Why Buy Bonds If You Have A Mortgage?

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

Post by KlangFool » Mon Jan 15, 2018 12:54 am

inbox788 wrote:
Sun Jan 14, 2018 11:47 pm
KlangFool wrote:
Sun Jan 14, 2018 10:00 pm
inbox788 wrote:
Sun Jan 14, 2018 5:58 pm
KlangFool wrote:
Sun Jan 14, 2018 4:59 pm
I borrow 300K from my mortgage to be invested in a 60/40 portfolio. And, if and when I pay off my mortgage, I will move 300K from my 60/40 portfolio to pay off the mortgage. Now, some other folks want to think about the negative bond or whatever does not make any sense to me.
There are 2 issue at play, changing AA and comparing bond return vs mortgage. You don't have to think about mortgage as a negative bond to improve your situation. Instead of borrowing $300k at 3.49% and investing $180k inequities hoping for 9.67% and $120k in bonds for 3%, just borrow the 180k to invest in 100% equities.
Why would I want to do that? I have a 300K mortgage. I choose to invest that 300K in a 60/40 portfolio because I like the risk-adjusted return of a 60/40 portfolio versus a 3.49% mortgage.

You had boxed yourself into a corner by the "negative bond" thinking. Why would you want to do that if it is not useful and profitable for you?
It's not investing the whole 300k in the mortgage, just replacing the bonds! I'm making the case for NOT buying the bonds.

You have a 180k+120k mortgage that you chose to invest 180k in equities and 120k in bonds for a 7% blended return. I just choose to invest in the same 180k equities, but don't take out the mortgage. We have the same risk on the equity side and I'm arguing that the return I get is going to be higher with less risk. 180k@9.67% + 120k@3.49% is 7.2%! (I would only do this if the return on the mortgage was higher than the bond)

IMO, 180k borrowed from mortgage and invested in 100% equities is LESS RISKY than 300k borrowed mortgage invested 60/40.

Anyway, you seem to have a hard time with the negative bond thinking, but I hope this illustration helps others who may be more open minded to the idea.
inbox788,

<< IMO, 180k borrowed from mortgage and invested in 100% equities is LESS RISKY than 300k borrowed mortgage invested 60/40.>>

I have a 400K house with a 300K mortgage.

So, it is between

A) 180K 100% stock with 120K mortgage which does not change my mortgage payment unless I recast the loan

B) 300K 60/40 portfolio with the 300K mortgage.

In a recession, the stock crash 50% and the bond stay flat. My annual expense is 60K per year.

For (A), I can only last 90K/60K = 1 1/2 years. For (B), 210K/60K = 3 1/2 years. Please tell me how (A) is less risky? It is not.

KlangFool

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

Post by pezblanco » Mon Jan 15, 2018 10:54 am

KlangFool wrote:
Mon Jan 15, 2018 12:54 am
inbox788 wrote:
Sun Jan 14, 2018 11:47 pm
KlangFool wrote:
Sun Jan 14, 2018 10:00 pm
inbox788 wrote:
Sun Jan 14, 2018 5:58 pm
KlangFool wrote:
Sun Jan 14, 2018 4:59 pm
I borrow 300K from my mortgage to be invested in a 60/40 portfolio. And, if and when I pay off my mortgage, I will move 300K from my 60/40 portfolio to pay off the mortgage. Now, some other folks want to think about the negative bond or whatever does not make any sense to me.
There are 2 issue at play, changing AA and comparing bond return vs mortgage. You don't have to think about mortgage as a negative bond to improve your situation. Instead of borrowing $300k at 3.49% and investing $180k inequities hoping for 9.67% and $120k in bonds for 3%, just borrow the 180k to invest in 100% equities.
Why would I want to do that? I have a 300K mortgage. I choose to invest that 300K in a 60/40 portfolio because I like the risk-adjusted return of a 60/40 portfolio versus a 3.49% mortgage.

You had boxed yourself into a corner by the "negative bond" thinking. Why would you want to do that if it is not useful and profitable for you?
It's not investing the whole 300k in the mortgage, just replacing the bonds! I'm making the case for NOT buying the bonds.

You have a 180k+120k mortgage that you chose to invest 180k in equities and 120k in bonds for a 7% blended return. I just choose to invest in the same 180k equities, but don't take out the mortgage. We have the same risk on the equity side and I'm arguing that the return I get is going to be higher with less risk. 180k@9.67% + 120k@3.49% is 7.2%! (I would only do this if the return on the mortgage was higher than the bond)

IMO, 180k borrowed from mortgage and invested in 100% equities is LESS RISKY than 300k borrowed mortgage invested 60/40.

Anyway, you seem to have a hard time with the negative bond thinking, but I hope this illustration helps others who may be more open minded to the idea.
inbox788,

<< IMO, 180k borrowed from mortgage and invested in 100% equities is LESS RISKY than 300k borrowed mortgage invested 60/40.>>

I have a 400K house with a 300K mortgage.

So, it is between

A) 180K 100% stock with 120K mortgage which does not change my mortgage payment unless I recast the loan

B) 300K 60/40 portfolio with the 300K mortgage.

In a recession, the stock crash 50% and the bond stay flat. My annual expense is 60K per year.

For (A), I can only last 90K/60K = 1 1/2 years. For (B), 210K/60K = 3 1/2 years. Please tell me how (A) is less risky? It is not.

KlangFool
Well, one thing is that you

a) Assume that bonds are completely safe in your analysis: Here is the last 50 years of real long term bond rates taken from the DFA data matrix

Image

Does that look like a completely risk free asset? The bond-like return from paying down your mortgage IS risk free.

b) You acknowledge that you don't recast the loan ... but why not? It is usually not a big fee (in my case it is free for the first time). That would radically change your numbers. It's almost as if you were trying to present the other side in the worst possible light! :D

c) Money put into a mortgage is not completely unaccessible. I have a HELOC on my house as do many other people. It is at a larger rate than my mortgage but still .... during bad times, I do have access to my house equity.

inbox788
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Re: Why Buy Bonds If You Have A Mortgage?

Post by inbox788 » Mon Jan 15, 2018 12:06 pm

KlangFool wrote:
Mon Jan 15, 2018 12:54 am
A) 180K 100% stock with 120K mortgage which does not change my mortgage payment unless I recast the loan

B) 300K 60/40 portfolio with the 300K mortgage.

In a recession, the stock crash 50% and the bond stay flat. My annual expense is 60K per year.

For (A), I can only last 90K/60K = 1 1/2 years. For (B), 210K/60K = 3 1/2 years. Please tell me how (A) is less risky? It is not.
That's a liquidity risk and liquidity is not a factor. Market risk is identical on the equities. Bond funds returns are not guaranteed, just projections, that's why B is more risky. Moreover, the comparative yields on those projections are lower.

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

Post by aristotelian » Mon Jan 15, 2018 12:15 pm

KlangFool wrote:
Mon Jan 15, 2018 12:54 am
I have a 400K house with a 300K mortgage.

So, it is between

A) 180K 100% stock with 120K mortgage which does not change my mortgage payment unless I recast the loan

B) 300K 60/40 portfolio with the 300K mortgage.

In a recession, the stock crash 50% and the bond stay flat. My annual expense is 60K per year.

For (A), I can only last 90K/60K = 1 1/2 years. For (B), 210K/60K = 3 1/2 years. Please tell me how (A) is less risky? It is not.

KlangFool
For B, you can last 3.5 years, but you have a bigger mortgage at the end. A only owes the bank $150K when he runs out of money. B still owes maybe $275K. If you lose your job in a recession, it doesn't matter to me whether you have to sell the house in 1.5 years or 3.5 years. It is true that B can delay the inevitable longer but in terms of net worth the risk appears the same to me.

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

Post by mffl » Mon Jan 15, 2018 4:40 pm

cb474 wrote:
Sun Jan 14, 2018 10:46 pm
mffl wrote:
Sat Jan 13, 2018 10:40 pm
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.
Wait a minute. Usually when we talk about the market returning 7% long term, we mean total real return after dividends and inflation. Your 3% mortgage rate is before inflation, so the real rate ought to be expected to be somewhere between 1.3% (10 year moving average of inflation is 1.7%), 0.8% (2017 inflation was 2.2%), and -0.75% (inflation since WW2 is 3.75%). And that's assuming you're taking the standard deduction. If you can itemize, the rate drops further.

This not to say that it's necessarily a good idea for everyone, but it's not quite "bond like returns for stock like risks". It's quite a bit better than that, and if you're young enough and conscious that you're probably over 100% stocks with the leverage of your mortgage taken into consideration, it's a quite inexpensive form of leverage. YMMV, of course.

A 3% mortgage is practically a free loan given even recent lower inflation figures. Now decide whether you actually want over 100% stock market allocation. I think that's the real risk. Personally, I'm young enough to actually want that. Others, with <30 year time frames, should maybe not do that. It even rebalances for you -- as you pay it off over 30 years and your investment portfolio grows, your stock allocation gradually decreases towards "only" 100%. :)
I suggest you read the articles if you want to understand the point being made.
I don't think that my points conflict with the content of the articles, but the author doesn't spend much time talking about mortgage rates at 3% and below. He talks about average mortgage rates over time being 7% and whether 7.8% average market returns is something worth borrowing money at 7% for to try to eke out a 0.8% expected return. Well yeah, that's likely to end badly, though even still his numbers show that it works out most of the time. The OP has an interest rate only a few tenths of a percentage point away from recent inflation figures, and that is way below long term inflation figures. If the OP was going to get a mortgage rate at random to go along with random future inflation market returns, then it all gets much riskier. But OP's rate isn't randomly selected from historical data, it's 2.625%.

Obviously as both you and the author of the article stated, YMMV based on age and other factors. I was only wanting to point out that a mortgage rate around 0% to 1.5% after inflation, which would mean 5% or better expected net real return (assuming long term market return, which obviously nobody can guarantee) is quite a different animal than picking a random point in history to keep a mortgage and simultaneously invest. Sequence of returns matters, but that's why this bet is better for young people (which the author also states), and obviously better when the gap between mortgage rate minus expected inflation and long term real CAGR of the market is wider.

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

Post by grabiner » Mon Jan 15, 2018 7:31 pm

KlangFool wrote:
Mon Jan 15, 2018 12:54 am
Well, one thing is that you

a) Assume that bonds are completely safe in your analysis: Here is the last 50 years of real long term bond rates taken from the DFA data matrix

Image

Does that look like a completely risk free asset? The bond-like return from paying down your mortgage IS risk free.
This is not a fair comparison. A bond held to maturity is risk-free unless the issuer defaults; if you know you will hold it to maturity, you don't care about what happens along the way. This is why I have suggested that the most fair comparison is a bond portfolio which produces enough income to make the mortgage payment every year.

Conversely, prepaying your mortgage is not risk-free until the term of the eliminated payments. The reported balance of your mortgage will grow at the mortgage rate, but the value of your mortgage to the bank (and its real cost to you) also change every year as interest rates change.
b) You acknowledge that you don't recast the loan ... but why not? It is usually not a big fee (in my case it is free for the first time). That would radically change your numbers. It's almost as if you were trying to present the other side in the worst possible light!
This is an important point in favor of paying down the mortgage. If you can recast of your mortgage, then the benefit from paying it down is proportional to the amount paid down. If you pay down a 10-year mortgage to 8 years without recasting, your benefit has a 9-year duration; if you recast, your benefit has a 5-year duration because you reduce every payment for the next 10 years.

(Are recasts guaranteed, though? If rates have increased, I could see a bank being reluctant to recast, as it would lose on the deal.)
Wiki David Grabiner

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

Post by KlangFool » Mon Jan 15, 2018 7:35 pm

inbox788 wrote:
Mon Jan 15, 2018 12:06 pm
KlangFool wrote:
Mon Jan 15, 2018 12:54 am
A) 180K 100% stock with 120K mortgage which does not change my mortgage payment unless I recast the loan

B) 300K 60/40 portfolio with the 300K mortgage.

In a recession, the stock crash 50% and the bond stay flat. My annual expense is 60K per year.

For (A), I can only last 90K/60K = 1 1/2 years. For (B), 210K/60K = 3 1/2 years. Please tell me how (A) is less risky? It is not.
That's a liquidity risk and liquidity is not a factor. Market risk is identical on the equities. Bond funds returns are not guaranteed, just projections, that's why B is more risky. Moreover, the comparative yields on those projections are lower.
inbox788,

Please explain to me how liquidity is not a factor?

<<Bond funds returns are not guaranteed, just projections, that's why B is more risky.>>

Here we go again. Are you saying that a 60/40 portfolio is riskier than 100/0 portfolio? I have a 60/40 portfolio. I am looking at the total portfolio return and risk profile.

KlangFool

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Mon Jan 15, 2018 7:37 pm

aristotelian wrote:
Mon Jan 15, 2018 12:15 pm
KlangFool wrote:
Mon Jan 15, 2018 12:54 am
I have a 400K house with a 300K mortgage.

So, it is between

A) 180K 100% stock with 120K mortgage which does not change my mortgage payment unless I recast the loan

B) 300K 60/40 portfolio with the 300K mortgage.

In a recession, the stock crash 50% and the bond stay flat. My annual expense is 60K per year.

For (A), I can only last 90K/60K = 1 1/2 years. For (B), 210K/60K = 3 1/2 years. Please tell me how (A) is less risky? It is not.

KlangFool
For B, you can last 3.5 years, but you have a bigger mortgage at the end. A only owes the bank $150K when he runs out of money. B still owes maybe $275K. If you lose your job in a recession, it doesn't matter to me whether you have to sell the house in 1.5 years or 3.5 years. It is true that B can delay the inevitable longer but in terms of net worth the risk appears the same to me.
aristotelian,

In a full recession, the question is how long you can last before market recover. With (B), you have a greater chance of survival. With (A), you may not survive. If you cannot survive, you have no house.

KlangFool

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Mon Jan 15, 2018 7:39 pm

pezblanco wrote:
Mon Jan 15, 2018 10:54 am
KlangFool wrote:
Mon Jan 15, 2018 12:54 am
inbox788 wrote:
Sun Jan 14, 2018 11:47 pm
KlangFool wrote:
Sun Jan 14, 2018 10:00 pm
inbox788 wrote:
Sun Jan 14, 2018 5:58 pm

There are 2 issue at play, changing AA and comparing bond return vs mortgage. You don't have to think about mortgage as a negative bond to improve your situation. Instead of borrowing $300k at 3.49% and investing $180k inequities hoping for 9.67% and $120k in bonds for 3%, just borrow the 180k to invest in 100% equities.
Why would I want to do that? I have a 300K mortgage. I choose to invest that 300K in a 60/40 portfolio because I like the risk-adjusted return of a 60/40 portfolio versus a 3.49% mortgage.

You had boxed yourself into a corner by the "negative bond" thinking. Why would you want to do that if it is not useful and profitable for you?
It's not investing the whole 300k in the mortgage, just replacing the bonds! I'm making the case for NOT buying the bonds.

You have a 180k+120k mortgage that you chose to invest 180k in equities and 120k in bonds for a 7% blended return. I just choose to invest in the same 180k equities, but don't take out the mortgage. We have the same risk on the equity side and I'm arguing that the return I get is going to be higher with less risk. 180k@9.67% + 120k@3.49% is 7.2%! (I would only do this if the return on the mortgage was higher than the bond)

IMO, 180k borrowed from mortgage and invested in 100% equities is LESS RISKY than 300k borrowed mortgage invested 60/40.

Anyway, you seem to have a hard time with the negative bond thinking, but I hope this illustration helps others who may be more open minded to the idea.
inbox788,

<< IMO, 180k borrowed from mortgage and invested in 100% equities is LESS RISKY than 300k borrowed mortgage invested 60/40.>>

I have a 400K house with a 300K mortgage.

So, it is between

A) 180K 100% stock with 120K mortgage which does not change my mortgage payment unless I recast the loan

B) 300K 60/40 portfolio with the 300K mortgage.

In a recession, the stock crash 50% and the bond stay flat. My annual expense is 60K per year.

For (A), I can only last 90K/60K = 1 1/2 years. For (B), 210K/60K = 3 1/2 years. Please tell me how (A) is less risky? It is not.

KlangFool
Well, one thing is that you

a) Assume that bonds are completely safe in your analysis: Here is the last 50 years of real long term bond rates taken from the DFA data matrix
pezblanco,

I have a 60/40 portfolio. It is safer than either 100/0 or 0/100. Do you disagree?

KlangFool

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

Post by aristotelian » Mon Jan 15, 2018 8:16 pm

KlangFool wrote:
Mon Jan 15, 2018 7:37 pm
aristotelian wrote:
Mon Jan 15, 2018 12:15 pm
For B, you can last 3.5 years, but you have a bigger mortgage at the end. A only owes the bank $150K when he runs out of money. B still owes maybe $275K. If you lose your job in a recession, it doesn't matter to me whether you have to sell the house in 1.5 years or 3.5 years. It is true that B can delay the inevitable longer but in terms of net worth the risk appears the same to me.
aristotelian,

In a full recession, the question is how long you can last before market recover. With (B), you have a greater chance of survival. With (A), you may not survive. If you cannot survive, you have no house.

KlangFool
If I am unemployed and going through all my savings, I am selling the house much sooner than 3.5 years. Being able to stay in the house another two years is not a big concern to me.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Mon Jan 15, 2018 8:28 pm

aristotelian wrote:
Mon Jan 15, 2018 8:16 pm
KlangFool wrote:
Mon Jan 15, 2018 7:37 pm
aristotelian wrote:
Mon Jan 15, 2018 12:15 pm
For B, you can last 3.5 years, but you have a bigger mortgage at the end. A only owes the bank $150K when he runs out of money. B still owes maybe $275K. If you lose your job in a recession, it doesn't matter to me whether you have to sell the house in 1.5 years or 3.5 years. It is true that B can delay the inevitable longer but in terms of net worth the risk appears the same to me.
aristotelian,

In a full recession, the question is how long you can last before market recover. With (B), you have a greater chance of survival. With (A), you may not survive. If you cannot survive, you have no house.

KlangFool
If I am unemployed and going through all my savings, I am selling the house much sooner than 3.5 years. Being able to stay in the house another two years is not a big concern to me.
aristotelian,

<<Being able to stay in the house another two years is not a big concern to me.>>

Do you remember 2008/2009 recession? Aka, the house price drop by 50% in many places. The difference of 2 years is significant in a recession. This is on top of your main portfolio.

I know I can last 5 years without selling my stock in a recession. Many folks will not survive or suffer the permanent financial loss that they cannot recover.

1) How much will you lose if you have to sell your house at 50% or more loss?

2) There are times when there is no buyer even if you want to sell your house.

KlangFool

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

Post by pezblanco » Mon Jan 15, 2018 9:44 pm

grabiner wrote:
Mon Jan 15, 2018 7:31 pm
KlangFool wrote:
Mon Jan 15, 2018 12:54 am
Well, one thing is that you

a) Assume that bonds are completely safe in your analysis: Here is the last 50 years of real long term bond rates taken from the DFA data matrix

Image

Does that look like a completely risk free asset? The bond-like return from paying down your mortgage IS risk free.
This is not a fair comparison. A bond held to maturity is risk-free unless the issuer defaults; if you know you will hold it to maturity, you don't care about what happens along the way. This is why I have suggested that the most fair comparison is a bond portfolio which produces enough income to make the mortgage payment every year.

Conversely, prepaying your mortgage is not risk-free until the term of the eliminated payments. The reported balance of your mortgage will grow at the mortgage rate, but the value of your mortgage to the bank (and its real cost to you) also change every year as interest rates change.
b) You acknowledge that you don't recast the loan ... but why not? It is usually not a big fee (in my case it is free for the first time). That would radically change your numbers. It's almost as if you were trying to present the other side in the worst possible light!
This is an important point in favor of paying down the mortgage. If you can recast of your mortgage, then the benefit from paying it down is proportional to the amount paid down. If you pay down a 10-year mortgage to 8 years without recasting, your benefit has a 9-year duration; if you recast, your benefit has a 5-year duration because you reduce every payment for the next 10 years.

(Are recasts guaranteed, though? If rates have increased, I could see a bank being reluctant to recast, as it would lose on the deal.)
But David, we have to be reasonable about what is actually going to be invested in. Very very few people are going to construct a bond ladder to match their mortgage payments, right? They are just going to go buy some "safe" long term bond mutual fund. And those bounce around ever year... not as much as stocks but certainly not the constant value assumed by KF.

I think in my case, I'm allowed one "free" recast ... but they might have some "gotcha provision" that I didn't see.

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

Post by grabiner » Mon Jan 15, 2018 10:08 pm

pezblanco wrote:
Mon Jan 15, 2018 9:44 pm
grabiner wrote:
Mon Jan 15, 2018 7:31 pm
KlangFool wrote:
Mon Jan 15, 2018 12:54 am
Well, one thing is that you

a) Assume that bonds are completely safe in your analysis: Here is the last 50 years of real long term bond rates taken from the DFA data matrix

Image

Does that look like a completely risk free asset? The bond-like return from paying down your mortgage IS risk free.
This is not a fair comparison. A bond held to maturity is risk-free unless the issuer defaults; if you know you will hold it to maturity, you don't care about what happens along the way. This is why I have suggested that the most fair comparison is a bond portfolio which produces enough income to make the mortgage payment every year.

Conversely, prepaying your mortgage is not risk-free until the term of the eliminated payments. The reported balance of your mortgage will grow at the mortgage rate, but the value of your mortgage to the bank (and its real cost to you) also change every year as interest rates change.
But David, we have to be reasonable about what is actually going to be invested in. Very very few people are going to construct a bond ladder to match their mortgage payments, right? They are just going to go buy some "safe" long term bond mutual fund. And those bounce around ever year... not as much as stocks but certainly not the constant value assumed by KF.
The value of bonds, whether in a ladder or not, varies with interest rates. If your mortgage payment has a 5-year duration, the value of a bond ladder with a 5-year duration and the value of an intermediate-term bond fund should change by the same amount. And so does the negative value (but not the quoted price) of the mortgage. If rates rise, your mortgage becomes less costly to you and less valuable to the bank, and your bonds become less valuable to you and less costly to the Treasury/state/corporation which issued them.

The difference is what happens after the first year, but it is a fair trade-off. If you had bought the 10-year ladder, then both it and your mortgage would have a 3-year duration when the mortgage was down to 6 years. You could switch to a shorter-term bond fund, but if you don't, then your intermediate-term fund has higher risk, but also higher returns.
Wiki David Grabiner

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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Mon Jan 15, 2018 10:20 pm

mffl wrote:
Mon Jan 15, 2018 4:40 pm
I don't think that my points conflict with the content of the articles, but the author doesn't spend much time talking about mortgage rates at 3% and below. He talks about average mortgage rates over time being 7% and whether 7.8% average market returns is something worth borrowing money at 7% for to try to eke out a 0.8% expected return. Well yeah, that's likely to end badly, though even still his numbers show that it works out most of the time. The OP has an interest rate only a few tenths of a percentage point away from recent inflation figures, and that is way below long term inflation figures. If the OP was going to get a mortgage rate at random to go along with random future inflation market returns, then it all gets much riskier. But OP's rate isn't randomly selected from historical data, it's 2.625%.

Obviously as both you and the author of the article stated, YMMV based on age and other factors. I was only wanting to point out that a mortgage rate around 0% to 1.5% after inflation, which would mean 5% or better expected net real return (assuming long term market return, which obviously nobody can guarantee) is quite a different animal than picking a random point in history to keep a mortgage and simultaneously invest. Sequence of returns matters, but that's why this bet is better for young people (which the author also states), and obviously better when the gap between mortgage rate minus expected inflation and long term real CAGR of the market is wider.
On your second point, the model the author of the articles uses does account for inflation. He explains this.

On the first point, yes mortgage rates are different in the period of historical data he uses for his analysis. But so were bond rates and market performance. So you can't just say one factor (mortgage rates) have changes and not account for the other changes. And the author is clear that he believes analysis applies in the current mortgage rate environment also.

One of his main points, I think, is that people don't consider downside risk enough. Sure, maybe the market will "average" 7% return or maybe one is being modest in only assuming an "average" 5% return (as used on one example, in one post in this thread), but when people talk about "averages" they tend to treat them more or less as guarantees (perhaps intellectually they know that's not true, but emotionally they act as if it is). But as the author points out, when you leverage your equity investments, via a mortgage, there's a lot more downside risk than people think. On "average," if you got to rerun history over and over, like in a Monte Carlo simulation, you might come out ahead leveraging equity investments in this way. But the odds aren't that bad that in the one version of history that you live through that you will end up losing money instead.

I agree that if you have a thirty year or longer time horizon (at which point one's mortgage will be paid off anyway), it's probably a reasonable bet. But over ten and even fifteen years, there's a lot more downside risk they people think. You have to get above twenty years at least to start to get in a safer zone (based on analyses or rolling time periods, over historical data).

In any case, I can see that the author of those articles is still actively blogging. And he seems to respond to comments. So why not post a comment on his article and run your argument by him? It would be interesting to see what he says. I don't want to speak for him or assume I have perfectly represented all the details of his analysis. But I haven't really seen anything yet that convinces me he overlooked something.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by pezblanco » Mon Jan 15, 2018 10:32 pm

grabiner wrote:
Mon Jan 15, 2018 10:08 pm
pezblanco wrote:
Mon Jan 15, 2018 9:44 pm
grabiner wrote:
Mon Jan 15, 2018 7:31 pm
KlangFool wrote:
Mon Jan 15, 2018 12:54 am
Well, one thing is that you

a) Assume that bonds are completely safe in your analysis: Here is the last 50 years of real long term bond rates taken from the DFA data matrix

Image

Does that look like a completely risk free asset? The bond-like return from paying down your mortgage IS risk free.
This is not a fair comparison. A bond held to maturity is risk-free unless the issuer defaults; if you know you will hold it to maturity, you don't care about what happens along the way. This is why I have suggested that the most fair comparison is a bond portfolio which produces enough income to make the mortgage payment every year.

Conversely, prepaying your mortgage is not risk-free until the term of the eliminated payments. The reported balance of your mortgage will grow at the mortgage rate, but the value of your mortgage to the bank (and its real cost to you) also change every year as interest rates change.
But David, we have to be reasonable about what is actually going to be invested in. Very very few people are going to construct a bond ladder to match their mortgage payments, right? They are just going to go buy some "safe" long term bond mutual fund. And those bounce around ever year... not as much as stocks but certainly not the constant value assumed by KF.
The value of bonds, whether in a ladder or not, varies with interest rates. If your mortgage payment has a 5-year duration, the value of a bond ladder with a 5-year duration and the value of an intermediate-term bond fund should change by the same amount. And so does the negative value (but not the quoted price) of the mortgage. If rates rise, your mortgage becomes less costly to you and less valuable to the bank, and your bonds become less valuable to you and less costly to the Treasury/state/corporation which issued them.

The difference is what happens after the first year, but it is a fair trade-off. If you had bought the 10-year ladder, then both it and your mortgage would have a 3-year duration when the mortgage was down to 6 years. You could switch to a shorter-term bond fund, but if you don't, then your intermediate-term fund has higher risk, but also higher returns.
Again, I don't think I'm following this. Surely you're not saying that a fixed bond ladder matched precisely to the projected mortgage payments has exactly the same risk as a never ending bond ladder aka a bond mutual fund? Yes, I agree that the value must change but that is irrelevant with the fixed ladder since the securities are held to maturity and used to pay the mortgage. You do not have that surety with a bond mutual fund. There could be a large jump in rates and the money to pay your mortgage is just not there in the fund at the times we need it. The risks are not the same.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by aristotelian » Mon Jan 15, 2018 10:40 pm

KlangFool wrote:
Mon Jan 15, 2018 8:28 pm

Do you remember 2008/2009 recession? Aka, the house price drop by 50% in many places. The difference of 2 years is significant in a recession. This is on top of your main portfolio.

I know I can last 5 years without selling my stock in a recession. Many folks will not survive or suffer the permanent financial loss that they cannot recover.

1) How much will you lose if you have to sell your house at 50% or more loss?

2) There are times when there is no buyer even if you want to sell your house.

KlangFool
Yeah, I see your point. I guess I just wouldn't feel comfortable leveraging my house to cover living expenses in that situation. If I couldn't rent the house, I would still probably eat a big loss and sell the house during the recession than risk burning through my savings, still have the $300k mortgage, and then get foreclosed on.

I think what I am taking away from this thread is that most people shouldn't buy a house.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Mon Jan 15, 2018 10:54 pm

KlangFool wrote:
Mon Jan 15, 2018 12:54 am
B) 300K 60/40 portfolio with the 300K mortgage.

In a recession, the stock crash 50% and the bond stay flat. My annual expense is 60K per year.

For (A), I can only last 90K/60K = 1 1/2 years. For (B), 210K/60K = 3 1/2 years. Please tell me how (A) is less risky? It is not.
This is a little bit of an aside, but it does affect your assumptions about risk. People seem to take it as a rule of thumb that in a big market crash the worst case scenario is that stocks lose 50% of their value. But there is no guarantee of that and there are historical examples of worse market crashes. Just in 2007-2009, the market dropped 56.8% and in 1929-1932 the market dropped 86.2%.

Also, it can take a couple years just to go from top to bottom and much longer to get back to even. So time horizons for riding out the worst crashes can easily be a lot longer than 3.5 years. It can take decades.
KlangFool wrote:
Mon Jan 15, 2018 8:28 pm
Do you remember 2008/2009 recession? Aka, the house price drop by 50% in many places. The difference of 2 years is significant in a recession. This is on top of your main portfolio.
One could take this as an argument for prepaying a mortgage as much as possible. The less you owe on your house, in a housing market crash, the more likely you won't be underwater and can sell it if need be.

*
grabiner wrote:
Mon Jan 15, 2018 7:31 pm
(Are recasts guaranteed, though? If rates have increased, I could see a bank being reluctant to recast, as it would lose on the deal.)
It really depends on the loan and the bank. Some loans can't be recast at all. Sometimes they'll only let you do it once. And it does seem to be at the discretion of the bank to change the rules (it's not, I believe, part of the terms of the loan).

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Mon Jan 15, 2018 10:57 pm

aristotelian wrote:
Mon Jan 15, 2018 10:40 pm
KlangFool wrote:
Mon Jan 15, 2018 8:28 pm

Do you remember 2008/2009 recession? Aka, the house price drop by 50% in many places. The difference of 2 years is significant in a recession. This is on top of your main portfolio.

I know I can last 5 years without selling my stock in a recession. Many folks will not survive or suffer the permanent financial loss that they cannot recover.

1) How much will you lose if you have to sell your house at 50% or more loss?

2) There are times when there is no buyer even if you want to sell your house.

KlangFool
Yeah, I see your point. I guess I just wouldn't feel comfortable leveraging my house to cover living expenses in that situation. If I couldn't rent the house, I would still probably eat a big loss and sell the house during the recession than risk burning through my savings, still have the $300k mortgage, and then get foreclosed on.

I think what I am taking away from this thread is that most people shouldn't buy a house.
aristotelian,

<< I guess I just wouldn't feel comfortable leveraging my house to cover living expenses in that situation. >>

Almost everyone with a house is in the same situation. People with paid off house have the same problem too. They still need to cover their living expense with their portfolio. If they do not pay the property tax, they will lose their houses too.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Mon Jan 15, 2018 11:01 pm

cb474 wrote:
Mon Jan 15, 2018 10:54 pm

KlangFool wrote:
Mon Jan 15, 2018 8:28 pm
Do you remember 2008/2009 recession? Aka, the house price drop by 50% in many places. The difference of 2 years is significant in a recession. This is on top of your main portfolio.
One could take this as an argument for prepaying a mortgage as much as possible. The less you owe on your house, in a housing market crash, the more likely you won't be underwater and can sell it if need be.
cb474,

1) Come on. It is a 400K house. You lose 200K if you sell it at 50% loss. It has nothing to do with whether it is fully paid off. The only difference is if you do not pay off the house, you have the liquidity to last longer without selling the house.

2) Yes, the recession could last longer. But, people that survive longer has a better chance of outlasting the recession.

KlangFool

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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Mon Jan 15, 2018 11:04 pm

pezblanco wrote:
Mon Jan 15, 2018 10:32 pm
Again, I don't think I'm following this. Surely you're not saying that a fixed bond ladder matched precisely to the projected mortgage payments has exactly the same risk as a never ending bond ladder aka a bond mutual fund? Yes, I agree that the value must change but that is irrelevant with the fixed ladder since the securities are held to maturity and used to pay the mortgage. You do not have that surety with a bond mutual fund. There could be a large jump in rates and the money to pay your mortgage is just not there in the fund at the times we need it. The risks are not the same.
I think grabiner is right. I've seen Larry Swedroe explain this. Your bond ladder also has a market rate. If you had to sell the bonds before maturity, they would go up or down in value depending on the giving market. In a bond fund, you just see those fluctuations, because the fund is priced daily. But the same thing is really happening to the bonds in your bond ladder and they are no different from the fund in this regard.

As long as you hold the money in the bond fund for the extent of its duration (I think, grabiner can probably explain it better), you will get your principle back.

I think what your overlooking is that when you say the bond fund could lose value just "at the times we need it" is that if there were some event where you suddenly needed the money in your bond ladder and no bond was coming to maturity at that moment, then you would have to sell a bond on the open market and you would experience the same loss. So if you are forced to sell the bond ladder it really is subject to the same volatility as the bond fund.
Last edited by cb474 on Mon Jan 15, 2018 11:11 pm, edited 1 time in total.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Mon Jan 15, 2018 11:08 pm

KlangFool wrote:
Mon Jan 15, 2018 11:01 pm
b474,

1) Come on. It is a 400K house. You lose 200K if you sell it at 50% loss. It has nothing to do with whether it is fully paid off. The only difference is if you do not pay off the house, you have the liquidity to last longer without selling the house.
That depends entirely on what happens in the housing market. You could last a couple extra years, the housing market could go down more, you could still be underwater and then get foreclosed on.

Let us also not forget that it takes time to sell a house. It's not like if you have to sell, you can just cash out the next day, like in the stock market. If there's a crash and everyone is selling and no on can get loans (as we just experienced), you may not be able to sell in time after you've used up your liquidity and then get foreclosed. So you have to get the timing right, which is basically just a gamble.

So there are just a lot of complicated variables with a house that do not reduce to the nice clean numbers of what a mortgage costs, versus what bonds are earning. In a normal housing market it's probably not hard to get it right. But in a crash where everyone is scrambling, things may not play out the way one imagines they should.
KlangFool wrote:
Mon Jan 15, 2018 11:01 pm
2) Yes, the recession could last longer. But, people that survive longer has a better chance of outlasting the recession.
First, let's not confuse recessions with bear markets and returns to former peaks in the market. Recessions can end a lot faster than it takes to go from top to bottom in the market and then break even again (to say nothing of breaking even again in real terms).

Second, you were talking about how long it woud take for the market to recover and the benefits a larger portfolio with a larger loan (i.e. being more heavily leveraged). You wrote, "In a full recession, the question is how long you can last before market recover." In your scenario with a larger portfolio you surmised you could last two years longer. But that depended on the assumption that a 50% drop in the market is the worst case scenario, which it clearly is not. And on the idea that the extra two years gives you a significantly better chance of making it until the market recovers, but that was based on the rosey assumption that after large bear markets they might recover anywhere close to that quickly, when in reality it can take decades. So the extra two years may turn out to be trivial, whereas the extra principle in the house may not (market crashes are by no means always tied to housing crashes, as in 2008).

So I think that the odds of your scenario "B" above turning out better than "A" are less than you make them out to be, because you downplay the real nature of many bear markets. That's my only point.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by pezblanco » Mon Jan 15, 2018 11:43 pm

cb474 wrote:
Mon Jan 15, 2018 11:04 pm
pezblanco wrote:
Mon Jan 15, 2018 10:32 pm
Again, I don't think I'm following this. Surely you're not saying that a fixed bond ladder matched precisely to the projected mortgage payments has exactly the same risk as a never ending bond ladder aka a bond mutual fund? Yes, I agree that the value must change but that is irrelevant with the fixed ladder since the securities are held to maturity and used to pay the mortgage. You do not have that surety with a bond mutual fund. There could be a large jump in rates and the money to pay your mortgage is just not there in the fund at the times we need it. The risks are not the same.
I think grabiner is right. I've seen Larry Swedroe explain this. Your bond ladder also has a market rate. If you had to sell the bonds before maturity, they would go up or down in value depending on the giving market. In a bond fund, you just see those fluctuations, because the fund is priced daily. But the same thing is really happening to the bonds in your bond ladder and they are no different from the fund in this regard.

As long as you hold the money in the bond fund for the extent of its duration (I think, grabiner can probably explain it better), you will get your principle back.

I think what your overlooking is that when you say the bond fund could lose value just "at the times we need it" is that if there were some event where you suddenly needed the money in your bond ladder and no bond was coming to maturity at that moment, then you would have to sell a bond on the open market and you would experience the same loss. So if you are forced to sell the bond ladder it really is subject to the same volatility as the bond fund.
But you can't "hold the bonds for their duration", can you? Think about it. You on day one are going to purchase shares in a bond fund. Then at the end of the month, the first mortgage payment comes due. You haven't had time to hold it for the duration ... the bond fund has one duration and you have varying times of need. With a self constructed bond ladder, you can match exactly the bonds and their durations that you need for the payments (at least theoretically you could ... no one would actually go to the trouble I wouldn't think.)

A bond ladder that terminates is not the same risk as a never ending bond ladder ... unless of course I'm wrong ... and when it comes to bonds that is not going to surprise me at all. :D

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Re: Why Buy Bonds If You Have A Mortgage?

Post by mffl » Tue Jan 16, 2018 12:19 am

cb474 wrote:
Mon Jan 15, 2018 10:20 pm
mffl wrote:
Mon Jan 15, 2018 4:40 pm
I don't think that my points conflict with the content of the articles, but the author doesn't spend much time talking about mortgage rates at 3% and below. He talks about average mortgage rates over time being 7% and whether 7.8% average market returns is something worth borrowing money at 7% for to try to eke out a 0.8% expected return. Well yeah, that's likely to end badly, though even still his numbers show that it works out most of the time. The OP has an interest rate only a few tenths of a percentage point away from recent inflation figures, and that is way below long term inflation figures. If the OP was going to get a mortgage rate at random to go along with random future inflation market returns, then it all gets much riskier. But OP's rate isn't randomly selected from historical data, it's 2.625%.

Obviously as both you and the author of the article stated, YMMV based on age and other factors. I was only wanting to point out that a mortgage rate around 0% to 1.5% after inflation, which would mean 5% or better expected net real return (assuming long term market return, which obviously nobody can guarantee) is quite a different animal than picking a random point in history to keep a mortgage and simultaneously invest. Sequence of returns matters, but that's why this bet is better for young people (which the author also states), and obviously better when the gap between mortgage rate minus expected inflation and long term real CAGR of the market is wider.
On your second point, the model the author of the articles uses does account for inflation. He explains this.

On the first point, yes mortgage rates are different in the period of historical data he uses for his analysis. But so were bond rates and market performance. So you can't just say one factor (mortgage rates) have changes and not account for the other changes. And the author is clear that he believes analysis applies in the current mortgage rate environment also.

One of his main points, I think, is that people don't consider downside risk enough. Sure, maybe the market will "average" 7% return or maybe one is being modest in only assuming an "average" 5% return (as used on one example, in one post in this thread), but when people talk about "averages" they tend to treat them more or less as guarantees (perhaps intellectually they know that's not true, but emotionally they act as if it is). But as the author points out, when you leverage your equity investments, via a mortgage, there's a lot more downside risk than people think. On "average," if you got to rerun history over and over, like in a Monte Carlo simulation, you might come out ahead leveraging equity investments in this way. But the odds aren't that bad that in the one version of history that you live through that you will end up losing money instead.

I agree that if you have a thirty year or longer time horizon (at which point one's mortgage will be paid off anyway), it's probably a reasonable bet. But over ten and even fifteen years, there's a lot more downside risk they people think. You have to get above twenty years at least to start to get in a safer zone (based on analyses or rolling time periods, over historical data).

In any case, I can see that the author of those articles is still actively blogging. And he seems to respond to comments. So why not post a comment on his article and run your argument by him? It would be interesting to see what he says. I don't want to speak for him or assume I have perfectly represented all the details of his analysis. But I haven't really seen anything yet that convinces me he overlooked something.
Great points. We also probably psychologically overestimate the probability that the market will average 7% real or better over shorter time periods when the market is performing well like it is now. One should decide to do this with all the applicable risks in mind. But yeah, I think we agree that it's a much better option over 20-30 years than 10. Or perhaps, as the author suggests, it's more important how far you are from retirement. If you're paying the mortgage payments with income from work, that is much better than paying it by selling the stocks you've purchased with your leverage if you're no longer working.

I'm just suggesting that a rate that is particularly below the current market rate may have better statistical properties than a Monte Carlo simulation of a bunch of historical data. The closer the rate gets to expected inflation, the more the question becomes whether 100%+ stocks is a good idea at all, and less of a question of how much the leverage costs. If the rate was equal to current inflation, then all the historical data is irrelevant. The loan is "free" in real terms. At that point, the loan only starts costing something if inflation goes back towards zero (or negative), which would be bad. But inflation could just as well go up, meaning you're being paid to maintain the loan in real terms. A 2.625% loan has a fairly high probability of having a negative real cost for some duration of the loan. In my eyes, a loan with those properties should be carefully considered as to whether it's actually an "asset". You're right that we can't be sure the market will return 7% (or even 5%) real going forward, especially during short time periods. But at that point we're having a different discussion. If the loan is free or near-free, we're talking about whether 80/20 (or 125/-25!) is too risky for a given investor's circumstances. You may very well be right that that's not a good idea either, but I think the cost of the loan and the AA that results from the leverage should be considered separately. The fact that it's a bad idea for a retiree to do this is partially because a retiree shouldn't have 125% stocks. And maybe because his leverage is too expensive, or maybe not. Of course OP's mortgage isn't currently free in real terms, but it's awfully close to zero, ignoring itemizing.

Good discussion. I appreciated the articles. Lots of things to consider.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Tue Jan 16, 2018 3:45 am

pezblanco wrote:
Mon Jan 15, 2018 11:43 pm
But you can't "hold the bonds for their duration", can you? Think about it. You on day one are going to purchase shares in a bond fund. Then at the end of the month, the first mortgage payment comes due. You haven't had time to hold it for the duration ... the bond fund has one duration and you have varying times of need. With a self constructed bond ladder, you can match exactly the bonds and their durations that you need for the payments (at least theoretically you could ... no one would actually go to the trouble I wouldn't think.)

A bond ladder that terminates is not the same risk as a never ending bond ladder ... unless of course I'm wrong ... and when it comes to bonds that is not going to surprise me at all. :D
It is entirely possible that I did not explain it well or correctly. I'll be interested to see what grabiner has to say. As I said, I do recall seeing Larry Swedroe write about this a long time ago and saying that there really isn't anything difference between the bond ladder and the bond fund, in this regard. You might want to search around for that. No one understands these things better than he does.

*
mffl wrote:
Tue Jan 16, 2018 12:19 am
I'm just suggesting that a rate that is particularly below the current market rate may have better statistical properties than a Monte Carlo simulation of a bunch of historical data. The closer the rate gets to expected inflation, the more the question becomes whether 100%+ stocks is a good idea at all, and less of a question of how much the leverage costs. If the rate was equal to current inflation, then all the historical data is irrelevant. The loan is "free" in real terms. At that point, the loan only starts costing something if inflation goes back towards zero (or negative), which would be bad. But inflation could just as well go up, meaning you're being paid to maintain the loan in real terms. A 2.625% loan has a fairly high probability of having a negative real cost for some duration of the loan. In my eyes, a loan with those properties should be carefully considered as to whether it's actually an "asset". You're right that we can't be sure the market will return 7% (or even 5%) real going forward, especially during short time periods. But at that point we're having a different discussion. If the loan is free or near-free, we're talking about whether 80/20 (or 125/-25!) is too risky for a given investor's circumstances. You may very well be right that that's not a good idea either, but I think the cost of the loan and the AA that results from the leverage should be considered separately. The fact that it's a bad idea for a retiree to do this is partially because a retiree shouldn't have 125% stocks. And maybe because his leverage is too expensive, or maybe not. Of course OP's mortgage isn't currently free in real terms, but it's awfully close to zero, ignoring itemizing.
I understand what you're saying. I just remain skeptical that the downside risk is not higher than one imagines. With market valuations as high as they are it might even be generous to think expected market returns are 5% real going forward (I don't think any reasonable estimate would say 7% real expected returns). Not too long ago, Larry Swedroe said depending on how you calculate expected returns for the U.S. markets, you could say that they are 3.3% real. http://www.etf.com/sections/index-inves ... nopaging=1 And valuations are slightly higher now than when he wrote that, further depressing expected returns. So yeah, mortgage rates are very low, compared to how they were in the period of analysis in those articles, but expected market returns are also pretty low compared to most of that period (but the market is no less risky).

Anyway, I still think it would be interesting to post a comment on those articles and see if the author thinks really low current mortgage rates change the calculus, along the lines you outline. He seems pretty sophisticated and could probably give an interesting response. I do see one person, in the comments on the last of the three articles mentions having a 3.5% loan and he responds:
It IS a cheap loan. But the strategy has the same risk as the stock market with a lower expected return and that isn't "cheap money." http://www.theretirementcafe.com/2014/0 ... 8119401381
At least from that comment it doesn't seem like he thinks super low mortgage rates change the point he is making.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by inbox788 » Tue Jan 16, 2018 12:33 pm

KlangFool wrote:
Mon Jan 15, 2018 7:35 pm
Please explain to me how liquidity is not a factor?
If liquidity was a factor, I'd be solving that problem instead of hocking my house, borrowing money to invest in the market.

We went through the liquidity issue a while back on on this thread.
pezblanco wrote:
Wed Jan 10, 2018 9:50 am
IF THE LOSS OF LIQUIDITY IS NOT A PROBLEM, that it is a no-brainer to pay down the mortgage instead of buying bonds.

It is very interesting the arguments that mortgages are not REALLY negative bonds but if we condition on that we think that our job/retirement/money flow/emergency funds are safe enough that we are not going to lose our house, then the money flow considerations of a mortgage are that it acts exactly like a negative bond and hence the above conclusion that paying down the mortgage is a no-brainer is valid.
viewtopic.php?f=10&t=236421&start=50#p3712240

What happened to your $900K and if you had it, how many years would it last?
KlangFool wrote:
Sun Jan 14, 2018 9:43 am
Okay. Let's consider the following case:

My 60/40 portfolio return on the average of 7% over the last 10 years. I have a 300K 30 years fixed 3.49% mortgage and 1.2 million 60/40 portfolio. The choice is between

A) 1.2 million 60/40 portfolio and 300K 3.49% mortgage

versus

B) 900K 60/40 portfolio with no mortgage
viewtopic.php?f=10&t=236421&start=100#p3719961
KlangFool wrote:
Mon Jan 15, 2018 7:35 pm
<<Bond funds returns are not guaranteed, just projections, that's why B is more risky.>>

Here we go again. Are you saying that a 60/40 portfolio is riskier than 100/0 portfolio? I have a 60/40 portfolio. I am looking at the total portfolio return and risk profile.
That's not at all what I said. I don't know where you're getting that idea. You're comparing different things.

Is it not true that "Bond funds returns are not guaranteed"? Is $100 invested in equities the same as $100 invested in equities? Is $60 invested in equities the same as $60 invested in equities? Is $60 invested in equities the different from $100 invested in equities?

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Tue Jan 16, 2018 8:17 pm

pezblanco wrote:
Mon Jan 15, 2018 11:43 pm
But you can't "hold the bonds for their duration", can you? Think about it. You on day one are going to purchase shares in a bond fund. Then at the end of the month, the first mortgage payment comes due. You haven't had time to hold it for the duration ... the bond fund has one duration and you have varying times of need. With a self constructed bond ladder, you can match exactly the bonds and their durations that you need for the payments (at least theoretically you could ... no one would actually go to the trouble I wouldn't think.)

A bond ladder that terminates is not the same risk as a never ending bond ladder ... unless of course I'm wrong ... and when it comes to bonds that is not going to surprise me at all. :D
In theory, you could match durations. If you have 10 years left on your mortgage, so that you have a 5-year duration, you would start with an intermediate-term fund, and gradually move money to a shorter-term fund. When your mortgage is down to 5 years, your bonds are all in a short-term fund. When it is down to 1 year, your bonds are in a money-market fund. This would be using your bond funds as if they were a ladder.

In practice, you won't do this, but it is a voluntary decision, and a fair one. If you choose to take a bond portfolio with a longer duration than your liability-matching portfolio, you take interest-rate risk. But you are rewarded appropriately for that risk in the form of higher yields.

This is a similar issue to deciding whether to invest in stocks or bonds. You can take X amount of stock-market risk, and Y amount of interest-rate risk, and Z amount of credit risk, whether you have a mortgage or not. The mortgage affects only Y, so the equal-risk comparison is to a portfolio with the same Y: that is, risk-free bonds with the same duration as the mortgage. But you may well choose to change any of X (more stock), Y (longer-term bonds, or callable long-term munis), or Z (corporate bonds rather than Treasury bonds), to earn a higher expected return with more risk, without much extra cost.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Tue Jan 16, 2018 8:48 pm

inbox788 wrote:
Tue Jan 16, 2018 12:33 pm

[/u][/b]
Is it not true that "Bond funds returns are not guaranteed"? Is $100 invested in equities the same as $100 invested in equities? Is $60 invested in equities the same as $60 invested in equities? Is $60 invested in equities the different from $100 invested in equities?
inbox788,

Bingo!

For whatever reason, you choose to insist that extra money from not paying the mortgage can only be invested and compared with the bond fund. My point is you do not have to. It could be invested in a 60/40 portfolio.

KlangFool

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Re: Why Buy Bonds If You Have A Mortgage?

Post by inbox788 » Tue Jan 16, 2018 9:06 pm

KlangFool wrote:
Tue Jan 16, 2018 8:48 pm
For whatever reason, you choose to insist that extra money from not paying the mortgage can only be invested and compared with the bond fund. My point is you do not have to. It could be invested in a 60/40 portfolio.
Again, that's not what I'm saying. I hope others aren't coming to the same misunderstanding you are.
inbox788 wrote:
Sun Jan 14, 2018 12:58 pm
Getting back to the original question, "Why Buy Bonds If You Have A Mortgage?"

If bonds return more than mortage, then you'd buy bonds for the higher return.
If bonds return less than mortgage, they you'd buy bonds because they're more liquid.
If liquidity isn't an issue, then it makes more sense to get the better return by paying down mortgage.
viewtopic.php?f=10&t=236421&start=100#p3720366

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Tue Jan 16, 2018 9:19 pm

inbox788 wrote:
Tue Jan 16, 2018 9:06 pm
KlangFool wrote:
Tue Jan 16, 2018 8:48 pm
For whatever reason, you choose to insist that extra money from not paying the mortgage can only be invested and compared with the bond fund. My point is you do not have to. It could be invested in a 60/40 portfolio.
Again, that's not what I'm saying. I hope others aren't coming to the same misunderstanding you are.
inbox788 wrote:
Sun Jan 14, 2018 12:58 pm
Getting back to the original question, "Why Buy Bonds If You Have A Mortgage?"

If bonds return more than mortage, then you'd buy bonds for the higher return.
If bonds return less than mortgage, they you'd buy bonds because they're more liquid.
If liquidity isn't an issue, then it makes more sense to get the better return by paying down mortgage.
viewtopic.php?f=10&t=236421&start=100#p3720366
inbox788,

The question assumes that the choice is between

A) Invest in the bond

Versus

B) Pre-paying mortgage

It is the wrong question. The correct question is between

A) Invest in your portfolio aka in my case (60/40)

Versus

B) Pre-paying mortgage

KlangFool

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Re: Why Buy Bonds If You Have A Mortgage?

Post by inbox788 » Tue Jan 16, 2018 9:21 pm

KlangFool wrote:
Tue Jan 16, 2018 9:19 pm
A) Invest in your portfolio aka in my case (60/40)
When you invest $100, are you not buying $40 in bonds?

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Tue Jan 16, 2018 9:25 pm

inbox788 wrote:
Tue Jan 16, 2018 9:21 pm
KlangFool wrote:
Tue Jan 16, 2018 9:19 pm
A) Invest in your portfolio aka in my case (60/40)
When you invest $100, are you not buying $40 in bonds?
inbox788,

I am investing $100 in my 60/40 portfolio. I believe that my 60/40 risk-adjusted return is better than my mortgage rate.

KlangFool

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Re: Why Buy Bonds If You Have A Mortgage?

Post by inbox788 » Tue Jan 16, 2018 9:35 pm

KlangFool wrote:
Tue Jan 16, 2018 9:25 pm
inbox788 wrote:
Tue Jan 16, 2018 9:21 pm
KlangFool wrote:
Tue Jan 16, 2018 9:19 pm
A) Invest in your portfolio aka in my case (60/40)
When you invest $100, are you not buying $40 in bonds?
inbox788,

I am investing $100 in my 60/40 portfolio. I believe that my 60/40 risk-adjusted return is better than my mortgage rate.

KlangFool
So you're not buying $60 in equities and $40 in bonds?

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Re: Why Buy Bonds If You Have A Mortgage?

Post by Lyonsguy » Tue Jan 16, 2018 9:36 pm

In my experience there is very very little loss in liquidity...if a home equity line of credit is available. So the argument that a loss of liquidity keep people from paying down their mortgage isn’t considering the liquidity returned via a home equity line of credit. There is some risk that the line gets cancelled, but a lot has to go south for the bank to close that. At that point I’ve got worse things to worry about. I feel comfortable with that risk and feel that short term loans from my mortgage are very conservative (my maximum heloc is less than 20% of my equity). I typically borrow 1000-2000 for a month when my wife’s tuition is due or we needed to buy solar panels for my house at 4% interest for 4 months. Just don’t barrow anything you can’t pay back with monthly cash flow quickly. I wouldn’t use heloc for speculative ventures or even stock purchase.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Tue Jan 16, 2018 10:09 pm

KlangFool wrote:
Tue Jan 16, 2018 9:19 pm
inbox788,

The question assumes that the choice is between

A) Invest in the bond

Versus

B) Pre-paying mortgage

It is the wrong question. The correct question is between

A) Invest in your portfolio aka in my case (60/40)

Versus

B) Pre-paying mortgage
Actually, there are two different choices: Do you pay down the mortgage? What do you invest in?

You can combine them to make four.
A: Invest in bonds
B: Pay down the mortgage
C: Invest with your preferred allocation
D: Pay down the mortgage, and move money from bonds to your preferred allocation

A and B have the same risk, and differ in return by the difference between bond and mortgage rates. Similarly for C and D. If you prefer B to A, then you also prefer D to C, so C cannot be the right choice; either B or D is better. (The exception is the discussion which started this thread, when you don't have any bonds, and thus don't have option D unless you take out a margin loan.)

At the moment, I am doing C, because I prefer A to B and C to D given my low mortgage rate. If interest rates fall, I will do D, keeping the same amount in stock.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Tue Jan 16, 2018 11:47 pm

inbox788 wrote:
Tue Jan 16, 2018 9:35 pm
KlangFool wrote:
Tue Jan 16, 2018 9:25 pm
inbox788 wrote:
Tue Jan 16, 2018 9:21 pm
KlangFool wrote:
Tue Jan 16, 2018 9:19 pm
A) Invest in your portfolio aka in my case (60/40)
When you invest $100, are you not buying $40 in bonds?
inbox788,

I am investing $100 in my 60/40 portfolio. I believe that my 60/40 risk-adjusted return is better than my mortgage rate.

KlangFool
So you're not buying $60 in equities and $40 in bonds?
inbox788,

I have $100 in the 60/40 portfolio. If it goes up to $120, it will be 60/40. If it goes down to $80, it will be 60/40.

<<So you're not buying $60 in equities and $40 in bonds?>>

No. Depending on what my current portfolio ratio is, I add the $100 to maintain the 60/40 ratio.

KlangFool

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Joined: Thu Mar 15, 2012 5:24 pm

Re: Why Buy Bonds If You Have A Mortgage?

Post by inbox788 » Wed Jan 17, 2018 2:20 am

KlangFool wrote:
Tue Jan 16, 2018 11:47 pm
<<So you're not buying $60 in equities and $40 in bonds?>>

No. Depending on what my current portfolio ratio is, I add the $100 to maintain the 60/40 ratio.
Well, if you're not buying bonds, then it's moot to ask why buy bonds.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by fmzip » Wed Jan 17, 2018 9:10 pm

aristotelian wrote:
Mon Jan 15, 2018 10:40 pm

I think what I am taking away from this thread is that most people shouldn't buy a house.
LOL, I totally have been thinking the same with all this discussion. And here I thought having a paid for house was just another piece of the puzzle. Silly me :)

Guess a few months before I retire, I will be sure to sell my paid off house at 63. Then I will buy another, and take out another 30 year mortgage payment and put 15% down. I will take all that home equity and throw it at the stock market to be that much smarter than the average Joe. Sounds like a great plan, safe and sound.
Last edited by fmzip on Thu Jan 18, 2018 8:04 am, edited 1 time in total.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by BrandonBogle » Wed Jan 17, 2018 11:02 pm

fmzip wrote:
Wed Jan 17, 2018 9:10 pm
aristotelian wrote:
Mon Jan 15, 2018 10:40 pm
I think what I am taking away from this thread is that most people shouldn't buy a house.
LOL, I totally have been thinking the same with all this discussion. And here I thought having a paid for house was just another piece of the puzzle. Silly me :)

Guess a few months before I retire, I will be sure to sell my paid off house at 63. The I will buy another, and take out another 30 year mortgage payment and put 15% down. I will take all that home equity and throw it at the stock market to be that much smarter than the average Joe. Sounds like a great plan, safe and sound.
Well that would be quite the extreme. In my case, it is worth it to not prepay my mortgage. My mortgage is 2.875% (refi'd back in May and took more money out of the house), I currently have a little more than my mortgage balance in my taxable account, and throw funds each month at VWLUX (Vanguard's "Long Term" Muni Bond fund - 2.54% SEC Yield, average maturity @ 17 years, average duration @ 7 years), am gainfully employed, and have an emergency fund that covers all expenses (including mortgage) for 6 months. If there was ever a change in circumstances, I could pay off the mortgage. At the moment, it isn't worth paying off early.

Depending on how you look at AA, I'm either at 75/25 (not considering the mortgage) or 98.5/1.5 (counting mortgage as a negative bond). I sleep just fine at night, though I am in my 30s and while I was investing in 2008 and 2001, my balance was so low that the market drop wasn't meaningful.

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