Why Buy Bonds If You Have A Mortgage?

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

Post by Admiral » Thu Jan 11, 2018 10:55 am

pezblanco wrote:
Thu Jan 11, 2018 10:49 am
Admiral wrote:
Thu Jan 11, 2018 10:35 am
grabiner wrote:
Wed Jan 10, 2018 10:08 pm
Admiral wrote:
Wed Jan 10, 2018 7:09 am
There is no rational financial argument for paying down a mortgage over saving that money in tax advantaged space. The former saves you the relatively low interest rate of your loan. The latter saves you 15, 22, 25, 28%....whatever your fed tax rate is.
The tax savings is not a return, because you have to pay tax on the withdrawal. If you put $1000 in a traditional IRA, you get $220 back in taxes, but this is not a 28% return ($780 out of pocket growing to $1000) because you can't spend that $1000. The $1000 will turn back into $780 when you withdraw it. If you invest your IRA in something which doubles in value, you have $2000 in the IRA, which becomes $1560 when you withdraw it. This is no better than a Roth IRA, which would give you no increase in the reported dollar balance but would also grow $780 to $1560.

You do get a return if you withdraw in a lower tax bracket, but it still isn't the full savings. If you contribute in a 22% tax bracket and withdraw in a 15% tax bracket, your $780 out of pocket was as good as $850 tax-free, but that is only a 9% gain.

And this is still not the right comparison, because paying down a loan gives you a return every year, while that 9% gain is a one-time return. If your loan is at a 1% higher rate than you can earn in the IRA risk-free, then you get a 10% gain by making a payment on the loan ten years early, relative to the IRA investment.

That said, it is still usually desirable to invest in an IRA or 401(k) over paying down a mortgage. You can usually get a comparable rate without taking much risk, and you get the benefit of tax-deferral of your investments even after the mortgage is gone.

But if your mortgage is at a high rate (because you have poor credit and cannot refinance to a low rate, or have to pay PMI, or it is a second mortgage to avoid PMI), then it may be worth paying down the mortgage once you get the employer match on a 401(k).
Let’s look at some numbers. I made inflation = 0% for simplicity

Option 1
Mortgage amount: $200,000
Term: 15 years
Rate: 2.5%
Payment: 1,333.58
Total interest paid over 15 years:
$40,044.12

Prepayment plan of $1,000 per month toward principal:
Total Interest paid: 20,543.12
Savings (rounded): $19,000
Years of payments saved: 8

Option 2

Now let’s consider an investment plan with a modest return to replace the prepayments:
Amount: $1,000 per month
Term: 15 years
Rate: 5%
Total Principal $180,000.00
Total Interest $85,903.52
End Balance $265,903.52

Even assuming a 22% tax on withdrawal, you come out with $86,000 x .78 or $67,000. And that's only if the money is taken out all at once and not over time, where it can grow.

Now let’s assume that in option 1, once the mortgage is paid off, you invest your former payment of $1,333 for the remaining 8 years at the same rate as option 2. That gives us an additional $ 28,885.62 before taxes.

In the prepayment-then-invest option, you have $19,000 in interest savings, plus $29,000 pretax, or $23,000 after tax.

It’s not even close.
But this isn't a fair comparison ... you are comparing the investing in stocks to that of the risk-less investment in what is essentially a bond. Of course if you just look at the average or statistical expectation, the risky asset will come out ahead ... but by doing this you are completely ignoring the RISK.
I'm not ignoring it. I'm simply willing to play the odds, which I believe are in my favor. Of course if you want a guaranteed return with no risk, the equation is different. But you could also make the argument that you're ignoring the risk of a housing crash by pre-paying. Not to mention the opportunity cost and the liquidity risk. All investing has some some risk.

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

Post by pezblanco » Thu Jan 11, 2018 11:29 am

Admiral,

I think you're now confounding all risk levels no matter how remote e.g another housing crash vs the inherent year by year real risk of stocks (where historically 1/3 of the years we have a loss).

If you follow your arguments to their logical conclusion, you will conclude that the only thing that makes sense is a portfolio of 100% (or greater if you leverage) stocks.
[/quote]

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

Post by Admiral » Thu Jan 11, 2018 4:18 pm

pezblanco wrote:
Thu Jan 11, 2018 11:29 am
Admiral,

I think you're now confounding all risk levels no matter how remote e.g another housing crash vs the inherent year by year real risk of stocks (where historically 1/3 of the years we have a loss).

If you follow your arguments to their logical conclusion, you will conclude that the only thing that makes sense is a portfolio of 100% (or greater if you leverage) stocks.
[/quote]

Not at all. The OP was "why buy bonds if you have a mortgage?" In a diversified portfolio, bonds play an important role in terms of stability and reducing volatility, and hopefully have some decent return over the long run. They are also not correlated to the movement of stocks (for the most part). That role is not filled by your house. Therefore, prepaying (or even holding) a mortgage, while clearly helpful on the balance sheet, is not the same as owning bonds.

No where did I post that one should only hold equities...though many will claim that's the case for very young investors (and I disagree).

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

Post by MindBogler » Thu Jan 11, 2018 5:33 pm

Admiral wrote:
Thu Jan 11, 2018 4:18 pm
Therefore, prepaying (or even holding) a mortgage, while clearly helpful on the balance sheet, is not the same as owning bonds.
Succinct.

cb474
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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Thu Jan 11, 2018 8:28 pm

Admiral wrote:
Thu Jan 11, 2018 10:35 am
Let’s look at some numbers. I made inflation = 0% for simplicity

Option 1
Mortgage amount: $200,000
Term: 15 years
Rate: 2.5%
Payment: 1,333.58
Total interest paid over 15 years:
$40,044.12

Prepayment plan of $1,000 per month toward principal:
Total Interest paid: 20,543.12
Savings (rounded): $19,000
Years of payments saved: 8

Option 2

Now let’s consider an investment plan with a modest return to replace the prepayments:
Amount: $1,000 per month
Term: 15 years
Rate: 5%
Total Principal $180,000.00
Total Interest $85,903.52
End Balance $265,903.52

Even assuming a 22% tax on withdrawal, you come out with $86,000 x .78 or $67,000. And that's only if the money is taken out all at once and not over time, where it can grow.

Now let’s assume that in option 1, once the mortgage is paid off, you invest your former payment of $1,333 for the remaining 8 years at the same rate as option 2. That gives us an additional $ 28,885.62 before taxes.

In the prepayment-then-invest option, you have $19,000 in interest savings, plus $29,000 pretax, or $23,000 after tax.

It’s not even close.
The main problem with this analysis, I think, is that it ignores sequence of returns risk. It's not that hard to find ten and even fifteen year periods where the market has a no return, almost no return, or even a loss (yes you can have a loss over a long period of time). Further, even if the average return for the period is 5%, it will not be exactly 5% every year, so merely calculating the return in Option 2, by compounding 5% per year is not an accurate way to calculate actual portfolio returns over an extended period of time, because the market is going to be doing its random walk. So there is a much better chance than people think (maybe 1 in 10) that they could lose money in Option 2. And an even higher chance that it would turn out a lot closer to or even worse than Option 1. It would be closer to what historical market returns have been like, to figure you have a 2/3 chance of beating Option 1 with Option 2 and a 1/3 chance of doing no better or possibly significantly worse. Those aren't bad odds, but not nearly as good as people imagine when they look at the phrase "average returns."

This is one of the main points of the three articles I link to above (which uses a 50/50 treasuries/S&P500 portfolio, to do its sequence of returns analysis). How Option 2 goes will be highly variable depending on the year you start it in. And the odds of it not doing so well are much higher than people think.

I'm not saying people should not do Option 2. I'm just saying that few people really understand the risk appropriately. It's more than they think.

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

Post by grabiner » Thu Jan 11, 2018 8:47 pm

Admiral wrote:
Thu Jan 11, 2018 10:55 am
pezblanco wrote:
Thu Jan 11, 2018 10:49 am
But this isn't a fair comparison ... you are comparing the investing in stocks to that of the risk-less investment in what is essentially a bond. Of course if you just look at the average or statistical expectation, the risky asset will come out ahead ... but by doing this you are completely ignoring the RISK.
I'm not ignoring it. I'm simply willing to play the odds, which I believe are in my favor. Of course if you want a guaranteed return with no risk, the equation is different. But you could also make the argument that you're ignoring the risk of a housing crash by pre-paying. Not to mention the opportunity cost and the liquidity risk. All investing has some some risk.
Is 100% of your portfolio in the stock market? If not, then you aren't willing to play the odds even though they are in your favor. (And even if 100% is in the stock market, you could buy on margin, with the odds in your favor.)

Opportunity cost is defined as the cost of the lost opportunity. The money you use to pay down your mortgage could be invested, so the opportunity cost is the return (and potential risk) of investing.

And that leaves the liquidity issue, which is important if you compare paying down a loan to making a taxable investment (in either bonds or stocks). If you use money to pay down your mortgage, to get it back out of your house, you need to take a home-equity loan which is likely at a higher rate. But if you compare paying down a loan to investing in a 401(k) (which is usually a good deal), liquidity isn't as much of an issue; you have a significant penalty for taking the money out of the 401(k).

My taxable account is much larger than my mortgage, so I ignore the liquidity issue in the decision whether to pay off my own mortgage. I don't pay it off now because I would get a poor return on the payoff; I would save in interest, but I would have a huge capital gain selling enough stock to make the payoff. (I have carryover losses, so the cost would not be immediate, but I will run out of carryover losses eventually.)
Wiki David Grabiner

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

Post by KlangFool » Thu Jan 11, 2018 8:48 pm

cb474 wrote:
Thu Jan 11, 2018 8:28 pm
Admiral wrote:
Thu Jan 11, 2018 10:35 am
Let’s look at some numbers. I made inflation = 0% for simplicity

Option 1
Mortgage amount: $200,000
Term: 15 years
Rate: 2.5%
Payment: 1,333.58
Total interest paid over 15 years:
$40,044.12

Prepayment plan of $1,000 per month toward principal:
Total Interest paid: 20,543.12
Savings (rounded): $19,000
Years of payments saved: 8

Option 2

Now let’s consider an investment plan with a modest return to replace the prepayments:
Amount: $1,000 per month
Term: 15 years
Rate: 5%
Total Principal $180,000.00
Total Interest $85,903.52
End Balance $265,903.52

Even assuming a 22% tax on withdrawal, you come out with $86,000 x .78 or $67,000. And that's only if the money is taken out all at once and not over time, where it can grow.

Now let’s assume that in option 1, once the mortgage is paid off, you invest your former payment of $1,333 for the remaining 8 years at the same rate as option 2. That gives us an additional $ 28,885.62 before taxes.

In the prepayment-then-invest option, you have $19,000 in interest savings, plus $29,000 pretax, or $23,000 after tax.

It’s not even close.
The main problem with this analysis, I think, is that it ignores sequence of returns risk. It's not that hard to find ten and even fifteen year periods where the market has a no return, almost no return, or even a loss (yes you can have a loss over a long period of time). Further, even if the average return for the period is 5%, it will not be exactly 5% every year, so merely calculating the return in Option 2, by compounding 5% per year is not an accurate way to calculate actual portfolio returns over an extended period of time, because the market is going to be doing its random walk. So there is a much better chance than people think (maybe 1 in 10) that they could lose money in Option 2. And an even higher chance that it would turn out a lot closer to or even worse than Option 1. It would be closer to what historical market returns have been like, to figure you have a 2/3 chance of beating Option 1 with Option 2 and a 1/3 chance of doing no better or possibly significantly worse. Those aren't bad odds, but not nearly as good as people imagine when they look at the phrase "average returns."

This is one of the main points of the three articles I link to above (which uses a 50/50 treasuries/S&P500 portfolio, to do its sequence of returns analysis). How Option 2 goes will be highly variable depending on the year you start it in. And the odds of it not doing so well are much higher than people think.

I'm not saying people should not do Option 2. I'm just saying that few people really understand the risk appropriately. It's more than they think.
cb474,

Let's assume that you are correct and the market does return less than 5%, then, the person could choose to prepay the mortgage. That option always existed. It does not have to be a one-time decision.

So, it could be

A) Do not pre-pay the mortgage if the return is more than 5%. For example, 7% or more.

B) If the return is less than 5%, pre-pay the mortgage.

This could be a year by year decision. Or, make this decision every 2 or 3 years.

This option exists for people that choose not to pre-pay their mortgage all the times.

KlangFool

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

Post by ThePrince » Thu Jan 11, 2018 9:07 pm

fmzip wrote:
Wed Jan 10, 2018 2:22 pm
WhiteMaxima wrote:
Wed Jan 10, 2018 12:45 pm
Open a line of credit on your house equity. If market crashes, use line of credit to rebalance. Better rate than Bond.
Yikes! Been down that road. I would never borrow against my home equity to invest a dime.
+1

It is amusing to read all the supposedly sophisticated ways people use to entertain themselves with debt.

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willthrill81
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Re: Why Buy Bonds If You Have A Mortgage?

Post by willthrill81 » Thu Jan 11, 2018 9:12 pm

ThePrince wrote:
Thu Jan 11, 2018 9:07 pm
fmzip wrote:
Wed Jan 10, 2018 2:22 pm
WhiteMaxima wrote:
Wed Jan 10, 2018 12:45 pm
Open a line of credit on your house equity. If market crashes, use line of credit to rebalance. Better rate than Bond.
Yikes! Been down that road. I would never borrow against my home equity to invest a dime.
+1

It is amusing to read all the supposedly sophisticated ways people use to entertain themselves with debt.
It's interesting how rare it is to hear of anyone financing a new car purchase at a promo 0-2% rate in order to invest the money instead. Or using promotional credit card checks with a 3% fee and 0% interest for 12-18 months to invest. The specifics are obviously different (e.g. the interest, if any, cannot be deducted from one's taxes), but the principle is the same.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

ThePrince
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Location: U.S.A.

Re: Why Buy Bonds If You Have A Mortgage?

Post by ThePrince » Thu Jan 11, 2018 9:19 pm

willthrill81 wrote:
Thu Jan 11, 2018 9:12 pm
ThePrince wrote:
Thu Jan 11, 2018 9:07 pm
fmzip wrote:
Wed Jan 10, 2018 2:22 pm
WhiteMaxima wrote:
Wed Jan 10, 2018 12:45 pm
Open a line of credit on your house equity. If market crashes, use line of credit to rebalance. Better rate than Bond.
Yikes! Been down that road. I would never borrow against my home equity to invest a dime.
+1

It is amusing to read all the supposedly sophisticated ways people use to entertain themselves with debt.
It's interesting how rare it is to hear of anyone financing a new car purchase at a promo 0-2% rate in order to invest the money instead. Or using promotional credit card checks with a 3% fee and 0% interest for 12-18 months to invest. The specifics are obviously different (e.g. the interest, if any, cannot be deducted from one's taxes), but the principle is the same.
+1

ThrustVectoring
Posts: 422
Joined: Wed Jul 12, 2017 2:51 pm

Re: Why Buy Bonds If You Have A Mortgage?

Post by ThrustVectoring » Thu Jan 11, 2018 9:19 pm

willthrill81 wrote:
Wed Jan 10, 2018 11:17 am
Admiral wrote:
Wed Jan 10, 2018 11:10 am
I don't hold bonds in a taxable account, nor should most people, unless they are munis, which have a low yield, nor do I intend to borrow against my home. I also hold Total Bond Index, which is medium duration not long duration.
Actually, it can be optimal to hold bonds in taxable accounts. See here for an explanation.
That link isn't an argument for not holding bonds in your tax-advantaged account. It's an argument for not holding bonds whatsoever. If you're just looking at ending value after 30 years, you go 100% stocks. The point of having bonds is that over shorter timeframes (under, say, 10-20 years), they have a better worst-case performance than stocks do.

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

Post by pezblanco » Thu Jan 11, 2018 10:18 pm

KlangFool wrote:
Thu Jan 11, 2018 8:48 pm
cb474 wrote:
Thu Jan 11, 2018 8:28 pm
Admiral wrote:
Thu Jan 11, 2018 10:35 am
Let’s look at some numbers. I made inflation = 0% for simplicity

Option 1
Mortgage amount: $200,000
Term: 15 years
Rate: 2.5%
Payment: 1,333.58
Total interest paid over 15 years:
$40,044.12

Prepayment plan of $1,000 per month toward principal:
Total Interest paid: 20,543.12
Savings (rounded): $19,000
Years of payments saved: 8

Option 2

Now let’s consider an investment plan with a modest return to replace the prepayments:
Amount: $1,000 per month
Term: 15 years
Rate: 5%
Total Principal $180,000.00
Total Interest $85,903.52
End Balance $265,903.52

Even assuming a 22% tax on withdrawal, you come out with $86,000 x .78 or $67,000. And that's only if the money is taken out all at once and not over time, where it can grow.

Now let’s assume that in option 1, once the mortgage is paid off, you invest your former payment of $1,333 for the remaining 8 years at the same rate as option 2. That gives us an additional $ 28,885.62 before taxes.

In the prepayment-then-invest option, you have $19,000 in interest savings, plus $29,000 pretax, or $23,000 after tax.

It’s not even close.
The main problem with this analysis, I think, is that it ignores sequence of returns risk. It's not that hard to find ten and even fifteen year periods where the market has a no return, almost no return, or even a loss (yes you can have a loss over a long period of time). Further, even if the average return for the period is 5%, it will not be exactly 5% every year, so merely calculating the return in Option 2, by compounding 5% per year is not an accurate way to calculate actual portfolio returns over an extended period of time, because the market is going to be doing its random walk. So there is a much better chance than people think (maybe 1 in 10) that they could lose money in Option 2. And an even higher chance that it would turn out a lot closer to or even worse than Option 1. It would be closer to what historical market returns have been like, to figure you have a 2/3 chance of beating Option 1 with Option 2 and a 1/3 chance of doing no better or possibly significantly worse. Those aren't bad odds, but not nearly as good as people imagine when they look at the phrase "average returns."

This is one of the main points of the three articles I link to above (which uses a 50/50 treasuries/S&P500 portfolio, to do its sequence of returns analysis). How Option 2 goes will be highly variable depending on the year you start it in. And the odds of it not doing so well are much higher than people think.

I'm not saying people should not do Option 2. I'm just saying that few people really understand the risk appropriately. It's more than they think.
cb474,

Let's assume that you are correct and the market does return less than 5%, then, the person could choose to prepay the mortgage. That option always existed. It does not have to be a one-time decision.

So, it could be

A) Do not pre-pay the mortgage if the return is more than 5%. For example, 7% or more.

B) If the return is less than 5%, pre-pay the mortgage.

This could be a year by year decision. Or, make this decision every 2 or 3 years.

This option exists for people that choose not to pre-pay their mortgage all the times.

KlangFool
But you don't know beforehand what your returns are going to be. Surely, you're not saying that after a couple of years and you lose 40% in the stock market, you can then decide to sell your stocks out and pay the mortgage?

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

Post by KlangFool » Thu Jan 11, 2018 10:46 pm

pezblanco wrote:
Thu Jan 11, 2018 10:18 pm
KlangFool wrote:
Thu Jan 11, 2018 8:48 pm
cb474 wrote:
Thu Jan 11, 2018 8:28 pm
Admiral wrote:
Thu Jan 11, 2018 10:35 am
Let’s look at some numbers. I made inflation = 0% for simplicity

Option 1
Mortgage amount: $200,000
Term: 15 years
Rate: 2.5%
Payment: 1,333.58
Total interest paid over 15 years:
$40,044.12

Prepayment plan of $1,000 per month toward principal:
Total Interest paid: 20,543.12
Savings (rounded): $19,000
Years of payments saved: 8

Option 2

Now let’s consider an investment plan with a modest return to replace the prepayments:
Amount: $1,000 per month
Term: 15 years
Rate: 5%
Total Principal $180,000.00
Total Interest $85,903.52
End Balance $265,903.52

Even assuming a 22% tax on withdrawal, you come out with $86,000 x .78 or $67,000. And that's only if the money is taken out all at once and not over time, where it can grow.

Now let’s assume that in option 1, once the mortgage is paid off, you invest your former payment of $1,333 for the remaining 8 years at the same rate as option 2. That gives us an additional $ 28,885.62 before taxes.

In the prepayment-then-invest option, you have $19,000 in interest savings, plus $29,000 pretax, or $23,000 after tax.

It’s not even close.
The main problem with this analysis, I think, is that it ignores sequence of returns risk. It's not that hard to find ten and even fifteen year periods where the market has a no return, almost no return, or even a loss (yes you can have a loss over a long period of time). Further, even if the average return for the period is 5%, it will not be exactly 5% every year, so merely calculating the return in Option 2, by compounding 5% per year is not an accurate way to calculate actual portfolio returns over an extended period of time, because the market is going to be doing its random walk. So there is a much better chance than people think (maybe 1 in 10) that they could lose money in Option 2. And an even higher chance that it would turn out a lot closer to or even worse than Option 1. It would be closer to what historical market returns have been like, to figure you have a 2/3 chance of beating Option 1 with Option 2 and a 1/3 chance of doing no better or possibly significantly worse. Those aren't bad odds, but not nearly as good as people imagine when they look at the phrase "average returns."

This is one of the main points of the three articles I link to above (which uses a 50/50 treasuries/S&P500 portfolio, to do its sequence of returns analysis). How Option 2 goes will be highly variable depending on the year you start it in. And the odds of it not doing so well are much higher than people think.

I'm not saying people should not do Option 2. I'm just saying that few people really understand the risk appropriately. It's more than they think.
cb474,

Let's assume that you are correct and the market does return less than 5%, then, the person could choose to prepay the mortgage. That option always existed. It does not have to be a one-time decision.

So, it could be

A) Do not pre-pay the mortgage if the return is more than 5%. For example, 7% or more.

B) If the return is less than 5%, pre-pay the mortgage.

This could be a year by year decision. Or, make this decision every 2 or 3 years.

This option exists for people that choose not to pre-pay their mortgage all the times.

KlangFool
But you don't know beforehand what your returns are going to be. Surely, you're not saying that after a couple of years and you lose 40% in the stock market, you can then decide to sell your stocks out and pay the mortgage?
pezblanco,

1) Unless you are 100% stock, how does losing 40% in the stock market matters?

2) If you are 100% stock, you have a bigger problem. It is beyond the amount that you plan to pre-pay the mortgage.

KlangFool

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

Post by pezblanco » Thu Jan 11, 2018 10:54 pm

KlangFool wrote:
Thu Jan 11, 2018 10:46 pm

pezblanco,

1) Unless you are 100% stock, how does losing 40% in the stock market matters?

2) If you are 100% stock, you have a bigger problem. It is beyond the amount that you plan to pre-pay the mortgage.

KlangFool
I'm just saying that I don't understand your advice ... you say that if your return is less than 5% you can then pay off the mortgage? How does that make any sense? You've already lost the money at that point. How is that a good strategy?

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

Post by KlangFool » Thu Jan 11, 2018 11:05 pm

pezblanco wrote:
Thu Jan 11, 2018 10:54 pm
KlangFool wrote:
Thu Jan 11, 2018 10:46 pm

pezblanco,

1) Unless you are 100% stock, how does losing 40% in the stock market matters?

2) If you are 100% stock, you have a bigger problem. It is beyond the amount that you plan to pre-pay the mortgage.

KlangFool
I'm just saying that I don't understand your advice ... you say that if your return is less than 5% you can then pay off the mortgage? How does that make any sense? You've already lost the money at that point. How is that a good strategy?
pezblanco,

1) Let's assume that we are not 100% stock and have a reasonable portfolio like 60/40.

2) Are you willing to bet that a 60/40 portfolio will beat 5% for most years?

A) Yes, do not pre-pay the mortgage.

B) No, pre-pay the mortgage.

And, if you choose (A) and it does not work out, you take your loses and pre-pay the mortgage.

KlangFool

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willthrill81
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Re: Why Buy Bonds If You Have A Mortgage?

Post by willthrill81 » Thu Jan 11, 2018 11:39 pm

ThrustVectoring wrote:
Thu Jan 11, 2018 9:19 pm
willthrill81 wrote:
Wed Jan 10, 2018 11:17 am
Admiral wrote:
Wed Jan 10, 2018 11:10 am
I don't hold bonds in a taxable account, nor should most people, unless they are munis, which have a low yield, nor do I intend to borrow against my home. I also hold Total Bond Index, which is medium duration not long duration.
Actually, it can be optimal to hold bonds in taxable accounts. See here for an explanation.
That link isn't an argument for not holding bonds in your tax-advantaged account. It's an argument for not holding bonds whatsoever. If you're just looking at ending value after 30 years, you go 100% stocks. The point of having bonds is that over shorter timeframes (under, say, 10-20 years), they have a better worst-case performance than stocks do.
I doubt that anyone would dispute that stocks are extremely likely to outperform bonds over the next 30 years. And the most common reasons that people hold bonds is for liquidity, having 'safe' money when stocks plunge, and for smoothing out portfolio volatility. Very few believe that bonds will outperform stocks in most 10-20 year periods.
Last edited by willthrill81 on Thu Jan 11, 2018 11:48 pm, edited 1 time in total.
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BrandonBogle
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Re: Why Buy Bonds If You Have A Mortgage?

Post by BrandonBogle » Thu Jan 11, 2018 11:44 pm

willthrill81 wrote:
Thu Jan 11, 2018 9:12 pm
It's interesting how rare it is to hear of anyone financing a new car purchase at a promo 0-2% rate in order to invest the money instead. Or using promotional credit card checks with a 3% fee and 0% interest for 12-18 months to invest. The specifics are obviously different (e.g. the interest, if any, cannot be deducted from one's taxes), but the principle is the same.
And of course I did both of these. Bought my 4Runner for a specific price, then took the 0% financing rather than paying 80% of the car in cash (I had secure outside financing for a year to pay off the rest). Invested that in some high-yield PenFed CDs in a ladder that provided the funds each year at maturity to cover the next year's of payments.

Then later one when SECU of MD was offer their phenomenal CDs for a couple years (one was like 7.5% or something), I had $100k out in credit card balance transfers at 0% (each had a capped fee, so while 3% transfer fee, it was "up to $50" or stuff like that). Made out like a bandit on that.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by ThrustVectoring » Fri Jan 12, 2018 12:59 am

willthrill81 wrote:
Thu Jan 11, 2018 11:39 pm
ThrustVectoring wrote:
Thu Jan 11, 2018 9:19 pm
willthrill81 wrote:
Wed Jan 10, 2018 11:17 am
Admiral wrote:
Wed Jan 10, 2018 11:10 am
I don't hold bonds in a taxable account, nor should most people, unless they are munis, which have a low yield, nor do I intend to borrow against my home. I also hold Total Bond Index, which is medium duration not long duration.
Actually, it can be optimal to hold bonds in taxable accounts. See here for an explanation.
That link isn't an argument for not holding bonds in your tax-advantaged account. It's an argument for not holding bonds whatsoever. If you're just looking at ending value after 30 years, you go 100% stocks. The point of having bonds is that over shorter timeframes (under, say, 10-20 years), they have a better worst-case performance than stocks do.
I doubt that anyone would dispute that stocks are extremely likely to outperform bonds over the next 30 years. And the most common reason that people hold bonds is for liquidity, having 'safe' money when stocks plunge, and for smoothing out portfolio volatility. Very few believe that bonds will outperform stocks in most 10-20 year periods.
Liquidity, sure. "Safe" money when stocks plunge is a non-factor, you get out-performed too badly in bull markets for it to matter. Smoothing out portfolio volatility also doesn't matter, since the smoothing is something like getting $500k for sure rather than something between $1M and $10M.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » Fri Jan 12, 2018 4:22 am

pezblanco wrote:
Thu Jan 11, 2018 10:18 pm
But you don't know beforehand what your returns are going to be. Surely, you're not saying that after a couple of years and you lose 40% in the stock market, you can then decide to sell your stocks out and pay the mortgage?
I agree. That strategy does not make sense. It assumes you know before hand what the next years returns are going to be. If the decision is based on the previous years returns, then it makes even less sense. You are investing more money only after the market has gone up a lot. And not investing when it has done more poorly. It's almost like a market timing strategy to only buy when prices are high--although the effects would probably be mostly arbitrary.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by Admiral » Fri Jan 12, 2018 6:45 am

grabiner wrote:
Thu Jan 11, 2018 8:47 pm
Admiral wrote:
Thu Jan 11, 2018 10:55 am
pezblanco wrote:
Thu Jan 11, 2018 10:49 am
But this isn't a fair comparison ... you are comparing the investing in stocks to that of the risk-less investment in what is essentially a bond. Of course if you just look at the average or statistical expectation, the risky asset will come out ahead ... but by doing this you are completely ignoring the RISK.
I'm not ignoring it. I'm simply willing to play the odds, which I believe are in my favor. Of course if you want a guaranteed return with no risk, the equation is different. But you could also make the argument that you're ignoring the risk of a housing crash by pre-paying. Not to mention the opportunity cost and the liquidity risk. All investing has some some risk.
Is 100% of your portfolio in the stock market? If not, then you aren't willing to play the odds even though they are in your favor. (And even if 100% is in the stock market, you could buy on margin, with the odds in your favor.)

Opportunity cost is defined as the cost of the lost opportunity. The money you use to pay down your mortgage could be invested, so the opportunity cost is the return (and potential risk) of investing.

And that leaves the liquidity issue, which is important if you compare paying down a loan to making a taxable investment (in either bonds or stocks). If you use money to pay down your mortgage, to get it back out of your house, you need to take a home-equity loan which is likely at a higher rate. But if you compare paying down a loan to investing in a 401(k) (which is usually a good deal), liquidity isn't as much of an issue; you have a significant penalty for taking the money out of the 401(k).

My taxable account is much larger than my mortgage, so I ignore the liquidity issue in the decision whether to pay off my own mortgage. I don't pay it off now because I would get a poor return on the payoff; I would save in interest, but I would have a huge capital gain selling enough stock to make the payoff. (I have carryover losses, so the cost would not be immediate, but I will run out of carryover losses eventually.)
I don't follow your logic. Just because I am willing to put SOME money at risk does not mean (and it does not follow logically) that I am willing to put ALL money at risk. That's the point of an investment plan and an asset allocation strategy. I do not consider my house part of either. It's part of my assets, yes, but because it's illiquid (which a retirement account is not, it's still accessible, with penalty) it is out of the investing picture. Once I decide that (for example) I want 30% bonds-plus-cash, then I am 70% stocks. If I have extra after tax monies, I can pre-pay my low mortgage rate for a guaranteed low return, or I can use that money to invest, in bonds, cash, or stocks. I choose to make that money part of my 70% stock allocation, in the belief that over time it will make more than my interest rate. That doesn't mean I think that stocks can't have down years and I will have made a bet that didn't pan out. It means I think that over 10-15 years, the up years will win out and I will come out ahead.

Once the allocation moves 5%, I rebalance. So, in that sense perhaps eventually some of the "extra" mortgage payment money goes into bonds. But really that's only the gains, not the principal.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by luke123 » Fri Jan 12, 2018 10:59 am

<author="Admiral" post_id="3714322" time="1515684958" user_id="57537"><s>
Admiral wrote:
Thu Jan 11, 2018 10:35 am
</s>
author="grabiner" post_id="3713696" time="1515640119" user_id="182"><s>
grabiner wrote:
Wed Jan 10, 2018 10:08 pm
</s>
author="Admiral" post_id="3712069" time="1515586182" user_id="57537"><s>
Admiral wrote:
Wed Jan 10, 2018 7:09 am
</s>
There is no rational financial argument for paying down a mortgage over saving that money in tax advantaged space. The former saves you the relatively low interest rate of your loan. The latter saves you 15, 22, 25, 28%....whatever your fed tax rate is.
<e>
</e>

The tax savings is not a return, because you have to pay tax on the withdrawal. If you put $1000 in a traditional IRA, you get $220 back in taxes, but this is not a 28% return ($780 out of pocket growing to $1000) because you can't spend that $1000. The $1000 will turn back into $780 when you withdraw it. If you invest your IRA in something which doubles in value, you have $2000 in the IRA, which becomes $1560 when you withdraw it. This is no better than a Roth IRA, which would give you no increase in the reported dollar balance but would also grow $780 to $1560.<br/>
<br/>
You do get a return if you withdraw in a lower tax bracket, but it still isn't the full savings. If you contribute in a 22% tax bracket and withdraw in a 15% tax bracket, your $780 out of pocket was as good as $850 tax-free, but that is only a 9% gain. <br/>
<br/>
And this is still not the right comparison, because paying down a loan gives you a return every year, while that 9% gain is a one-time return. If your loan is at a 1% higher rate than you can earn in the IRA risk-free, then you get a 10% gain by making a payment on the loan ten years early, relative to the IRA investment.<br/>
<br/>
That said, it is still usually desirable to invest in an IRA or 401(k) over paying down a mortgage. You can usually get a comparable rate without taking much risk, and you get the benefit of tax-deferral of your investments even after the mortgage is gone. <br/>
<br/>
But if your mortgage is at a high rate (because you have poor credit and cannot refinance to a low rate, or have to pay PMI, or it is a second mortgage to avoid PMI), then it may be worth paying down the mortgage once you get the employer match on a 401(k).
<e>
</e>

Let’s look at some numbers. I made inflation = 0% for simplicity<br/>
<br/>
Option 1<br/>
Mortgage amount: $200,000<br/>
Term: 15 years<br/>
Rate: 2.5%<br/>
Payment: 1,333.58<br/>
Total interest paid over 15 years:<br/>
$40,044.12<br/>
<br/>
Prepayment plan of $1,000 per month toward principal:<br/>
Total Interest paid: 20,543.12<br/>
Savings (rounded): $19,000<br/>
Years of payments saved: 8<br/>
<br/>
Option 2<br/>
<br/>
Now let’s consider an investment plan with a modest return to replace the prepayments:<br/>
Amount: $1,000 per month<br/>
Term: 15 years<br/>
Rate: 5%<br/>
Total Principal $180,000.00<br/>
Total Interest $85,903.52<br/>
End Balance $265,903.52<br/>
<br/>
Even assuming a 22% tax on withdrawal, you come out with $86,000 x .78 or $67,000. And that's only if the money is taken out all at once and not over time, where it can grow.<br/>
<br/>
Now let’s assume that in option 1, once the mortgage is paid off, you invest your former payment of $1,333 for the remaining 8 years at the same rate as option 2. That gives us an additional $ 28,885.62 before taxes. <br/>
<br/>
In the prepayment-then-invest option, you have $19,000 in interest savings, plus $29,000 pretax, or $23,000 after tax.<br/>
<br/>
It’s not even close.
<e>
</e>

To compare apples to apples, you should add the additional $1,000 to the $1,333 i.e. In option 2 you were paying $1,333 for 15 yr mortgage plus investing an additional $1,000 and in option 1 you were paying an additional $1,000 towards the $1,333 mortgage. In option 1 you paid the mortgage off early with 8 yrs to invest $1,333 plus the $1,000 you were using to pay off the mortgage early. So you should use $2,333 invested for 8 yrs @ 5% interest which gives you an additional $50,000 ($39,000 after tax). $39,000 plus $19,000 in saved interest=$58,000 in after tax savings if you pay your mortgage off early vs. $67,000 by investing the extra payments. A difference of $9,000 over 15 yrs. </r>

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Fri Jan 12, 2018 6:54 pm

Admiral wrote:
Fri Jan 12, 2018 6:45 am
I don't follow your logic. Just because I am willing to put SOME money at risk does not mean (and it does not follow logically) that I am willing to put ALL money at risk. That's the point of an investment plan and an asset allocation strategy.
The issue is that you are comparing options with different amounts of risk:
Once I decide that (for example) I want 30% bonds-plus-cash, then I am 70% stocks. If I have extra after tax monies, I can pre-pay my low mortgage rate for a guaranteed low return, or I can use that money to invest, in bonds, cash, or stocks. I choose to make that money part of my 70% stock allocation, in the belief that over time it will make more than my interest rate.
Compare the following four options:

A: $100K mortgage, $280K stocks, $220K bonds
B: No mortgage, $280K stocks, $120K bonds
C: $100K mortgage, $350K stocks, $150K bonds
D: No mortgage, $350K stocks, $50K bonds

Do you prefer C or D? They have the same risk; you will lose $175K either way if the stock market crashes, which will have the same effect on your standard of living in retirement. Thus, you should prefer D over C if the bonds in C are better than the mortgage prepayment in D.
Do you prefer A or B? Again, they have the same risk, so you should prefer B over A if the bonds are better than the mortgage prepayment.

So if you prefer B over A, and D over C, then you should prepay your mortgage, and choose either B or D. If you are risk-tolerant enough that you prefer C over B (which is perfectly reasonable), then D is better than either.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by Admiral » Sat Jan 13, 2018 9:19 am

grabiner wrote:
Fri Jan 12, 2018 6:54 pm
Admiral wrote:
Fri Jan 12, 2018 6:45 am
I don't follow your logic. Just because I am willing to put SOME money at risk does not mean (and it does not follow logically) that I am willing to put ALL money at risk. That's the point of an investment plan and an asset allocation strategy.
The issue is that you are comparing options with different amounts of risk:
Once I decide that (for example) I want 30% bonds-plus-cash, then I am 70% stocks. If I have extra after tax monies, I can pre-pay my low mortgage rate for a guaranteed low return, or I can use that money to invest, in bonds, cash, or stocks. I choose to make that money part of my 70% stock allocation, in the belief that over time it will make more than my interest rate.
Compare the following four options:

A: $100K mortgage, $280K stocks, $220K bonds
B: No mortgage, $280K stocks, $120K bonds
C: $100K mortgage, $350K stocks, $150K bonds
D: No mortgage, $350K stocks, $50K bonds

Do you prefer C or D? They have the same risk; you will lose $175K either way if the stock market crashes, which will have the same effect on your standard of living in retirement. Thus, you should prefer D over C if the bonds in C are better than the mortgage prepayment in D.
Do you prefer A or B? Again, they have the same risk, so you should prefer B over A if the bonds are better than the mortgage prepayment.

So if you prefer B over A, and D over C, then you should prepay your mortgage, and choose either B or D. If you are risk-tolerant enough that you prefer C over B (which is perfectly reasonable), then D is better than either.
This analysis assumes that bonds rates and my mortgage rate remain static. But they don't. My mortgage rate is static. Bond rates move. And, based on the history of the bond market, they are now low.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Sat Jan 13, 2018 11:20 am

Admiral wrote:
Sat Jan 13, 2018 9:19 am
grabiner wrote:
Fri Jan 12, 2018 6:54 pm
Compare the following four options:

A: $100K mortgage, $280K stocks, $220K bonds
B: No mortgage, $280K stocks, $120K bonds
C: $100K mortgage, $350K stocks, $150K bonds
D: No mortgage, $350K stocks, $50K bonds

Do you prefer C or D? They have the same risk; you will lose $175K either way if the stock market crashes, which will have the same effect on your standard of living in retirement. Thus, you should prefer D over C if the bonds in C are better than the mortgage prepayment in D.
Do you prefer A or B? Again, they have the same risk, so you should prefer B over A if the bonds are better than the mortgage prepayment.

So if you prefer B over A, and D over C, then you should prepay your mortgage, and choose either B or D. If you are risk-tolerant enough that you prefer C over B (which is perfectly reasonable), then D is better than either.
This analysis assumes that bonds rates and my mortgage rate remain static. But they don't. My mortgage rate is static. Bond rates move. And, based on the history of the bond market, they are now low.
Bond rates change, but that isn't relevant to this analysis. If you have a bond portfolio, you don't get the benefit of the rising rates; your bond prices fall as the yields rise.

The natural comparison is a bond portfolio which makes bond payments equal to your mortgage payments every year for the rest of your mortgage. If rates rise, your bonds lose market value, but they still make the mortgage payments. And your mortgage also loses market value, which is a net gain for you; you have to make future mortgage payments with dollars which will be easier to get from your investments. So you could buy Portfolio A with the extra bonds exactly matching your mortgage payments, and be guaranteed to outperform Portfolio B if those bonds cost less than $100K (yield above the mortgage rate) or underperform if they cost more.

You might not buy exactly this bond portfolio, but it gives a fair comparison. If you have 11 years left on your mortgage, an 11-year bond ladder would exactly match it. If you aren't interested in buying a ladder, a very similar investment would be a bond fund with the same interest-rate risk, such as a bond fund with a five-year duration. This is the comparison I use; I have 11 years left on my mortgage, and the fund I use for comparison is Vanguard Intermediate-Term Tax-Exempt. (My bonds are in my retirement account, but I still use this fund for a fair comparison. If I pay off my mortgage, I will sell taxable stock, and move an equal amount from bonds to stock in my retirement account, so that I keep the same risk.)

In fact, the non-static rates slightly favor keeping the mortgage, but for an entirely different reason. If rates fall, you can refinance your mortgage, while the lender who issued your bonds cannot refinance the bonds (unless they are callable). Therefore, if your bond portfolio has the same yield as your mortgage, and the same duration, you break even if rates rise, and gain if rates fall by enough to be worth refinancing. If your mortgage is already lower than the current market rate (usually the situation now, particularly if you paid points to lower your initial rate), this is not worth much.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by vitaflo » Sat Jan 13, 2018 12:20 pm

KlangFool wrote:
Thu Jan 11, 2018 11:05 pm
1) Let's assume that we are not 100% stock and have a reasonable portfolio like 60/40.

2) Are you willing to bet that a 60/40 portfolio will beat 5% for most years?

A) Yes, do not pre-pay the mortgage.

B) No, pre-pay the mortgage.

And, if you choose (A) and it does not work out, you take your loses and pre-pay the mortgage.

KlangFool
Or if you choose B) take your gains and pre-pay it. That's what I'm doing. I took out my mortgage 6+ years ago for $330k. My CAGR over that time has been 10%+. That's given me a return of over $280k on that $330k. My current mortgage balance is much less than that.

I took my risk and it (thankfully) paid off. It's time to take that risk off the table and pay off the mortgage.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by Admiral » Sat Jan 13, 2018 12:36 pm

grabiner wrote:
Sat Jan 13, 2018 11:20 am
Admiral wrote:
Sat Jan 13, 2018 9:19 am
grabiner wrote:
Fri Jan 12, 2018 6:54 pm
Compare the following four options:

A: $100K mortgage, $280K stocks, $220K bonds
B: No mortgage, $280K stocks, $120K bonds
C: $100K mortgage, $350K stocks, $150K bonds
D: No mortgage, $350K stocks, $50K bonds

Do you prefer C or D? They have the same risk; you will lose $175K either way if the stock market crashes, which will have the same effect on your standard of living in retirement. Thus, you should prefer D over C if the bonds in C are better than the mortgage prepayment in D.
Do you prefer A or B? Again, they have the same risk, so you should prefer B over A if the bonds are better than the mortgage prepayment.

So if you prefer B over A, and D over C, then you should prepay your mortgage, and choose either B or D. If you are risk-tolerant enough that you prefer C over B (which is perfectly reasonable), then D is better than either.
This analysis assumes that bonds rates and my mortgage rate remain static. But they don't. My mortgage rate is static. Bond rates move. And, based on the history of the bond market, they are now low.
Bond rates change, but that isn't relevant to this analysis. If you have a bond portfolio, you don't get the benefit of the rising rates; your bond prices fall as the yields rise.

The natural comparison is a bond portfolio which makes bond payments equal to your mortgage payments every year for the rest of your mortgage. If rates rise, your bonds lose market value, but they still make the mortgage payments. And your mortgage also loses market value, which is a net gain for you; you have to make future mortgage payments with dollars which will be easier to get from your investments. So you could buy Portfolio A with the extra bonds exactly matching your mortgage payments, and be guaranteed to outperform Portfolio B if those bonds cost less than $100K (yield above the mortgage rate) or underperform if they cost more.

You might not buy exactly this bond portfolio, but it gives a fair comparison. If you have 11 years left on your mortgage, an 11-year bond ladder would exactly match it. If you aren't interested in buying a ladder, a very similar investment would be a bond fund with the same interest-rate risk, such as a bond fund with a five-year duration. This is the comparison I use; I have 11 years left on my mortgage, and the fund I use for comparison is Vanguard Intermediate-Term Tax-Exempt. (My bonds are in my retirement account, but I still use this fund for a fair comparison. If I pay off my mortgage, I will sell taxable stock, and move an equal amount from bonds to stock in my retirement account, so that I keep the same risk.)

In fact, the non-static rates slightly favor keeping the mortgage, but for an entirely different reason. If rates fall, you can refinance your mortgage, while the lender who issued your bonds cannot refinance the bonds (unless they are callable). Therefore, if your bond portfolio has the same yield as your mortgage, and the same duration, you break even if rates rise, and gain if rates fall by enough to be worth refinancing. If your mortgage is already lower than the current market rate (usually the situation now, particularly if you paid points to lower your initial rate), this is not worth much.
As usual, Grabiner, I don't think I'm smart enough to understand the nuances of your response. But as I see it, for this discussion you have two options with an extra $1000 per month:

You can pay down a mortgage, earning the fixed mortgage rate pf return; or
You can invest the money in an investment with a varying rate

Let's say that you want to invest the money in bonds, so we have apples-to-apples risk premiums.

Because we're comparing a fixed rate with an investment rate that varies, I need do nothing except continue to pay my mortgage, sit on my money at a low-yield CD or bank account, and wait until bond rates rise above my mortgage rate. If I pre-pay, I cannot invest that money later.

At that point, I can buy bonds. Now, of course bonds rates can also fall, which would affect bonds that I already hold. But bond yields are very low right now, not very high. If I have a sub 3% mortgage rate, the chances of rates falling far enough below my rate to make refinancing worthwhile are also low.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by Atgard » Sat Jan 13, 2018 3:07 pm

willthrill81 wrote:
Thu Jan 11, 2018 9:12 pm
It's interesting how rare it is to hear of anyone financing a new car purchase at a promo 0-2% rate in order to invest the money instead. Or using promotional credit card checks with a 3% fee and 0% interest for 12-18 months to invest. The specifics are obviously different (e.g. the interest, if any, cannot be deducted from one's taxes), but the principle is the same.
Are those locked-in 30-year loans at those rates, like mortgages can be?

Also, while someone saying "I'm gonna finance a car (that I can't afford in cash), then invest whatever money I save into stocks and hope to be able to make payments over the next 5 years" would be frowned upon... someone saying "I could buy this car in cash, but at 0%, I'll just keep the funds invested according to my asset allocation and pull them out if needed to make payments" would not be frowned upon. In fact, it's probably a good idea since the expected return of any investment portfolio is greater than 0%.

I'm just saying it can be rational to hold low-rate debt. If anyone wants to give me a loan at 0%, I will take it. I can stick it in a savings account or CD and come out ahead, let alone invest it according to my AA. And if you want to give me a 30-year loan at 0%, I will happily invest it in stocks and pay back your principal in 30 years and keep any gains. I will come out ahead 99+% of the time, odds don't get much better than that.

How about student loans at 2%? I am not going to pay those off early either.

How about a mortgage at 3–4%? That's getting a little tougher, but there's still a good argument to be made for keeping the liquidity and investing the difference, expecting a positive return net of interest over a 30-year timeframe. (And a good argument can be made for the reverse.)

Any debt at 10%+? Heck no. Pay off ASAP.

Of course the exact inflection point of interest rate / duration for each person may be different depending on risk tolerance, total assets, age, etc., and that's fine.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by willthrill81 » Sat Jan 13, 2018 3:12 pm

Atgard wrote:
Sat Jan 13, 2018 3:07 pm
willthrill81 wrote:
Thu Jan 11, 2018 9:12 pm
It's interesting how rare it is to hear of anyone financing a new car purchase at a promo 0-2% rate in order to invest the money instead. Or using promotional credit card checks with a 3% fee and 0% interest for 12-18 months to invest. The specifics are obviously different (e.g. the interest, if any, cannot be deducted from one's taxes), but the principle is the same.
Are those locked-in 30-year loans at those rates, like mortgages can be?
Obviously not. But the principle , creating/maintaining debt in order to invest instead, is the same. It's all leverage.

I'm not saying that it's never the 'correct' move to make, but a lot of it comes down to the individual investor. Blanket statements to either side of the debate are not appropriate.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Sat Jan 13, 2018 5:24 pm

Admiral wrote:
Sat Jan 13, 2018 12:36 pm
As usual, Grabiner, I don't think I'm smart enough to understand the nuances of your response. But as I see it, for this discussion you have two options with an extra $1000 per month:

You can pay down a mortgage, earning the fixed mortgage rate pf return; or
You can invest the money in an investment with a varying rate

Let's say that you want to invest the money in bonds, so we have apples-to-apples risk premiums.
If you buy a bond, its return will vary over time, but over its full term, the rate of return is fixed.

Suppose you have 10 years left on your 3% mortgage. If you pay $1000 against your mortgage, you are guaranteed to have $1344 more in ten years, as you eliminate your last mortgage payment. If you buy a 10-year bond yielding 3%, you are also guaranteed to have $1344 more in ten years. This is break-even; the bond might be worth more or less than the principal along the way, but it will be equal when it matters.

Similarly, if you have enough money to pay off the whole 3% mortgage, you could instead buy a bond portfolio of bonds maturing in the next ten years. If those bonds have an average yield of 3%, you are guaranteed to have enough money to make every mortgage payments. This is less likely to be advantageous, because your bond portfolio has a duration of only five years.

In the break-even situation, the reason it is better to invest is that you retain the option to either refinance or pay off the mortgage later. If you don't refinance because rates don't fall, you will break even.
Because we're comparing a fixed rate with an investment rate that varies, I need do nothing except continue to pay my mortgage, sit on my money at a low-yield CD or bank account, and wait until bond rates rise above my mortgage rate.
A CD is equivalent to a bond. Unlike a bond, it doesn't quote a changing price, but you can't get the face value of the CD until it matures. (It may be a good investment; short-term CDs often yield more than short-term bonds.) Given the interest-rate risk, it may be a good deal to invest in CDs earning less than your mortgage rate; for example, if the average rate on two-year CDs and eight-year bonds is more than the rate on five-year bonds, you can buy two-year CDs and eight-year bonds to get a better return with a five-year duration.
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Re: Why Buy Bonds If You Have A Mortgage?

Post by zeugmite » Sat Jan 13, 2018 5:31 pm

If you are leveraged, shouldn't you hold more bonds? Sure, if you are purchasing new bonds with cash, that cash can equivalently be directed to paying down the mortgage, both are acts of deleveraging. But as a static portfolio question, you should have more bonds in the AA when you have negative bonds in a mortgage. As a practical matter, most will never be able to construct the desired AA when starting out with a large mortgage, it will be effectively a portfolio of >100% equities + real estate.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Sat Jan 13, 2018 8:00 pm

vitaflo wrote:
Sat Jan 13, 2018 12:20 pm
KlangFool wrote:
Thu Jan 11, 2018 11:05 pm
1) Let's assume that we are not 100% stock and have a reasonable portfolio like 60/40.

2) Are you willing to bet that a 60/40 portfolio will beat 5% for most years?

A) Yes, do not pre-pay the mortgage.

B) No, pre-pay the mortgage.

And, if you choose (A) and it does not work out, you take your loses and pre-pay the mortgage.

KlangFool
Or if you choose B) take your gains and pre-pay it. That's what I'm doing. I took out my mortgage 6+ years ago for $330k. My CAGR over that time has been 10%+. That's given me a return of over $280k on that $330k. My current mortgage balance is much less than that.

I took my risk and it (thankfully) paid off. It's time to take that risk off the table and pay off the mortgage.
vitaflo,

Please note that I am not against paying off the whole mortgage. I am against pre-paying a portion of the mortgage.

KlangFool

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Re: Why Buy Bonds If You Have A Mortgage?

Post by inbox788 » Sat Jan 13, 2018 9:08 pm

KlangFool wrote:
Sat Jan 13, 2018 8:00 pm
vitaflo wrote:
Sat Jan 13, 2018 12:20 pm
KlangFool wrote:
Thu Jan 11, 2018 11:05 pm
1) Let's assume that we are not 100% stock and have a reasonable portfolio like 60/40.

2) Are you willing to bet that a 60/40 portfolio will beat 5% for most years?

A) Yes, do not pre-pay the mortgage.

B) No, pre-pay the mortgage.

And, if you choose (A) and it does not work out, you take your loses and pre-pay the mortgage.

KlangFool
Or if you choose B) take your gains and pre-pay it. That's what I'm doing. I took out my mortgage 6+ years ago for $330k. My CAGR over that time has been 10%+. That's given me a return of over $280k on that $330k. My current mortgage balance is much less than that.

I took my risk and it (thankfully) paid off. It's time to take that risk off the table and pay off the mortgage.
vitaflo,

Please note that I am not against paying off the whole mortgage. I am against pre-paying a portion of the mortgage.

KlangFool
I'm not sure I follow the logic. It's good to pay off the whole mortgage, but not part of it? And it's also better to not pay of any additional mortgage than some of it? Isn't there a point of equivalence where it doesn't matter what you do? And it's often where right there or near there that the error in estimation are bigger than the differences, which means splitting the baby isn't a bad thing to do.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Sat Jan 13, 2018 9:45 pm

inbox788 wrote:
Sat Jan 13, 2018 9:08 pm
KlangFool wrote:
Sat Jan 13, 2018 8:00 pm
vitaflo wrote:
Sat Jan 13, 2018 12:20 pm
KlangFool wrote:
Thu Jan 11, 2018 11:05 pm
1) Let's assume that we are not 100% stock and have a reasonable portfolio like 60/40.

2) Are you willing to bet that a 60/40 portfolio will beat 5% for most years?

A) Yes, do not pre-pay the mortgage.

B) No, pre-pay the mortgage.

And, if you choose (A) and it does not work out, you take your loses and pre-pay the mortgage.

KlangFool
Or if you choose B) take your gains and pre-pay it. That's what I'm doing. I took out my mortgage 6+ years ago for $330k. My CAGR over that time has been 10%+. That's given me a return of over $280k on that $330k. My current mortgage balance is much less than that.

I took my risk and it (thankfully) paid off. It's time to take that risk off the table and pay off the mortgage.
vitaflo,

Please note that I am not against paying off the whole mortgage. I am against pre-paying a portion of the mortgage.

KlangFool
I'm not sure I follow the logic. It's good to pay off the whole mortgage, but not part of it? And it's also better to not pay of any additional mortgage than some of it? Isn't there a point of equivalence where it doesn't matter what you do? And it's often where right there or near there that the error in estimation are bigger than the differences, which means splitting the baby isn't a bad thing to do.
inbox788,

1) If you pay off the whole mortgage, you no longer need to pay your mortgage. You improve your monthly cash flow.

2) If you pre-pay a portion of your mortgage, you still need to pay the same amount of mortgage every month. Hence, you do not improve your monthly cash flow. Furthermore, you tied up more of money into the house. Aka, an illiquid asset.

KlangFool

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Re: Why Buy Bonds If You Have A Mortgage?

Post by mffl » 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%. :)

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Re: Why Buy Bonds If You Have A Mortgage?

Post by inbox788 » Sat Jan 13, 2018 11:27 pm

KlangFool wrote:
Sat Jan 13, 2018 9:45 pm
1) If you pay off the whole mortgage, you no longer need to pay your mortgage. You improve your monthly cash flow.

2) If you pre-pay a portion of your mortgage, you still need to pay the same amount of mortgage every month. Hence, you do not improve your monthly cash flow. Furthermore, you tied up more of money into the house. Aka, an illiquid asset.

KlangFool
Thanks for the clarification, even though I may not agree with it. I am all for simplification, so if you can pay off the mortgage and the financial benefit is equivocal for keeping it, then by all means pay off the mortgage.

Illiquid or not, I consider paying off mortgage equivalent to buying bonds. As long as I have sufficient liquidity, I don't consider tying up some more liquidity into home equity a negative. I don't mind paying off part of the mortgage if paying all of it would cause liquidity problems. And I would consider altering my AA for new contributions to compensate for the mortgage amount paid off, so if I was 60/40, I might buy equities with the 60 and pay down mortgage with the 40 instead of buying all equities (changing my AA) or 40 in bonds (with worse expected yield).

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Sun Jan 14, 2018 12:28 am

KlangFool wrote:
Sat Jan 13, 2018 9:45 pm
1) If you pay off the whole mortgage, you no longer need to pay your mortgage. You improve your monthly cash flow.

2) If you pre-pay a portion of your mortgage, you still need to pay the same amount of mortgage every month. Hence, you do not improve your monthly cash flow. Furthermore, you tied up more of money into the house. Aka, an illiquid asset.
Another disadvantage of a partial prepayment is that it has a longer duration. If you pay off a 10-year mortgage, that is equivalent to buying a bond portfolio with a 5-year duration, since you get the benefit every year for the next ten years. If you pay it down so that it is paid off in 8 years, that is equivalent to buying a bond portfolio with a 9-year duration. Therefore, even if you don't have liquidity or cash flow issues, if your mortgage rate is equal to the rate on a 7-year bond, it is not worth paying down, but is worth paying off if you can do so.
Wiki David Grabiner

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Sun Jan 14, 2018 9:43 am

inbox788 wrote:
Sat Jan 13, 2018 11:27 pm
KlangFool wrote:
Sat Jan 13, 2018 9:45 pm
1) If you pay off the whole mortgage, you no longer need to pay your mortgage. You improve your monthly cash flow.

2) If you pre-pay a portion of your mortgage, you still need to pay the same amount of mortgage every month. Hence, you do not improve your monthly cash flow. Furthermore, you tied up more of money into the house. Aka, an illiquid asset.

KlangFool
Thanks for the clarification, even though I may not agree with it. I am all for simplification, so if you can pay off the mortgage and the financial benefit is equivocal for keeping it, then by all means pay off the mortgage.

Illiquid or not, I consider paying off mortgage equivalent to buying bonds. As long as I have sufficient liquidity, I don't consider tying up some more liquidity into home equity a negative. I don't mind paying off part of the mortgage if paying all of it would cause liquidity problems. And I would consider altering my AA for new contributions to compensate for the mortgage amount paid off, so if I was 60/40, I might buy equities with the 60 and pay down mortgage with the 40 instead of buying all equities (changing my AA) or 40 in bonds (with worse expected yield).
inbox788,

<< Illiquid or not, I consider paying off mortgage equivalent to buying bonds. As long as I have sufficient liquidity, I don't consider tying up some more liquidity into home equity a negative.>>

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

The mortgage plus property tax is around 20K per year. Even if I pay off the mortgage, I still have to pay around 4K per year. IMHO, (A) is safer than (B). (B) tied up too much of my net worth with the house.

KlangFool

P.S.: I have about 100K of home equity with the house.
Last edited by KlangFool on Sun Jan 14, 2018 9:47 am, edited 1 time in total.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by Admiral » Sun Jan 14, 2018 9:45 am

grabiner wrote:
Sat Jan 13, 2018 5:24 pm
Admiral wrote:
Sat Jan 13, 2018 12:36 pm
As usual, Grabiner, I don't think I'm smart enough to understand the nuances of your response. But as I see it, for this discussion you have two options with an extra $1000 per month:

You can pay down a mortgage, earning the fixed mortgage rate pf return; or
You can invest the money in an investment with a varying rate

Let's say that you want to invest the money in bonds, so we have apples-to-apples risk premiums.
If you buy a bond, its return will vary over time, but over its full term, the rate of return is fixed.

Suppose you have 10 years left on your 3% mortgage. If you pay $1000 against your mortgage, you are guaranteed to have $1344 more in ten years, as you eliminate your last mortgage payment. If you buy a 10-year bond yielding 3%, you are also guaranteed to have $1344 more in ten years. This is break-even; the bond might be worth more or less than the principal along the way, but it will be equal when it matters.

Similarly, if you have enough money to pay off the whole 3% mortgage, you could instead buy a bond portfolio of bonds maturing in the next ten years. If those bonds have an average yield of 3%, you are guaranteed to have enough money to make every mortgage payments. This is less likely to be advantageous, because your bond portfolio has a duration of only five years.
Again, you are looking at a static snapshot in time and comparing rates at that time. This is not the strategy that I described. What I described is more flexible: instead of putting your $1,000 into your 3.0% mortgage and getting that return, you can simply hold the money (even putting it in your mattress) and wait until bond (or CD rates) rise above 3%. This is not my strategy, since I accept the risk that a mixed portfolio will beat my 3.0%. But it is a strategy that argues against pre-paying a low rate mortgage.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by vitaflo » Sun Jan 14, 2018 11:38 am

KlangFool wrote:
Sun Jan 14, 2018 9:43 am
inbox788 wrote:
Sat Jan 13, 2018 11:27 pm
KlangFool wrote:
Sat Jan 13, 2018 9:45 pm
1) If you pay off the whole mortgage, you no longer need to pay your mortgage. You improve your monthly cash flow.

2) If you pre-pay a portion of your mortgage, you still need to pay the same amount of mortgage every month. Hence, you do not improve your monthly cash flow. Furthermore, you tied up more of money into the house. Aka, an illiquid asset.

KlangFool
Thanks for the clarification, even though I may not agree with it. I am all for simplification, so if you can pay off the mortgage and the financial benefit is equivocal for keeping it, then by all means pay off the mortgage.

Illiquid or not, I consider paying off mortgage equivalent to buying bonds. As long as I have sufficient liquidity, I don't consider tying up some more liquidity into home equity a negative. I don't mind paying off part of the mortgage if paying all of it would cause liquidity problems. And I would consider altering my AA for new contributions to compensate for the mortgage amount paid off, so if I was 60/40, I might buy equities with the 60 and pay down mortgage with the 40 instead of buying all equities (changing my AA) or 40 in bonds (with worse expected yield).
inbox788,

<< Illiquid or not, I consider paying off mortgage equivalent to buying bonds. As long as I have sufficient liquidity, I don't consider tying up some more liquidity into home equity a negative.>>

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

The mortgage plus property tax is around 20K per year. Even if I pay off the mortgage, I still have to pay around 4K per year. IMHO, (A) is safer than (B). (B) tied up too much of my net worth with the house.

KlangFool

P.S.: I have about 100K of home equity with the house.
25% of net worth in home equity is too much? I find this to be a little silly, especially if you have ample liquidity. What happens when you lose your job and still have to find $20k per year to pay your mortgage? If "pull it from your portfolio" is the answer, what happens if your job loss was due to a major recession and that $1.2 million you had is now $600k?

I'm not worried about average percentages over long periods of time, I'm worried about bad situations happening in tandem and could cause me to lose my house.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by grabiner » Sun Jan 14, 2018 12:47 pm

vitaflo wrote:
Sun Jan 14, 2018 11:38 am
25% of net worth in home equity is too much? I find this to be a little silly, especially if you have ample liquidity. What happens when you lose your job and still have to find $20k per year to pay your mortgage? If "pull it from your portfolio" is the answer, what happens if your job loss was due to a major recession and that $1.2 million you had is now $600k?

I'm not worried about average percentages over long periods of time, I'm worried about bad situations happening in tandem and could cause me to lose my house.
That's why you compare mortgage rates to bond rates in deciding whether it is worth paying down the mortgage. If you have a $200K mortgage and $200K in low-risk bonds, the bonds can make the mortgage payments, and these bonds won't be affected by a stock-market decline or job loss, so you don't have any extra risk. If you pay down half your mortgage with half those bonds (say, because the other half are in an IRA where you want to keep the tax-deferred growth), you still have bonds to make the remaining mortgage payments.
Wiki David Grabiner

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Re: Why Buy Bonds If You Have A Mortgage?

Post by inbox788 » Sun Jan 14, 2018 12:58 pm

KlangFool wrote:
Sun Jan 14, 2018 9:43 am
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

The mortgage plus property tax is around 20K per year. Even if I pay off the mortgage, I still have to pay around 4K per year. IMHO, (A) is safer than (B). (B) tied up too much of my net worth with the house.
I'm NOT arguing that a 3.5% mortgage will return more than a 7% investment, but paying down a 3.5% mortgage is better than buying a 3% bond if liquidity isn't a concern. I don't agree that A) and B) are the same thing or that you're simply buying bonds with mortgage money. Some of that mortgage money went towards equities and you've changed the true AA.

For simplicity, assume the 7% return from 60/40 portfolio was the result of 3% bond returns, which would require equity returns to be 9.67% to average out to 7% overall. You can use your own numbers or assumptions and see if you reach similar conclusions.

Do you consider a mortgage a negative bond? Look at A) and break down 1.2M 60/40, you have 720k equities/480k bonds. If you subtract out the 300k mortgage, you don't really have a 60/40 portfolio, but a 720k/180k, which is a 900k 80/20 portfolio!

I'm not sure what is meant by safer, but if the market crashes 50%, the higher equity portfolio will suffer more. If you subtract out what's common between the two examples, the equal part is B) and what remains in A) is $300k in 60/40 and $300k mortgage vs. B) $0, so A) is basically borrowing $300k money to invest in the market (all else being equal). I would agree that this is likely to be profitable (borrowing at 3.49% and getting 9.67 or 7% returns), but I wouldn't describe it as safer.

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.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Sun Jan 14, 2018 4:53 pm

vitaflo wrote:
Sun Jan 14, 2018 11:38 am
KlangFool wrote:
Sun Jan 14, 2018 9:43 am
inbox788 wrote:
Sat Jan 13, 2018 11:27 pm
KlangFool wrote:
Sat Jan 13, 2018 9:45 pm
1) If you pay off the whole mortgage, you no longer need to pay your mortgage. You improve your monthly cash flow.

2) If you pre-pay a portion of your mortgage, you still need to pay the same amount of mortgage every month. Hence, you do not improve your monthly cash flow. Furthermore, you tied up more of money into the house. Aka, an illiquid asset.

KlangFool
Thanks for the clarification, even though I may not agree with it. I am all for simplification, so if you can pay off the mortgage and the financial benefit is equivocal for keeping it, then by all means pay off the mortgage.

Illiquid or not, I consider paying off mortgage equivalent to buying bonds. As long as I have sufficient liquidity, I don't consider tying up some more liquidity into home equity a negative. I don't mind paying off part of the mortgage if paying all of it would cause liquidity problems. And I would consider altering my AA for new contributions to compensate for the mortgage amount paid off, so if I was 60/40, I might buy equities with the 60 and pay down mortgage with the 40 instead of buying all equities (changing my AA) or 40 in bonds (with worse expected yield).
inbox788,

<< Illiquid or not, I consider paying off mortgage equivalent to buying bonds. As long as I have sufficient liquidity, I don't consider tying up some more liquidity into home equity a negative.>>

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

The mortgage plus property tax is around 20K per year. Even if I pay off the mortgage, I still have to pay around 4K per year. IMHO, (A) is safer than (B). (B) tied up too much of my net worth with the house.

KlangFool

P.S.: I have about 100K of home equity with the house.
25% of net worth in home equity is too much? I find this to be a little silly, especially if you have ample liquidity. What happens when you lose your job and still have to find $20k per year to pay your mortgage? If "pull it from your portfolio" is the answer, what happens if your job loss was due to a major recession and that $1.2 million you had is now $600k?

I'm not worried about average percentages over long periods of time, I'm worried about bad situations happening in tandem and could cause me to lose my house.
vitaflo,

It is a 60/40 portfolio. So, in a major recession, the stock drop 50% and the bond stays the same. So, the 1.2 million portfolio goes downs to 840K and 900K goes down to 630K.

A) Before the recession, 1.2 million with the 300K mortgage. After recession, 840K with 300K mortgage

The annual expense = 60K per year. I could last 840K/60K = 14 years.

B) Before the recession, 900K with a payoff house. After the recession, 630K.

The annual expense = 44K per year. I could last 630/44K = 14 years.

<< I'm worried about bad situations happening in tandem and could cause me to lose my house.>>

Please tell me why (B) is better. In both cases, I will only last 14 years. (B) does not make any difference.

KlangFool
Last edited by KlangFool on Sun Jan 14, 2018 5:01 pm, edited 1 time in total.

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Re: Why Buy Bonds If You Have A Mortgage?

Post by KlangFool » Sun Jan 14, 2018 4:59 pm

inbox788 wrote:
Sun Jan 14, 2018 12:58 pm
KlangFool wrote:
Sun Jan 14, 2018 9:43 am
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

The mortgage plus property tax is around 20K per year. Even if I pay off the mortgage, I still have to pay around 4K per year. IMHO, (A) is safer than (B). (B) tied up too much of my net worth with the house.
I'm NOT arguing that a 3.5% mortgage will return more than a 7% investment, but paying down a 3.5% mortgage is better than buying a 3% bond if liquidity isn't a concern. I don't agree that A) and B) are the same thing or that you're simply buying bonds with mortgage money. Some of that mortgage money went towards equities and you've changed the true AA.

For simplicity, assume the 7% return from 60/40 portfolio was the result of 3% bond returns, which would require equity returns to be 9.67% to average out to 7% overall. You can use your own numbers or assumptions and see if you reach similar conclusions.

Do you consider a mortgage a negative bond? Look at A) and break down 1.2M 60/40, you have 720k equities/480k bonds. If you subtract out the 300k mortgage, you don't really have a 60/40 portfolio, but a 720k/180k, which is a 900k 80/20 portfolio!
inbox788,

<<Do you consider a mortgage a negative bond?>>

I don't.

<<Look at A) and break down 1.2M 60/40, you have 720k equities/480k bonds. If you subtract out the 300k mortgage, you don't really have a 60/40 portfolio, but a 720k/180k, which is a 900k 80/20 portfolio! >>

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.

KlangFool

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Re: Why Buy Bonds If You Have A Mortgage?

Post by pezblanco » Sun Jan 14, 2018 5:33 pm

grabiner wrote:
Sun Jan 14, 2018 12:28 am
KlangFool wrote:
Sat Jan 13, 2018 9:45 pm
1) If you pay off the whole mortgage, you no longer need to pay your mortgage. You improve your monthly cash flow.

2) If you pre-pay a portion of your mortgage, you still need to pay the same amount of mortgage every month. Hence, you do not improve your monthly cash flow. Furthermore, you tied up more of money into the house. Aka, an illiquid asset.
Another disadvantage of a partial prepayment is that it has a longer duration. If you pay off a 10-year mortgage, that is equivalent to buying a bond portfolio with a 5-year duration, since you get the benefit every year for the next ten years. If you pay it down so that it is paid off in 8 years, that is equivalent to buying a bond portfolio with a 9-year duration. Therefore, even if you don't have liquidity or cash flow issues, if your mortgage rate is equal to the rate on a 7-year bond, it is not worth paying down, but is worth paying off if you can do so.
Grabiner, would you explain your duration calculations? Is this the Macaulay Duration you're computing?

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Re: Why Buy Bonds If You Have A Mortgage?

Post by inbox788 » 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.

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

Post by grabiner » Sun Jan 14, 2018 7:01 pm

pezblanco wrote:
Sun Jan 14, 2018 5:33 pm
grabiner wrote:
Sun Jan 14, 2018 12:28 am
KlangFool wrote:
Sat Jan 13, 2018 9:45 pm
1) If you pay off the whole mortgage, you no longer need to pay your mortgage. You improve your monthly cash flow.

2) If you pre-pay a portion of your mortgage, you still need to pay the same amount of mortgage every month. Hence, you do not improve your monthly cash flow. Furthermore, you tied up more of money into the house. Aka, an illiquid asset.
Another disadvantage of a partial prepayment is that it has a longer duration. If you pay off a 10-year mortgage, that is equivalent to buying a bond portfolio with a 5-year duration, since you get the benefit every year for the next ten years. If you pay it down so that it is paid off in 8 years, that is equivalent to buying a bond portfolio with a 9-year duration. Therefore, even if you don't have liquidity or cash flow issues, if your mortgage rate is equal to the rate on a 7-year bond, it is not worth paying down, but is worth paying off if you can do so.
Grabiner, would you explain your duration calculations? Is this the Macaulay Duration you're computing?
This is Macaulay duration, but it is very close to modified duration, particularly at these low rates. A 10-year zero-coupon bond has a Macaulay duration of 10 years by definition. A prepayment which eliminates the last payment on a 10-year mortgage also has a Macaulay duration of 10 years, since it gives you a fixed number of dollars 10 years from now.

If you pay down your 10-year mortgage so that it is paid off in 8 years, you have effectively bought 24 bonds, maturing in 97-120 months, each eliminating one payment. This portfolio has a duration of 9 years.

If you pay off your 10-year mortgage, you have effectively bought 120 bonds, maturing in 1-120 months. The duration is a bit less than 5 years, because the shorter-term "bonds" are more expensive; at 3% interest, it costs you $998 to eliminate a $1000 payment next month, and $744 to eliminate a $1000 payment ten years from now.
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pezblanco
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Re: Why Buy Bonds If You Have A Mortgage?

Post by pezblanco » Sun Jan 14, 2018 7:19 pm

grabiner wrote:
Sun Jan 14, 2018 7:01 pm

This is Macaulay duration, but it is very close to modified duration, particularly at these low rates. A 10-year zero-coupon bond has a Macaulay duration of 10 years by definition. A prepayment which eliminates the last payment on a 10-year mortgage also has a Macaulay duration of 10 years, since it gives you a fixed number of dollars 10 years from now.

If you pay down your 10-year mortgage so that it is paid off in 8 years, you have effectively bought 24 bonds, maturing in 97-120 months, each eliminating one payment. This portfolio has a duration of 9 years.

If you pay off your 10-year mortgage, you have effectively bought 120 bonds, maturing in 1-120 months. The duration is a bit less than 5 years, because the shorter-term "bonds" are more expensive; at 3% interest, it costs you $998 to eliminate a $1000 payment next month, and $744 to eliminate a $1000 payment ten years from now.
Awesome. Got it! I never thought of it that way ... that we are buying zero coupon bonds ... I kept on trying to think of the retired interest payments as coupons .... totally incorrect way to view it.

Thank you very much!

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

Post by KlangFool » 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.
inbox788,

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?

KlangFool

cb474
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Re: Why Buy Bonds If You Have A Mortgage?

Post by cb474 » 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.

inbox788
Posts: 5264
Joined: Thu Mar 15, 2012 5:24 pm

Re: Why Buy Bonds If You Have A Mortgage?

Post by inbox788 » 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.

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