Pay Off or Refinance?

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Topic Author
kappy
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Joined: Tue Jun 21, 2016 7:13 pm

Pay Off or Refinance?

Post by kappy »

I'm looking for comments and critiques of the following situation:

New house with 30yr @ 4.375% mortgage that can be refinanced to a 15yr @ 3.1%. $190k owed on mortgage. Assuming you have $2k per month of available funds for paying your mortgage and investing, what would you do? To make things even more tricky, if the house could be payed off in full with savings and selling some taxable investments, does this change anything?

I'm looking at this in terms of a 15 year horizon (ie. conservative investment gains at 15yrs minus interest paid on the loan minus any principal left on the mortgage at 15yrs.

My calculations show the following:
- Paying the 30yr mortgage at the normal rate leaves you with $325k and it's not paid off for 30 years :annoyed
- Paying down the 30yr mortgage with either a single large lump sum at the beginning or several hundred dollars every month throughout the mortgage leaves you with $350-380k. A little better plus the house gets paid off in 10-20 years depending on how aggressive you go.
- Refinancing to a 15yr at either $190k, $150k, or $100k all leave you with around $450k after 15 years.
- Paying the house off outright and investing $2000 a month for 15 years leaves you with $730k :shock: .

Assumptions: I used the 25th percentile Monte Carlo (60% stock/40% bonds) for investment gains. In reality, the bonds would go into tax advantaged accounts and the taxable investing will be 100% TSM. I did not take into account any tax deductions that holding onto the mortgage gives you.

Am I missing something? Do you really come out so far ahead by paying the mortgage off even in such a low interest rate environment?
venkman
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Re: Pay Off or Refinance?

Post by venkman »

I think you also have to compare what you would end up with if you took the same amount of money and left it invested it for 15 years while you pay off the mortgage. While there are always the standard disclaimers about market timing, it's entirely possible that a 60/40 portfolio might return less than 4.375% over the next 15 years. Or at the very least, it might return more, but with a lot more risk. (i.e. Paying off the mortgage will probably be the better choice on a risk-adjusted basis.)

I definitely would eliminate the 30-year mortgage as an option, and choose between the 15-year or paying it off up front. I like the idea of getting the mortgage to start, just because it's easy to change your mind and pay it off if you ever decide to go that route.
mega317
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Re: Pay Off or Refinance?

Post by mega317 »

What's your tax bracket? Do you itemize? If so, a 3.1% mortgage starts to look real attractive to keep.

Are you investing in tax-advantaged accounts? Is the 2k leftover after maxing out an employer plan and a Roth?

If you paid it in full, what would be your tax cost of selling said investments? What liquidity would you have left to cover emergencies, etc?

Do you have any anticipated changes in cash flow in the next 15 years?

I would definitely refinance to 15 years, and probably not pay it off now because I assume there will be some tax and/or liquidity consequences. Then the decision between paying the minimum for 15 years vs paying faster is largely based on your SWAN profile. You could always put that 2k to the mortgage for now (which would, after refi, get it paid off in about 6 years), and drop down to lower payments if something comes up.
https://www.bogleheads.org/forum/viewtopic.php?t=6212
Topic Author
kappy
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Re: Pay Off or Refinance?

Post by kappy »

Thanks for the replies. I max my 401k so the $2k per month would be taxable investments or a mega backdoor roth. If I paid it off, I’d still have around 6 months ($40k) of emergency funds and I’d pay around $5k in LTCG tax selling investments. I’m at the bottom of the 28% tax bracket but with OT, there’s a chance this year I’m over the MAGI to fully contribute to my Roth IRA. I do itemize, or at least I did with my prior residence until the mortgage got down to around $80k. At that point, I didn’t have enough deductions to itemize.
aristotelian
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Re: Pay Off or Refinance?

Post by aristotelian »

kappy wrote: Mon Oct 16, 2017 8:09 am Thanks for the replies. I max my 401k so the $2k per month would be taxable investments or a mega backdoor roth. If I paid it off, I’d still have around 6 months ($40k) of emergency funds and I’d pay around $5k in LTCG tax selling investments. I’m at the bottom of the 28% tax bracket but with OT, there’s a chance this year I’m over the MAGI to fully contribute to my Roth IRA. I do itemize, or at least I did with my prior residence until the mortgage got down to around $80k. At that point, I didn’t have enough deductions to itemize.
Keep in mind that selling taxable investments to pay off the mortgage might put you at further risk of exceeding the Roth limit. I did exactly what you are proposing this year. I don't regret it, but only realized after the fact that I was coming up to the Roth limit. You can just carry the contribution forward to next year, so not a big deal, but something to be aware of.

We paid ours off this year, but were left with more liquid funds in the brokerage account than you are describing.

One option would be to split the difference and take out a smaller mortgage.

I really like having the mortgage paid off so that my investment portfolio is a true representation of my exposure to market risk. With the mortgage, you have a 30 year negative bond working against whatever bond allocation you have in your portfolio.
niceguy7376
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Re: Pay Off or Refinance?

Post by niceguy7376 »

aristotelian wrote: Mon Oct 16, 2017 8:35 am Keep in mind that selling taxable investments to pay off the mortgage might put you at further risk of exceeding the Roth limit. I did exactly what you are proposing this year. I don't regret it, but only realized after the fact that I was coming up to the Roth limit. You can just carry the contribution forward to next year, so not a big deal, but something to be aware of.
I might be confused but what contribution can you forward to next year?
aristotelian
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Re: Pay Off or Refinance?

Post by aristotelian »

niceguy7376 wrote: Mon Oct 16, 2017 9:07 am
aristotelian wrote: Mon Oct 16, 2017 8:35 am Keep in mind that selling taxable investments to pay off the mortgage might put you at further risk of exceeding the Roth limit. I did exactly what you are proposing this year. I don't regret it, but only realized after the fact that I was coming up to the Roth limit. You can just carry the contribution forward to next year, so not a big deal, but something to be aware of.
I might be confused but what contribution can you forward to next year?

Sorry to be unclear. This would be if you made your Roth contribution for 2017 already but then selling stocks to pay off the mortgage puts you over the Roth limit. You pay a 6% surcharge but then you can just forward the contribution to 2018.
mega317
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Re: Pay Off or Refinance?

Post by mega317 »

I wouldn't pay 5k in capital gains taxes now if you can pay off a huge chunk of it and then pay the rest off quickly for "free".

Edit to add it might not even be worth a refi if you're going to pay it all off within in a couple years.
https://www.bogleheads.org/forum/viewtopic.php?t=6212
marklar13
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Re: Pay Off or Refinance?

Post by marklar13 »

Maybe I'm wrong, but I think you are missing something. Are you assuming that you invest the savings from the refinance? It seems like in the last scenario you are investing $2000 month (presumably with your improved cash flow from paying off the mortgage). In the refinance scenario, you will also have improved cashflow (not as much as having no mortgage, but it is still there). Are you assuming that those savings are also re-invested?
Edit: scratch that cashflow stmt. You are going to a 15 year, not just lowering the rate so you are paying more principal each month. Anyway... still curious about the calculations.

Could be that I am missing something instead... but in most of these threads it works out that keeping the mortgage gives you the better expected return -- since you will be keeping more money on hand to invest into higher expected return equities. It seems surprising to me that you came to the opposite conclusion. The pros and cons in terms of risk, liquidity, etc are consistently debated on the forums, but from a theoretical "maximize my earnings" perspective... it seems that keeping the mortgage almost always comes out ahead.

Maybe you could show the calculations?
Topic Author
kappy
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Re: Pay Off or Refinance?

Post by kappy »

I’ll try to put it into a google spreadsheet. It’s in excel right now. This is why I wanted to ask the question. It seems wrong but I’ve never really compared dumping $120k into the market today with small contributions moving forward vs starting at zero but adding $2k a month.
marklar13
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Re: Pay Off or Refinance?

Post by marklar13 »

Here are some quick calculations I did, comparing the 30 yr mortgage to paying off in full right now. The assumptions are maybe slightly different than your scenario, but I was having trouble understanding what you mean by having 2k available each month (extra, or total?)

** Disclaimer... you'll want to double check these... I'm not a math wiz
** ... and my initial calculations were way off (made the contributions annual instead of monthly) -- fixed

My assumptions:
  • Currently have 190k mortgage - 30yrs@4.375%
  • 190k in liquid assets right now (you said you could pay off your mortgage)
  • You have total of $2000 per month to either invest or pay mortgage
  • Assume you can earn 5% nominal in the market with your 60/40 AA (which I think is pretty conservative historically)

After 15 years...

1. 30 yr mortgage@4.375%
  • 15 years of mortgage balance left = ($124,556)
  • Current 190k invested for 15 years@5% = $394,996.35
  • additional investment:
    [**] principal and interest payment on mortgage is $948.64.
    [**] $2k - $948.64 = $1051.36/mnth left to invest
    [**] $1051.36/mnth invested for 15 years@5% = $282,187.81
  • Total = $394,996.35 - $124,556 + $282,187.81 = 552,628.16
2. Pay off mortgage
  • No mortgage
  • Nothing invested to start with (used to pay mortgage)
  • 2k/mnth invested for 15 years@5% = $536,805.30
  • Total = $536,805.30
So under these conditions I think the 30 year comes out way ahead. Again, this is strictly from a maximize my expected returns standpoint, and ignores lots of other factors that may tilt you towards paying off -- or paying extra -- on the mortgage. The 5% return assumed is historically pretty low I believe, and if you increase it then the 30 year mortgage is going to win out even more.

If it were me (and I am in a somewhat similar position) -- I would not pay off the mortgage, but would put some extra money towards it. So I would keep my 190k fully invested, and then throw some extra money at the mortgage each month so that I feel a little better. Not "optimal", but for me it is a good balance between staying invested, and making me feel good about my debt levels.
Last edited by marklar13 on Mon Oct 16, 2017 1:05 pm, edited 1 time in total.
mega317
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Re: Pay Off or Refinance?

Post by mega317 »

marklar13 wrote: Mon Oct 16, 2017 12:26 pm [*] Assume you can earn 5% nominal in the market with your 60/40 AA (which I think is pretty conservative
I think this is not particularly conservative. And yes, any loan is worth keeping as long as possible if you are assuming a higher rate of investment return.
https://www.bogleheads.org/forum/viewtopic.php?t=6212
marklar13
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Re: Pay Off or Refinance?

Post by marklar13 »

mega317 wrote: Mon Oct 16, 2017 12:40 pm
marklar13 wrote: Mon Oct 16, 2017 12:26 pm [*] Assume you can earn 5% nominal in the market with your 60/40 AA (which I think is pretty conservative
I think this is not particularly conservative. And yes, any loan is worth keeping as long as possible if you are assuming a higher rate of investment return.
Fair enough. Your second sentence is basically my point, though. The original calculations were presumably using some historical rate of return... and I think at least historically speaking, 5% nominal is relatively conservative -- so this is why I am questioning the calculations. Will it be 5% or more going forward... who knows. Is it better off to pay the mortgage down/off or not -- no one knows. There are lots of threads with pros/cons and predictions. But all that aside, I still think there is something off with the numbers in the OP.
Topic Author
kappy
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Re: Pay Off or Refinance?

Post by kappy »

marklar13 wrote: Mon Oct 16, 2017 12:26 pm
After 15 years...

2. Pay off mortgage
  • No mortgage
  • Nothing invested to start with (used to pay mortgage)
  • 2k/mnth invested for 15 years@5% = $45,314.98
  • Total = $45,314.98
Are you sure you didn’t miss a zero? $2k per month for 15 years with 0% return is $360k
marklar13
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Re: Pay Off or Refinance?

Post by marklar13 »

kappy wrote: Mon Oct 16, 2017 12:51 pm
marklar13 wrote: Mon Oct 16, 2017 12:26 pm
After 15 years...

2. Pay off mortgage
  • No mortgage
  • Nothing invested to start with (used to pay mortgage)
  • 2k/mnth invested for 15 years@5% = $45,314.98
  • Total = $45,314.98
Are you sure you didn’t miss a zero? $2k per month for 15 years with 0% return is $360k
haha, yes I did... annual instead of monthly. Minor detail :P . Let me update that.

Updated -- still I think the most important point is mega317. If you think you can get higher rate of return in the market than with your loan rate, then the being invested wins. If not, then paying off the mortgage wins.

I think a lot of people actually compare the mortgage rate to a bond rate, since the risk profile is more similar (paying off the mortgage being a guaranteed return...at the expense of losing liquidity). You are right that it probably doesn't make sense to keep the mortgage and invest in bonds of similar/lower return. I guess it boils down to an AA/risk question more than anything ... as it seems most of these threads do. Make sure you read the other similar threads and take into account taxes, liquidity, etc as well.
Topic Author
kappy
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Re: Pay Off or Refinance?

Post by kappy »

Ok, I see where your numbers are coming from now. I've been using PITI instead of PI so my payment for the 30yr mortgage is $1275.

Anyway, It looks like I had two issues. First, I was double dipping the interest on the mortgage. I was subtracting interest paid from the total but in reality, it's already baked into the monthly payment. Second, I was only using $120k as a starting investment for any of the options that held onto the mortgage because I'd need to sell investments and dip a little into the EF to fund payoff. If I run everything with a blanket $190k, my numbers jive with yours.

I'm glad that I asked the question. I've already locked in the 3.1% refinance rate and will enjoy the tax deduction it brings.
ThePrince
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Re: Pay Off or Refinance?

Post by ThePrince »

mega317 wrote: Mon Oct 16, 2017 12:40 pm
marklar13 wrote: Mon Oct 16, 2017 12:26 pm [*] Assume you can earn 5% nominal in the market with your 60/40 AA (which I think is pretty conservative
I think this is not particularly conservative. And yes, any loan is worth keeping as long as possible if you are assuming a higher rate of investment return.
This only looks at the math and not the risk of maintaining debt, which doesn’t make sense.
petulant
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Re: Pay Off or Refinance?

Post by petulant »

Tax implications absolutely need to be included since they reduce the interest cost of the mortgage and increase the cost of selling taxable investments to pay down the mortgage. Further, insurance/property tax shouldn't be included since you will continue to pay after paying off your house.
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