grabiner wrote: ↑Mon Sep 14, 2020 7:37 pm
hornet96 wrote: ↑Sun Sep 13, 2020 10:33 pm
Where I get hung up a bit is on the fact that a house is not
a risk-free asset, and it is one that is almost always owned via leverage. Thus, paying down the mortgage isn’t necessarily a “risk free” proposition in terms of ultimately realizing the return on your investment, which only happens after you sell the house. Even if you pay cash for a house, and some time later sell the house for less than you bought it for, you will realize a loss. Thus, the “extra” mortgage payment (in the form of an all cash offer) can experience a loss, which is obviously not a “risk free” use of cash.
What you miss here is that the benefit from the mortgage prepayment is independent of the house. If you pay $10,000 extra on a 3% mortgage with ten years left, you will eliminate $13,439 of payments in the tenth year. This is a risk-free return, because you have more cash in the bank than if you had not made the prepayment, and the same house whether you make the prepayment or not.
Alternatively, if you sell, you realize the same benefit regardless of what happens to the house. Your mortgage balance will be $10,609 less in two years. If you then sell your house, you will have $10,609 more in the bank after closing than if you had not made the prepayment. The $10,000 prepayment either increased your gain or decreased your loss by $10,609, which is a risk-free return.
The same thing applies to a balanced portfolio. If you buy $60,000 in stock and $40,000 in Treasury bonds, the bond return is risk-free, while the overall portfolio could easily have a loss. If you buy a single fund for $100,000 which is 60% stock and 40% bonds, you still get the same risk-free return on the bond portion of the fund, even if you eventually sell the fund for a loss.
Another way to see that the discussion is independent of the house is to compare different types of loans. Suppose you have a 10-year mortgage at 3% and a 10-year student loan at 3%. The student loan has no collateral, so it is clear that you get a 3% return on any prepayment. But you will have the same number of dollars no matter which loan you prepay.
Right, and I should note that I generally share the view that paying off interest bearing debt is a risk free return to the individual in “most” circumstances. However, the mortgage doesn’t exist in a vacuum that is completely separated from the asset it purchased - the house. Mortgage liabilities are a special animal that are inexorably linked to the house and all of the legal parameters surrounding ownership of residential real estate, which makes it more similar to an asset backed security or a collateralized debt obligation than a treasury bond.
Changes in the fair value of the collateral underlying an asset backed security “normally” have no effect on the fair value of the bond - however, upon the occurrence of a credit event (downgrade, default, etc), the fair value of the bond becomes more directly correlated with the fair value in the underlying collateral as it becomes more likely that the collateral will be used to settle the obligation (rather than cash from normal periodic payments). This effect is akin to my discussion of option values and “gamma” above, where the fair value of the house starts to become more relevant upon the prospect of default on the mortgage as the likelihood of the mortgage balance being settled from the sale of collateral (the house) increases.
It is thus the purchase of the house itself that gives rise to the “risk” in this equation - i.e. my example of paying cash for the house, but later selling it for a loss. According to the common view here, it would be implied that an all-cash home purchase immediately “earns” a risk free return equal to the then prevailing mortgage rate of your choice, effectively paying off a zero duration mortgage and “avoiding” the interest expense that would have otherwise been incurred. However, while this is generally true for the liability side of the equation, the risks associated with holding the underlying asset continue until the house is eventually sold, gifted, foreclosed, destroyed by natural disaster, rendered uninhabitable by new regulations, etc. As noted above, in some cases a valuable put option may exist if the mortgage is non-recourse, if one doesn’t care about ruining their credit and is willing to “put” an underwater house back to the bank in lieu of making mortgage payments.
What I (and I believe geerhard) am trying to do, is to illustrate that there may be a more comprehensive way to view this financial arrangement as a leveraged real estate investment, rather than completely bifurcating the asset from the liability and viewing associated returns on each in isolation - which can give rise to a simplistic form of mental accounting if some of these potential factors (e.g. put option) are ignored.
With all that said, I do believe it is likely prudent in most cases to pay down a mortgage early if you have the means to do so, and it is “ok” to mentally simplify all of this and think of this as a near risk-free return in 99% of situations (particularly for Bogleheads, a self-selecting group not representative of the overall population). But I also do believe the discussion of whether it is “risk free” or not is technically more nuanced than a statement in absolute terms saying “paying off a mortgage early ALWAYS results in a risk-free return.” There are scenarios where the amount of interest saved from prepayments may not exceed or only marginally reduce a loss on sale of the associated property, or the prepayments may be lost entirely in the event of foreclosure, short sale, etc. Thus, prepaying a mortgage cannot necessarily be said to be completely risk-free, as “risk-free” is a financial term that is generally defined in valuation methodology to mean a guaranteed rate of return on a financial instrument where the risk of loss is zero if held to maturity.