'm purchasing a bond paying 2.625 % tax free (due to the new tax law, I will not itemize). No conservative bond fund that I can purchase will have an SEC yield of greater than that even taxable. Isn't it a no-brainer to do option 2?

Am I missing something here? I would appreciate your thoughts.
Hi pezblanco -

Do you have an adequate cash reserves that you are consistently building?
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Re: Why Buy Bonds If You Have A Mortgage?

Post by MNS CA » Sun Jan 07, 2018 7:30 pm

The idea of thinking of a mortgage as a negative bond allocation (or leverage) and comparing it to the risk free rate (treasuries) net of tax consequences is interesting.

But here's a wrinkle:

Your mortgage may not be a riskless obligation, but rather an inexpensive put option / insurance on your investment in housing. By paying down the mortgage, you give up that option/insurance.

In many states, home mortgages are effectively non-recourse, which means that if your house is destroyed or the value plummets, the mortgage lender can foreclose on the house, but cannot pursue you for a deficiency judgment (the remaining balance of the loan). Check the rules in your state.

During 2007-2009 a lot of fine upstanding perfectly respectable upper middle class people decided to take advantage of this put option when a housing crash wiped out their equity. (I was not one of them, but I know people who did this).

The more "house" you own outright (your equity), the more you should insure as well, against fire, flood mudslides, earthquakes, wind, etc. With a mortgage, you can get the minimum insurance required by your lender and your lender is taking a lot of the risk of severe damage to the house exceeding your home equity.

It wouldn't be costless to exercise this option--your credit would take a hit for a while--but you'd recover eventually and could rent in the interim until you could get a mortgage to buy again at a reasonable interest rate and on reasonable terms. And honestly, if a natural disaster wipes out your house, many people won't judge you too harshly for defaulting on the mortgage.

Think of your mortgage put option as catastrophic insurance.

Our President pulled this move a few times as a Real Estate investor, and Mitt Romney's firm (and most PE firms) have done similar things as Private Equity sponsors. If it's good enough for the president and titans of industry, why isn't it good enough for homeowners?

Your lender gets paid to share risk with you.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Mon Jan 08, 2018 4:01 am

pezblanco wrote:
Sun Jan 07, 2018 11:08 am
But you have to look at the total portfolio. You can't just look at the mortgage part and the stock part. There is also a bond part. If you think of the mortgage as a negative bond and you have more "positive" bond than negative bond, then you have a net positive bond allocation ... whether or not you have equities means (at least to my mind) that you're not leveraged at all.
Yes, but I'm imagining that many people (even most?), especially when they are younger, have a mortage that eclipses their bond allocation. (People buy expensive homes, while also not saving much.) But they are still dutifully putting money into equities, following a basic rule of thumb about saving for retirement (assuming they are saving at all, since many people don't). In that case, they have a huge negative bond allocation.

As randomizer says above:
randomizer wrote:
Sun Jan 07, 2018 12:39 pm
I like the negative bond model. When I got a mortgage, this showed that I was at 107% stocks (ie. leveraged) despite my nominal 25% allocation to bonds. I think this is a useful heuristic that shows the actual level of risk that I was exposed to (and fortunately, was comfortable with).
So I imagine many people are effectively leveraged like this, without realizing it, because their mortgages are so much bigger than their savings.

*

That aside, doesn't holding a mortgage also entail other risks, which make it no so well compared to a riskless asset, like a treasury, but with a negative yield. If you get foreclosed on, you could lose your equity in the house--where is the analogy to a treasury here? The value of the underlying principal (the house) can vary over time and need not be the same when the bond, i.e. mortgage, reaches maturity (the housing market could crash at that moment)--but a bond is worth it's face value regardless if you hold it to maturity. A natural disaster could destroy your home, not be covered by insurance (not everyone holds earthquake or flood insurance, for example) or not be sufficiently insured, the home/property could become worthless, but you'd still hold the negative bond of the mortgage and be responsible for it; you could then walk away but that would ruin your credit and dramatically affect your life in other ways; how is that like a treasury? All these risks associated both with the underlying principal to the negative "bond" and with the mortgage itself seem to me to make the mortgage/house situation really different from a treasury bond. Am I missing something?

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Re: Why Buy Bonds If You Have A Mortgage?

Post by Admiral » Mon Jan 08, 2018 4:17 pm

DoubleDraw wrote:
Sun Jan 07, 2018 3:15 pm
What kinds of events require such large amounts of cash or liquidity? I have yet to run into any situation other than buying a home or car that requires more than $10k or so at a clip. We have great health insurance, home insurance and car insurance.

I understand the value of liquidity in order to rebalance when there are large shifts in the markets but don’t understand what people need $50k at a time for that is unplanned.
How about you lose your job? How about you want to take an expensive vacation? How about you get sued and have to pay an attorney...and then lose?

Life is full of curveballs. Again, if one has lots of liquidity (let's say a year's expenses left AFTER paying off a mortgage) then sure, if that's what you want to do, go ahead and get the guaranteed return. But my view is if, over the 14 years remaining on my low-rate mortgage, I cannot beat that by investing in a balanced portfolio, then I shouldn't be in the markets in the first place.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Mon Jan 08, 2018 5:30 pm

cb474 wrote:
Mon Jan 08, 2018 4:01 am
That aside, doesn't holding a mortgage also entail other risks, which make it no so well compared to a riskless asset, like a treasury, but with a negative yield. If you get foreclosed on, you could lose your equity in the house--where is the analogy to a treasury here?
If you get foreclosed on, you keep your equity. If you have a $150K mortgage that you can't pay, and your house is worth $200K, the buyer pays off the mortgage and you get the $50K. (More likely, in this situation, you would sell the house yourself before it got to foreclosure, so that you could use the equity immediately to find a place to rent.)

The asymmetry is in the other direction. If you have a $250K mortgage that you can't pay, and your house is worth $200K, then in most states, you don't have to cover the other $50K, and even if it is legally possible, the bank may not try. You have gained, not lost, by failing to cover your negative bond.

But when the issue of paying down the mortgage versus investing arises, you presumably have enough investments to keep making the mortgage payments if defaulting on the mortgage would be undesirable. You can withdraw contributions from your Roth IRA (no penalty), or withdraw from your IRA (possibly with penalty, but you're probably in a low tax bracket when you need to do this, so the total bill won't be too high), or take a hardship withdrawal from your 401(k) (again possibly with penalty).
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Re: Why Buy Bonds If You Have A Mortgage?

Post by willthrill81 » Mon Jan 08, 2018 5:58 pm

grabiner wrote:
Mon Jan 08, 2018 5:30 pm
cb474 wrote:
Mon Jan 08, 2018 4:01 am
That aside, doesn't holding a mortgage also entail other risks, which make it no so well compared to a riskless asset, like a treasury, but with a negative yield. If you get foreclosed on, you could lose your equity in the house--where is the analogy to a treasury here?
If you get foreclosed on, you keep your equity.
Fees of various sorts could really hurt your equity in a foreclosure.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Mon Jan 08, 2018 6:28 pm

willthrill81 wrote:
Mon Jan 08, 2018 5:58 pm
grabiner wrote:
Mon Jan 08, 2018 5:30 pm
cb474 wrote:
Mon Jan 08, 2018 4:01 am
That aside, doesn't holding a mortgage also entail other risks, which make it no so well compared to a riskless asset, like a treasury, but with a negative yield. If you get foreclosed on, you could lose your equity in the house--where is the analogy to a treasury here?
If you get foreclosed on, you keep your equity.
Fees of various sorts could really hurt your equity in a foreclosure.
But those fees are constant. As long as you have positive equity, every dollar you pay will come back as an additional dollar in equity, whenever you realize this equity (whether in foreclosure, distressed sale, or ordinary sale).
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Re: Why Buy Bonds If You Have A Mortgage?

Post by broslami » Mon Jan 08, 2018 6:39 pm

First, your mortgage is a way for you to short the US dollar. If inflation or hyper inflation hits, you can pay off your home in increasingly worthless dollars.

Secondly, you want to keep cash as a call option with no expiration date.

Your mortgage is where your cash goes to die.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by Admiral » Mon Jan 08, 2018 7:02 pm

In high interest rate environments (which we really have not seen for many years now) early payoff, or carrying no mortgage at all, may be desirable. However, many people with excessive liquidity--millions and millions--may carry a low-rate mortgage because they'd rather put their spare money to use in other ways: investing in the market, buying other assets, hedge funds, private equity, start ups, and so on.

Interest is the price you pay to hold on to your money. Over the last hundred or more years, the markets have beat real estate appreciation (at least on average if not in specific markets at specific times) handily.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Mon Jan 08, 2018 11:07 pm

grabiner wrote:
Mon Jan 08, 2018 5:30 pm
cb474 wrote:
Mon Jan 08, 2018 4:01 am
That aside, doesn't holding a mortgage also entail other risks, which make it no so well compared to a riskless asset, like a treasury, but with a negative yield. If you get foreclosed on, you could lose your equity in the house--where is the analogy to a treasury here?
If you get foreclosed on, you keep your equity. If you have a $150K mortgage that you can't pay, and your house is worth $200K, the buyer pays off the mortgage and you get the $50K. (More likely, in this situation, you would sell the house yourself before it got to foreclosure, so that you could use the equity immediately to find a place to rent.)

The asymmetry is in the other direction. If you have a $250K mortgage that you can't pay, and your house is worth $200K, then in most states, you don't have to cover the other $50K, and even if it is legally possible, the bank may not try. You have gained, not lost, by failing to cover your negative bond.

But when the issue of paying down the mortgage versus investing arises, you presumably have enough investments to keep making the mortgage payments if defaulting on the mortgage would be undesirable. You can withdraw contributions from your Roth IRA (no penalty), or withdraw from your IRA (possibly with penalty, but you're probably in a low tax bracket when you need to do this, so the total bill won't be too high), or take a hardship withdrawal from your 401(k) (again possibly with penalty).
In the second scenario, you are underwater, as happened to many people in 2008. But even though you did make a downpayment on the house and have paid off some principal on your loan, you still lose everything. Only the bank gets paid. So the crash in house prices, let's say they dropped by 30%, doesn't mean that you lose 30% of your equity and the bank loses 30% of it's outstanding principal. You do not effectively still own the precent of the house that your downpayment and principal payments equal relative to the purchase price. Instead, one party, the bank, always gets paid differently. So this makes a mortage not just a "negative bond." If you held a treasury and the market for treasuries crashed by 30% and you had to sell the bond before maturity for some reason, you'd still have 70% of your original principal; there's not some other party that would get paid first. So, I think my point stands, that having a mortgage on a house, from the point of view of the homeowner, is not simply equivalent to holding a riskless asset like a treasury bond, but with a negative yield. It's more complicated and can play out in different ways depending on the circumstances.

With your last point, that you could use your investments to make your mortgage payments to avoid defaulting, that is true as long as your investments don't crash at the same time your house loses a lot of value and you lose your job, say, as happened again to many people in 2008. So counting on the investments to save your house, because on average the market outperforms the current low mortgage rates, assumes that what is average always happens. But often it doesn't. Bad timing could result in the loss of a house that might have been paid off, if one had made extra principal payments for years, instead of investing. Which, I think, is yet another reason why investing while having a mortgage entails more risk and complications than one might assume.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by FIREchief » Tue Jan 09, 2018 4:03 am

Haven't seen it mentioned, and may not be a concern for some. A large mortgage is the most effective form of asset protection available for your personal residence.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by Dandy » Tue Jan 09, 2018 7:36 am

I would opt for liquidity vs paying down. When times get tough having liquidity will be appreciated in general and for possible re balancing when equities are cheaper. Your mortgage rate is great and you can find some 2 or 3 year CDs that pay that % or more - with interest rates likely to rise, the advantage of your fixed income choices vs mortgage might be even greater.

Paying down is nice but it doesn't reduce your monthly expenses it just has the longer term benefit of shortening the payment term.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by Admiral » Tue Jan 09, 2018 7:41 am

cb474 wrote:
Mon Jan 08, 2018 11:07 pm

With your last point, that you could use your investments to make your mortgage payments to avoid defaulting, that is true as long as your investments don't crash at the same time your house loses a lot of value and you lose your job, say, as happened again to many people in 2008. So counting on the investments to save your house, because on average the market outperforms the current low mortgage rates, assumes that what is average always happens. But often it doesn't.
This is true ONLY if one is not well diversified: stocks, bonds, cash, and a house. The point of an emergency fund is to have monies on which to draw in case of emergency: job loss, especially, so one can continue to make a mortgage payment. You should not be forced to sell at a steep loss due to a market drop to save your house.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Tue Jan 09, 2018 8:59 pm

FIREchief wrote:
Tue Jan 09, 2018 4:03 am
Haven't seen it mentioned, and may not be a concern for some. A large mortgage is the most effective form of asset protection available for your personal residence.
This is only a benefit if the money which would otherwise be used to pay down the mortgage is itself asset-protected, such as in a 401(k). If you have a taxable account, you can be more easily forced to pay its value than forced to give up your house.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by FIREchief » Tue Jan 09, 2018 9:23 pm

grabiner wrote:
Tue Jan 09, 2018 8:59 pm
FIREchief wrote:
Tue Jan 09, 2018 4:03 am
Haven't seen it mentioned, and may not be a concern for some. A large mortgage is the most effective form of asset protection available for your personal residence.
This is only a benefit if the money which would otherwise be used to pay down the mortgage is itself asset-protected, such as in a 401(k). If you have a taxable account, you can be more easily forced to pay its value than forced to give up your house.
Exactly. Those who are choosing between fully funding their retirement plans and paying down a mortgage have something to think about here.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by fmzip » Tue Jan 09, 2018 9:43 pm

Will all the negativity toward a mortgage, is there any plus's to it other than spending tons of money on it for the banks benefit? :P

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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Tue Jan 09, 2018 10:12 pm

Admiral wrote:
Tue Jan 09, 2018 7:41 am
cb474 wrote:
Mon Jan 08, 2018 11:07 pm

With your last point, that you could use your investments to make your mortgage payments to avoid defaulting, that is true as long as your investments don't crash at the same time your house loses a lot of value and you lose your job, say, as happened again to many people in 2008. So counting on the investments to save your house, because on average the market outperforms the current low mortgage rates, assumes that what is average always happens. But often it doesn't.
This is true ONLY if one is not well diversified: stocks, bonds, cash, and a house. The point of an emergency fund is to have monies on which to draw in case of emergency: job loss, especially, so one can continue to make a mortgage payment. You should not be forced to sell at a steep loss due to a market drop to save your house.
In an ideal circumstance, yes one would have lots of extra resources available to ride out a financial crisis. But most people are struggling just to make mortgage payments and save a little money.

So I think realisitically, except for those with very high incomes, many people could easily find themselves in a situation more like I outline. Also, job losses are not always so simple to recover from, depending on one's skills, education, area of work, age. People can be out of work for years or have to accept huge reductions in income. It would take a lot of savings to have the emergency funds to ride that out. So I think in the real world, where most people have limited resources and income, the risk of effectively leveraging to save money rather than pay down a mortage may not be the right choice (i.e. the choice with the least risk associated with it).

And even for higher income people who have the resources to have a sizable emergency fund, as well as other diversified savings/investments, if they really have that much money, why not just pay off the mortgage anyway (unless they can get treasury bonds with a higher interest rate, which has not been possible for a quite a while now)?

So I think in real world contexts, the people who have the resources to have a sizable emergency fund and are generally prudent with their money are probably going to be fine regardless of their strategy. But for people who don't have good choices, have minimal savings, and put a lot of their income into their mortgage, the long term less risky strategy might be to pay off the mortgage as soon as possible. Of course, everyone's circumstances are different.

All that to say, I think my point still stands that treating a mortgage as simply a riskless bond with a negative yield is a useful way to think about it, but not a perfect analogy. The mortgage has other potential complications (as I state above) that go with it.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Tue Jan 09, 2018 10:38 pm

cb474 wrote:
Tue Jan 09, 2018 10:12 pm
So I think in real world contexts, the people who have the resources to have a sizable emergency fund and are generally prudent with their money are probably going to be fine regardless of their strategy. But for people who don't have good choices, have minimal savings, and put a lot of their income into their mortgage, the long term less risky strategy might be to pay off the mortgage as soon as possible.
This does not make sense. Every dollar that was used to pay down the mortgage could have been used to build an emergency fund instead, or added to savings somewhere else. And it is less risky to have a $20K emergency fund and a $100K mortgage, rather than no emergency fund and an $80K mortgage; that emergency fund can make your mortgage payments if you lose your job.

Yes, it is riskier to not pay down your mortgage and spend the spare money (which too many people do) than to use the spare money to pay down the mortgage, but that is the result of the decision to spend the money, not the decision whether to pay down the mortgage.

Similarly, it is riskier to invest in stocks than to pay down the mortgage, but that is the result of the stocks; you could have invested in bonds instead without taking the risk.
And even for higher income people who have the resources to have a sizable emergency fund, as well as other diversified savings/investments, if they really have that much money, why not just pay off the mortgage anyway (unless they can get treasury bonds with a higher interest rate, which has not been possible for a quite a while now)?
Treasuries in an IRA or 401(k) earn more than the after-tax rate on a mortgage if you itemize deductions. The current yield on a 7-year Treasury is 2.46%, which is better after tax than the rate on a 15-year mortgage which has a 7-year duration. In addition, by not paying off the mortgage now, you retain the right to carry it at a bargain rate if rates rise, or pay it off or refinance later if rates fall. Therefore, it's usually better to contribute to an IRA and a decent 401(k) in preference to paying down the mortgage.

If you can max out, it's more complicated. The current yield on Admiral shares of Vanguard Long-Term Tax-Exempt, which also has a 7-year duration, is 2.51%. You get the benefit of liquidity, and retain the option, but you have credit risk which does not exist with treasuries.
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