asset allocation with debt paydown instead of bond investment

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shm317
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asset allocation with debt paydown instead of bond investment

Post by shm317 » Tue Aug 13, 2019 8:08 am

I have a question regarding asset allocation and paying down debt. Specifically, my current asset allocation is 75/25 stock/bonds. I have a lump sum of cash coming in of about $160k, and want to use 25% of it to pay down a 3.75% mortgage (in place of my bond allocation) that i view as more attractive than bond yields right now. So my question is, how do I factor that into my asset allocation? If i put the other 75% into equities, it will skew my asset allocation upwards. How do you guys approach that issue?

bloom2708
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Re: asset allocation with debt paydown instead of bond investment

Post by bloom2708 » Tue Aug 13, 2019 8:16 am

The SEC Yield on Total US Bond is 2.41% today.

+2.41% vs -3.75%

That is a 6.16% spread.


Some view debt as a negative bond. But, that would imply you match your debt with bonds (net to $0) and then you are 100% stocks with everything else.

I would either pay your mortgage normally or try to kill it as fast as possible.
Last edited by bloom2708 on Wed Aug 14, 2019 8:31 am, edited 1 time in total.
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Flyer24
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Re: asset allocation with debt paydown instead of bond investment

Post by Flyer24 » Tue Aug 13, 2019 8:43 am

I keep mine separate. I would invest the remaining amount according to your normal allocation.

Admiral
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Re: asset allocation with debt paydown instead of bond investment

Post by Admiral » Tue Aug 13, 2019 8:50 am

I would invest the money as per your AA (including bonds as appropriate) and not pre-pay your low-rate mortgage UNLESS you have some specific target date in mind, like getting rid of it by your retirement. You can always choose to pay it off later (or not). Once you pre-pay, the money is locked in your house. Think of it this way: you're considering pre-paying to save some interest and free up your mortgage payment at some point in the future. You will then invest that money, presumably. Why not invest it NOW and pay the mortgage off in full later?

Your mortgage is around 2% after inflation...

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shm317
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Re: asset allocation with debt paydown instead of bond investment

Post by shm317 » Tue Aug 13, 2019 9:12 am

All very helpful points. It's a tough call for me in terms of prepaying or not. I have $150k balance with 14 years left. I've been paying extra each month such that it will be paid off in 7-8 years. Now I'm tempted to just accelerate this to only 1-2 years, which frees up ~$1,500 a month. My goal is to semi retire early, ASAP, but realistically I have at least 3-5 years to go, and possibly a lot longer depending on markets.

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Re: asset allocation with debt paydown instead of bond investment

Post by Admiral » Tue Aug 13, 2019 9:24 am

shm317 wrote:
Tue Aug 13, 2019 9:12 am
All very helpful points. It's a tough call for me in terms of prepaying or not. I have $150k balance with 14 years left. I've been paying extra each month such that it will be paid off in 7-8 years. Now I'm tempted to just accelerate this to only 1-2 years, which frees up ~$1,500 a month. My goal is to semi retire early, ASAP, but realistically I have at least 3-5 years to go, and possibly a lot longer depending on markets.
Are all retirement accounts maxed to IRS limits? If not that should be tackled before pre-paying anything. If it were me, I'd invest the full sum in taxable (assuming all retirement accounts filled; you could also do backdoor Roth if applicable) and then revisit when a year or two out from retirement.

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shm317
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Re: asset allocation with debt paydown instead of bond investment

Post by shm317 » Tue Aug 13, 2019 9:43 am

Admiral wrote:
Tue Aug 13, 2019 9:24 am
shm317 wrote:
Tue Aug 13, 2019 9:12 am
All very helpful points. It's a tough call for me in terms of prepaying or not. I have $150k balance with 14 years left. I've been paying extra each month such that it will be paid off in 7-8 years. Now I'm tempted to just accelerate this to only 1-2 years, which frees up ~$1,500 a month. My goal is to semi retire early, ASAP, but realistically I have at least 3-5 years to go, and possibly a lot longer depending on markets.
Are all retirement accounts maxed to IRS limits? If not that should be tackled before pre-paying anything. If it were me, I'd invest the full sum in taxable (assuming all retirement accounts filled; you could also do backdoor Roth if applicable) and then revisit when a year or two out from retirement.
Yes maxed all retirements, including backdoor roth. So basically you suggest keep it liquid (and according to my asset allocation), then just kill the mortgage when I'm officially ready to step away from full time work? I guess I always looked at it the other way around (eliminating mortgage before evaluating potential to retire), but sounds like no reason to.

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Re: asset allocation with debt paydown instead of bond investment

Post by Admiral » Tue Aug 13, 2019 10:04 am

shm317 wrote:
Tue Aug 13, 2019 9:43 am
Admiral wrote:
Tue Aug 13, 2019 9:24 am
shm317 wrote:
Tue Aug 13, 2019 9:12 am
All very helpful points. It's a tough call for me in terms of prepaying or not. I have $150k balance with 14 years left. I've been paying extra each month such that it will be paid off in 7-8 years. Now I'm tempted to just accelerate this to only 1-2 years, which frees up ~$1,500 a month. My goal is to semi retire early, ASAP, but realistically I have at least 3-5 years to go, and possibly a lot longer depending on markets.
Are all retirement accounts maxed to IRS limits? If not that should be tackled before pre-paying anything. If it were me, I'd invest the full sum in taxable (assuming all retirement accounts filled; you could also do backdoor Roth if applicable) and then revisit when a year or two out from retirement.
Yes maxed all retirements, including backdoor roth. So basically you suggest keep it liquid (and according to my asset allocation), then just kill the mortgage when I'm officially ready to step away from full time work? I guess I always looked at it the other way around (eliminating mortgage before evaluating potential to retire), but sounds like no reason to.
I like having $ in a taxable account. In your case, with this windfall or whatever it is, that money can/will/should grow. But more than that, it gives you options. Say you retire and want to spend $30k on your round the world cruise. You'll have money to do that. Yes, you may still have your $1500/month mortgage payment. But so what? As long as you have the assets and cashflow to pay it, you can continue to pay it for a few years. Then pay it off if you want. Clearly if it's going to be a burden or it's going to force you into a high withdrawal rate, that's a different story; then I would def get it paid off.

But I'd rather have 200k in a taxable account when I retire than a paid off house and nothing in my taxable account. You can't spend home equity (well you can, but as a retiree you shouldn't.) All it does is increase your monthly cashflow by your payment amount.

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Re: asset allocation with debt paydown instead of bond investment

Post by Cyclesafe » Tue Aug 13, 2019 10:12 am

In my view, a 3.75% "risk-free" return trumps whatever the bond market currently offers (assuming no deductibility of mortgage interest, full funding of matched retirement accounts, full funding of Roth, and an adequate emergency fund / cash flow). What's much more important than your asset allocation ratio digits is whether the result allows you to sleep at night. Also, it might help to think of your taxable fixed asset portion as the multiple "on hand" to cover expenses for X number of years of low market performance.
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Re: asset allocation with debt paydown instead of bond investment

Post by Admiral » Tue Aug 13, 2019 11:23 am

Cyclesafe wrote:
Tue Aug 13, 2019 10:12 am
In my view, a 3.75% "risk-free" return trumps whatever the bond market currently offers (assuming no deductibility of mortgage interest, full funding of matched retirement accounts, full funding of Roth, and an adequate emergency fund / cash flow). What's much more important than your asset allocation ratio digits is whether the result allows you to sleep at night. Also, it might help to think of your taxable fixed asset portion as the multiple "on hand" to cover expenses for X number of years of low market performance.
I compare my mortgage rate to my total portfolio return, not to just the bond portion, as per my AA. Obviously others (Grabiner most prominently) don't use this yardstick. I hold enough bonds in my retirement accounts to pay off my mortgage, but I don't.

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Re: asset allocation with debt paydown instead of bond investment

Post by grabiner » Tue Aug 13, 2019 9:03 pm

bloom2708 wrote:
Tue Aug 13, 2019 8:16 am
The SEC Yield on Total US Bond is 2.41% today.

+2.41% vs -3.75%

That is a 6.16% spread.
See Paying down loans versus investing on the wiki

The correct spread is 3.75%-2.41%=1.34%. It is actually higher than that if the mortgage is non-deductible and the bond interest is taxable; at a 22% tax rate, the after-tax yield on Total Bond Market is 1.88%.

Whether this is the right comparison depends on the mortgage term. Total Bond Market has a duration of 6 years. Paying off a 13-year mortgage has a duration of 6 years. If you have a new 30-year mortgage, the duration is 12 years (less if you might sell the home early), so you should use longer-term bonds for comparison.

If the durations do match, then it is a fair comparison, because buying bonds and paying off the mortgage give you the same risk level. If you would rather buy stock than pay off the mortgage, you can still take the extra stock risk by paying off the mortgage and selling bonds in your IRA to buy stock. (This is what I will do if I pay off my mortgage; my taxable account is all stock, so I will sell an equal amount of bonds in my employer plan to buy stock.)

(edited to fix typo)
Last edited by grabiner on Wed Aug 14, 2019 8:21 am, edited 1 time in total.
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Re: asset allocation with debt paydown instead of bond investment

Post by miket29 » Tue Aug 13, 2019 11:10 pm

bloom2708 wrote:
Tue Aug 13, 2019 8:16 am
The SEC Yield on Total US Bond is 2.41% today.

+2.41% vs -3.75%

That is a 6.16% spread.
I'm not following the logic here. The bond in the amount of the mortgage invested in bonds is earning 2.41%, the negative bond in the equal amount paying off the mortgage is costing 3.75%. The net difference is 1.34% so that is the cost of not paying off the mortgage.

suppose you have a $100K mortgage. You receive $2410 in interest, you pay $3750 for the mortgage. The next cost (ignoring taxes) is $1340 per year, not the sum $6160

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Re: asset allocation with debt paydown instead of bond investment

Post by Admiral » Wed Aug 14, 2019 9:09 am

Let's not forget that there can be a not-insignificant opportunity cost to pre-paying a mortgage. You get a guaranteed return on your principal payment, yes, but that money is no longer available to invest...in anything, but use bonds if you want. Yields rise above your rate? You can stop pre-paying, but the money you've pre-paid is no longer available to capture gains.

Obviously this works both ways. But If you have a low mortgage rate, the current spread b/w bonds and your rate may be low enough that you're willing to hold onto your cash, even at a slight "loss" to await more favorable market conditions.

I believe it's important for MOST investors to go into retirement without housing debt, and especially if they have little taxable reserves. So, if one is getting close to retiring, paying down (and/or off) can make sense.

But here's the thing: when I look at my amortization sked, I can see exactly how many months/years of payments are eliminated with each pre-payment. In the last few years of my 15 year loan, the interest amounts to a few hundred bucks each year. (My rate is 2.25%). The interest in the final two years is $1,200 TOTAL.

I'd rather invest the money now than save a piddling amount of interest--in inflated dollars, no less--in 10 years. Obviously the higher the rate and the longer the term, the bigger the savings.

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Re: asset allocation with debt paydown instead of bond investment

Post by grabiner » Wed Aug 14, 2019 7:39 pm

Admiral wrote:
Wed Aug 14, 2019 9:09 am
Let's not forget that there can be a not-insignificant opportunity cost to pre-paying a mortgage. You get a guaranteed return on your principal payment, yes, but that money is no longer available to invest...in anything, but use bonds if you want. Yields rise above your rate? You can stop pre-paying, but the money you've pre-paid is no longer available to capture gains.
I discussed this about last week: The option value of not paying off a mortgage
If you do not pay off your mortgage now, the option to pay it off later works like a conventional option. Suppose that you keep the bond portfolio [with a 5-year duration, which provides fixed income to match the mortgage payments] and the mortgage. If bond rates fall by 1%, your bond portfolio gains 5% of its value, so your gain from paying off the mortgage increases from 1% to 6%. If bond rates rise by 1%, your bond portfolio loses 5% of its value, but you do not lose the 4% difference between your bond portfolio and mortgage balance, because you will now choose to keep the bonds at a higher yield than the mortgage.
So this is a good reason not to pay off a mortgage for a small spread, and this is why I did not pay off my mortgage; the spread, even now, is 0.32% in interest rates, reduced further by a small capital gain if I want to pay it off.

But I don't believe that applies to the OP, who has a spread of 1.88% if the mortgage is not tax-deductible and the investment is taxable at 22%. I don't know the mortgage duration, but assuming it is six years (so that the comparison is fair), he would lose 11% of the mortgage value by holding an amount equal to the mortgage balance in Total Bond Market rather than paying it off. That is probably more than the value of the option; bond yields would have to rise to 4.81% for the option to have any value.
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Re: asset allocation with debt paydown instead of bond investment

Post by Admiral » Wed Aug 14, 2019 8:22 pm

grabiner wrote:
Wed Aug 14, 2019 7:39 pm
Admiral wrote:
Wed Aug 14, 2019 9:09 am
Let's not forget that there can be a not-insignificant opportunity cost to pre-paying a mortgage. You get a guaranteed return on your principal payment, yes, but that money is no longer available to invest...in anything, but use bonds if you want. Yields rise above your rate? You can stop pre-paying, but the money you've pre-paid is no longer available to capture gains.
I discussed this about last week: The option value of not paying off a mortgage
If you do not pay off your mortgage now, the option to pay it off later works like a conventional option. Suppose that you keep the bond portfolio [with a 5-year duration, which provides fixed income to match the mortgage payments] and the mortgage. If bond rates fall by 1%, your bond portfolio gains 5% of its value, so your gain from paying off the mortgage increases from 1% to 6%. If bond rates rise by 1%, your bond portfolio loses 5% of its value, but you do not lose the 4% difference between your bond portfolio and mortgage balance, because you will now choose to keep the bonds at a higher yield than the mortgage.
So this is a good reason not to pay off a mortgage for a small spread, and this is why I did not pay off my mortgage; the spread, even now, is 0.32% in interest rates, reduced further by a small capital gain if I want to pay it off.

But I don't believe that applies to the OP, who has a spread of 1.88% if the mortgage is not tax-deductible and the investment is taxable at 22%. I don't know the mortgage duration, but assuming it is six years (so that the comparison is fair), he would lose 11% of the mortgage value by holding an amount equal to the mortgage balance in Total Bond Market rather than paying it off. That is probably more than the value of the option; bond yields would have to rise to 4.81% for the option to have any value.
IIRC your outstanding mortgage balance is 20% of your taxable account. In such a case, paying it off really is just a personal decision as your finances are not likely to be impacted, plus or minus, one way or the other.

However, many if not most people don't have hundreds of thousands of after tax dollars to use for a payoff. The decision is usually about pre-payment which, if the rate is low, results in some future savings which may be utterly immaterial when it's realized. That was my point in the example of my own mortgage that I used.

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Re: asset allocation with debt paydown instead of bond investment

Post by grabiner » Wed Aug 14, 2019 8:39 pm

Admiral wrote:
Wed Aug 14, 2019 8:22 pm
IIRC your outstanding mortgage balance is 20% of your taxable account. In such a case, paying it off really is just a personal decision as your finances are not likely to be impacted, plus or minus, one way or the other.

However, many if not most people don't have hundreds of thousands of after tax dollars to use for a payoff. The decision is usually about pre-payment which, if the rate is low, results in some future savings which may be utterly immaterial when it's realized. That was my point in the example of my own mortgage that I used.
Actually, that is a separate issue. Both I and the OP are considering paying off a mortgage with taxable money, and both will get a return from this equal to the difference between the mortgage rate and the return on an investment of the taxable money. The reason I recommend the OP pay it off and I don't pay mine off is that the OP's mortgage rate is much higher than mine. I would have paid off my mortgage last week if I had a slightly higher rate (and I could have easily had that higher rate, I paid a lot of points six years ago to get a lower rate), or even at the current rate if I didn't deduct all the interest.

The reason you might not pay off a mortgage with a small taxable account is that you lose liquidity, and you have to decide how valuable that liquidity is. The liquidity is of no value to me, because I still have enough liquid assets. I don't know what it is worth to the OP.
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