Mortgage as a "reverse bond" in Allocation Planning

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eurowizard
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Mortgage as a "reverse bond" in Allocation Planning

Post by eurowizard » Thu Dec 24, 2009 3:35 pm

There's a concept I recall reading a few people mention on here that I never quite understood. Perhaps someone can explain the logic to me? Even if it's flawed logic, I am curious what people follow it are thinking.

Some people said they considered their mortgages to be like reverse bonds. So that in their portfolio they have to have either more or less bonds than normal when they include their mortgage. I am not sure which.

This would assume that one considers their home to be an investment, which in my opinion is flawed logic on its own.

So if one considers it a negative bond, does that then mean that the mortgage counteracts such bond holdings, such that the portfolio winds up being artificially lower in equity? Or does it mean the opposite whereby they are counting the mortgage as a bond and making the portfolio higher in equity?


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Re: Mortgage as a "reverse bond" in Allocation Pla

Post by YDNAL » Thu Dec 24, 2009 4:01 pm

There's a concept I recall reading a few people mention on here that I never quite understood. Perhaps someone can explain the logic to me? Even if it's flawed logic, I am curious what people follow it are thinking.

Some people said they considered their mortgages to be like reverse bonds. So that in their portfolio they have to have either more or less bonds than normal when they include their mortgage. I am not sure which.
A mortgage note on real estate is a liability incurred to acquire an asset -- with its own FAIR market value (FMV). Count the liability... also include the asset.

Single-entry accounting doesn't work and you shouldn't prescribe to a hypothesis simply because it is written on a Wiki.
Bogleheads Wiki wrote:Purchasing a house with a mortgage represents both an asset and a liability. However, the two parts of the transaction interact with your portfolio in different and subtle ways.

As a liability, a mortgage is a negative bond. If you have 300 K in bond funds (loaning money), and a $300 K mortgage (borrowing money), you do not have any net allocation to bonds. The effect of the negative bonds (the mortgage) is to put you in a riskier asset allocation than you might otherwise choose to the extent that you choose to ignore the corresponding fair market value (FMV) a the asset -- regardless of immediate liquidity constraints (see below).

Now, let's consider the asset side of the ledger. There are two (THREE) financial aspects of owning a home, and neither (TWO) of them are at all like a real ("positive") bond. The first is the appreciation or depreciation of the property and housing stock, which is a very illiquid, undiversified form of equity. The second is implicit rent, which "is the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market". The implicit rent is only like a bond in that you can think of it paying a coupon, but that "coupon" is a housing voucher good for a month's implicit rent at a single address. The third is the value of the asset. Real Estate is illiquid until priced for sale at fair market value and subsequently sold (timeframe varies).
(my corrections in blue)
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Post by freebeer » Thu Dec 24, 2009 6:05 pm

Mortgages (fixed rate) hedge against inflation (since they leverage up the underlying real estate asset); bonds (other than TIPS) are subject to inflation risk.

The special twist is that mortgages can be considered to provide a free put option (at least in states where they are non-recourse), at the cost of a ruined credit rating.

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Post by freebeer » Thu Dec 24, 2009 6:05 pm

Mortgages (fixed rate) hedge against inflation (since they leverage up the underlying real estate asset); bonds (other than TIPS) are subject to inflation risk.

The special twist is that mortgages can be considered to provide a free put option (at least in states where they are non-recourse), at the cost of a ruined credit rating.

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Post by qatman » Thu Dec 24, 2009 6:33 pm

A mortgage is a liability (negative bond is one way to consider it), and a house is an asset (mixture of land - non-depreciating and building - depreciating). In my accounting, each item is treated as such, and consequently our net cash+bond position is negative (since our total cash+bonds are less than the outstanding mortgage).

Because of this, we sold all stock positions once we acquired the mortgage debt and will not resume stock investing until the net cash/bond position is positive. Then we will shoot for 50/50 stocks/bonds considering all investments. The house is not an investment but rather a depreciating asset.

Discussions from this board several years ago helped me to think this through; unfortunately I can't find the link I am remembering, but the logic was clear. I want to say that Larry Swedroe commented on it.

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Re: Mortgage as a "reverse bond" in Allocation Pla

Post by Rodc » Thu Dec 24, 2009 6:48 pm

YDNAL wrote:
There's a concept I recall reading a few people mention on here that I never quite understood. Perhaps someone can explain the logic to me? Even if it's flawed logic, I am curious what people follow it are thinking.

Some people said they considered their mortgages to be like reverse bonds. So that in their portfolio they have to have either more or less bonds than normal when they include their mortgage. I am not sure which.
A mortgage note on real estate is a liability incurred to acquire an asset -- with its own FAIR market value (FMV). Count the liability... also include the asset.

Single-entry accounting doesn't work and you shouldn't prescribe to a hypothesis simply because it is written on a Wiki.
Bogleheads Wiki wrote:Purchasing a house with a mortgage represents both an asset and a liability. However, the two parts of the transaction interact with your portfolio in different and subtle ways.

As a liability, a mortgage is a negative bond. If you have 300 K in bond funds (loaning money), and a $300 K mortgage (borrowing money), you do not have any net allocation to bonds. The effect of the negative bonds (the mortgage) is to put you in a riskier asset allocation than you might otherwise choose to the extent that you choose to ignore the corresponding fair market value (FMV) a the asset -- regardless of immediate liquidity constraints (see below).

Now, let's consider the asset side of the ledger. There are two (THREE) financial aspects of owning a home, and neither (TWO) of them are at all like a real ("positive") bond. The first is the appreciation or depreciation of the property and housing stock, which is a very illiquid, undiversified form of equity. The second is implicit rent, which "is the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market". The implicit rent is only like a bond in that you can think of it paying a coupon, but that "coupon" is a housing voucher good for a month's implicit rent at a single address. The third is the value of the asset. Real Estate is illiquid until priced for sale at fair market value and subsequently sold (timeframe varies).
(my corrections in blue)
I agree with those corrections.
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Re: Mortgage as a "reverse bond" in Allocation Pla

Post by LadyGeek » Thu Dec 24, 2009 6:57 pm

YDNAL wrote:
Single-entry accounting doesn't work and you shouldn't prescribe to a hypothesis simply because it is written on a Wiki.
Bogleheads Wiki wrote:Purchasing a house with a mortgage represents both an asset and a liability. However, the two parts of the transaction interact with your portfolio in different and subtle ways.

As a liability, a mortgage is a negative bond. If you have 300 K in bond funds (loaning money), and a $300 K mortgage (borrowing money), you do not have any net allocation to bonds. The effect of the negative bonds (the mortgage) is to put you in a riskier asset allocation than you might otherwise choose to the extent that you choose to ignore the corresponding fair market value (FMV) a the asset -- regardless of immediate liquidity constraints (see below).

Now, let's consider the asset side of the ledger. There are two (THREE) financial aspects of owning a home, and neither (TWO) of them are at all like a real ("positive") bond. The first is the appreciation or depreciation of the property and housing stock, which is a very illiquid, undiversified form of equity. The second is implicit rent, which "is the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market". The implicit rent is only like a bond in that you can think of it paying a coupon, but that "coupon" is a housing voucher good for a month's implicit rent at a single address. The third is the value of the asset. Real Estate is illiquid until priced for sale at fair market value and subsequently sold (timeframe varies).
(my corrections in blue)
I was going to update that page, as it's controversial. The quality of the wiki depends on contributions from the forum. I just updated the wiki with your correction. I was also going to do an update to remove the controversy (refer to the link at the top of the page).
Bogleheads Wiki wrote:As a liability, a mortgage is a negative bond. If you have 300 K in bond funds (loaning money), and a $300 K mortgage (borrowing money), you do not have any net allocation to bonds. The effect of the negative bonds (the mortgage) is to put you in a riskier asset allocation than you might otherwise choose to the extent that you choose to ignore the corresponding fair market value (FMV) as the asset -- regardless of immediate liquidity constraints (see below).

Now, let's consider the asset side of the ledger. There are three financial aspects of owning a home, and only two of them are at all like a real ("positive") bond. The first is the appreciation or depreciation of the property and housing stock, which is a very illiquid, undiversified form of equity. The second is implicit rent, which "is the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market"[5]. The implicit rent is only like a bond in that you can think of it paying a coupon, but that "coupon" is a housing voucher good for a month's implicit rent at a single address. The third is the value of the asset. Real Estate is illiquid until priced for sale at fair market value and subsequently sold (timeframe varies).[6]
Please review. I didn't understand your correction in the underlined part. Is it OK?
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Re: Mortgage as a "reverse bond" in Allocation Pla

Post by YDNAL » Fri Dec 25, 2009 2:43 am

LadyGeek,

Sorry, I didn't want to disturb the original composition of this section (in the quote) and my blue notes made it more confusing. It makes sense to simplify and remove controversial hypothesis.
Purchasing a house with a mortgage represents both an asset and a liability. However, the two parts of the transaction interact with your portfolio in different and subtle ways.

As a liability, a mortgage note is a negative bond. If you have $300K in bond funds (loaning money), a $300K mortgage note (borrowing money) offsets the bonds in the portfolio.

The house's fair market value (FMV) is an undiversified and illiquid asset that counteracts the negative effect of the mortgage note. The net asset value (FMV less mortgage note) can become liquid and subsequently diversified when the asset is sold in a competitive market [5]. Implicit rent, which is the amount a homeowner would pay to rent, or would earn from renting the house in a competitive market [6], is also considered a real (positive) bond. The implicit rent is only like a bond in that you can think of it paying a "coupon", but that coupon is a housing voucher good for a month's implicit rent at a single address.
Happy Holidays!

Edit: to make some changes in the last paragraph.
Last edited by YDNAL on Fri Dec 25, 2009 3:49 am, edited 1 time in total.
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Post by joppy » Fri Dec 25, 2009 3:30 am

Landy -

I agree that the implicit rent is like a bond coupon. But isn't the appreciation/depreciation of the underlying asset (real-estate) more like a stock than a bond?

I think that you simplify the analysis if you assume you don't live in the house you buy. Suppose you didn't live there, and just rent out property to someone else. Then,

Loan/Mortgage on Property = Negative Bond
Market Value of House = Positive Asset (equity? -- since it varies with market conditions just like equities)
Rent received from tenants = dividends that the Asset is throwing off
Taxes+repairs on house = negative dividends that the Asset is throwing off, or cost of maintaining the asset

(If you choose live in the house instead of rent it out, then you just "spend" the received dividends on your personal housing -- that is not an asset allocation decision, that is a personal spending decision.)

This whole setup seems to me to be much closer to buying dividend paying equity on a long-term margin agreement, than an illiquid positive bond.

Cheers,
Joppy

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Re: Mortgage as a "reverse bond" in Allocation Pla

Post by YDNAL » Fri Dec 25, 2009 3:42 am

joppy wrote:Landy -

I agree that the implicit rent is like a bond coupon. But isn't the appreciation/depreciation of the underlying asset (real-estate) more like a stock than a bond?
Joppy,

I was just about to update the quote. The thing to consider is not strictly appreciation/depreciation but the asset as a whole at FMV. For instance, if the mortgage note is $300K and FMV is $600K, the homeowner's equity in the asset (illiquid as it may be) counteracts and offsets the note. Please check the update and give me your comments.

Truth be told, my business is real estate, and net asset values are multiple times investable assets in our retirement portfolios. Say we had $25million in commercial RE assets and $10million in mortgage notes, I would never consider the $10million as negative bonds to offset (for instance) $1million in Bonds in a retirement portfolio.
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Post by LH » Fri Dec 25, 2009 9:04 am

joppy wrote:Landy -

I agree that the implicit rent is like a bond coupon. But isn't the appreciation/depreciation of the underlying asset (real-estate) more like a stock than a bond?

I think that you simplify the analysis if you assume you don't live in the house you buy. Suppose you didn't live there, and just rent out property to someone else. Then,

Loan/Mortgage on Property = Negative Bond
Market Value of House = Positive Asset (equity? -- since it varies with market conditions just like equities)
Rent received from tenants = dividends that the Asset is throwing off
Taxes+repairs on house = negative dividends that the Asset is throwing off, or cost of maintaining the asset

(If you choose live in the house instead of rent it out, then you just "spend" the received dividends on your personal housing -- that is not an asset allocation decision, that is a personal spending decision.)

This whole setup seems to me to be much closer to buying dividend paying equity on a long-term margin agreement, than an illiquid positive bond.

Cheers,
Joppy
I would say home equity is more like a bond than a stock. Traditionally, home ownership tracks inflation, traditionally home ownership prices do not jump around much, sometimes happens, but up until now, they did not even have a negative number for thier forward value change in a lot of formulas... Home values declining, was not expected by many, the stock market declining, is par for the course.. How something like that, is akin to a stock I dunno. It seems much more bond like

1)the value does not jump around much usually, like bonds.

2)after costs, it basically tracks inflation, or makes a bit more, like bonds.

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Post by LH » Fri Dec 25, 2009 9:08 am

qatman wrote:A mortgage is a liability (negative bond is one way to consider it), and a house is an asset (mixture of land - non-depreciating and building - depreciating). In my accounting, each item is treated as such, and consequently our net cash+bond position is negative (since our total cash+bonds are less than the outstanding mortgage).

Because of this, we sold all stock positions once we acquired the mortgage debt and will not resume stock investing until the net cash/bond position is positive. Then we will shoot for 50/50 stocks/bonds considering all investments. The house is not an investment but rather a depreciating asset.

Discussions from this board several years ago helped me to think this through; unfortunately I can't find the link I am remembering, but the logic was clear. I want to say that Larry Swedroe commented on it.
Whoa.

Do I get you right? You will not invest in the stock market, until you have enough bonds/cash such that

bonds + cash > mortgage debt

until then, ZERO stocks???????

Thats what your take on Boglehead books is?

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Re: Mortgage as a "reverse bond" in Allocation Pla

Post by joppy » Fri Dec 25, 2009 12:33 pm

YDNAL wrote:The thing to consider is not strictly appreciation/depreciation but the asset as a whole at FMV. For instance, if the mortgage note is $300K and FMV is $600K, the homeowner's equity in the asset (illiquid as it may be) counteracts and offsets the note.
Yes, I agree. The "counteract & offset" works in the same way that it would if you bought stocks on margin -- the value of the stock offsets the margin loan. Of course, one very important difference between a brokerage margin loan and a home loan is that the home loan is not callable based on variations in value of the home. It is only callable if you sell the home, or stop making payments.
YDNAL wrote: Please check the update and give me your comments.
This update is very clear. Thank you!

The only quibble I have is with the description of implicit rent. I like the definition that implicit rent is the amount a homeowner would pay to rent an equivalent place. However, the landlord also has expenses -- taxes, maintenance etc. -- which subtract from the net earnings of a landlord. So the amount the homeowner would earn from renting the house in a competitive market is lower than the implicit rent. Feel free to leave out this quibble out of the wiki if you feel it complicates the description unnecessarily -- but please let me know if you agree or disagree with it.
YDNAL wrote: Truth be told, my business is real estate, and net asset values are multiple times investable assets in our retirement portfolios. Say we had $25million in commercial RE assets and $10million in mortgage notes, I would never consider the $10million as negative bonds to offset (for instance) $1million in Bonds in a retirement portfolio.
Is the real estate business a separate entity that you own, or is it part of your personal balance sheet? If it is separate, than that is no different than my owning shares in a public company that also issues bonds, and not counting the company's debt as my own. However, if you are personally liable for the mortgage notes, then I am not so sure of your treatment.

Regardless, it is still advantageous to consider the notes differently. You would want to own some liquid bonds in your retirement portfolio, even if you also held negative illiquid bonds. This seems to me to be similar to the reason you would keep cash in your checkin account even though you had a car loan that wasn't paid off, just magnified in dollar and duration terms .

Cheers,
Joppy

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Post by joppy » Fri Dec 25, 2009 12:42 pm

LH wrote: I would say home equity is more like a bond than a stock.
Would you treat REITs as part of your equity allocation or your fixed income allocation? Many people on this board seem to recommend treating REITs as part of your equity allocation, which seems to go against your recommendation of treating real-estate like a bond.

Also, by "home equity" do you mean (Fair Market Value) or (Fair Market Value minus Mortgage Note)?
LH wrote: up until now, they did not even have a negative number for thier forward value change in a lot of formulas...
What does this mean?

Thanks,
Joppy

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Re: Mortgage as a "reverse bond" in Allocation Pla

Post by YDNAL » Fri Dec 25, 2009 12:55 pm

joppy wrote:
YDNAL wrote: Truth be told, my business is real estate, and net asset values are multiple times investable assets in our retirement portfolios. Say we had $25million in commercial RE assets and $10million in mortgage notes, I would never consider the $10million as negative bonds to offset (for instance) $1million in Bonds in a retirement portfolio.
Is the real estate business a separate entity that you own, or is it part of your personal balance sheet? If it is separate, than that is no different than my owning shares in a public company that also issues bonds, and not counting the company's debt as my own. However, if you are personally liable for the mortgage notes, then I am not so sure of your treatment.

Regardless, it is still advantageous to consider the notes differently. You would want to own some liquid bonds in your retirement portfolio, even if you also held negative illiquid bonds. This seems to me to be similar to the reason you would keep cash in your checkin account even though you had a car loan that wasn't paid off, just magnified in dollar and duration terms .

Cheers,
Joppy
Joppy,

Personal balance sheet, although each property is an LLC with only 2 members (DW and I). When you hold significant equity in real assets, personal collateral is the exception and not the norm. The notes go with assets - two-sided accounting.
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Post by stratton » Fri Dec 25, 2009 1:18 pm

Geoff Considine paper from early 2007:

Investing in Real Estate: REIT’s and Your Home

A home with 20% equity is more volatile than a REIT.
Next, we need to calculate the rates of return and the volatility that a home owner can achieve when he/she finances part of the purchase price. Imagine that you wanted to buy a $500K house and you put $100K down. Your debt-to-equity ratio would be 4 because you are borrowing $400K and have $100K in equity in the house. Please note that I am using the term debt-to-equity in an ad hoc way, rather than in a strict accounting sense. Used in this way, putting 20% down on a house means a debt-to-equity ratio of 4, and putting 50% down on a house means a debt-to-equity ratio of 1. If you can finance the debt for 6.5%, we can calculate the effective rate of return and effective risk using the adjusted Case-Schiller data. The idea here is that we achieve leverage by borrowing money and then paying interest on the debt and getting the returns achieved by an increase in the value of the house. It is straightforward to approximate the annualized return and risk for varying levels of debt.
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Accounting for leverage allows us to see a continuum of risk and return from residential real estate all the way up to the levels seen from REIT funds, and beyond.
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Post by adam1712 » Fri Dec 25, 2009 2:05 pm

We can talk about both the home equity and mortgage debt relationship but for many people investing for retirement the home value is not real relevant to asset allocation. In my case and probably many others, I have three goals before I feel I can safely retire:

1. Have a certain amount of stocks.
2. Have a certain amount of bonds.
3. Own a home completely with no mortgage.

The house may go up or down in value but that exactly matches the future liability I have of needing a place to live. The path I take to achieve goals 1,2, and 3 are up to me however. There is an especially clear relationship between 2 and 3.

Let's say I currently owe $100k on a mortgage and hold no bonds. I now have $1000 I want to invest. If mortgage and bond rates are both 5%, I can put $1000 toward paying down my mortgage. Then I have a mortgage of $99k and will have to pay $50 less in mortgage interest over the next year and every year in the future. If I put it into bonds, that $1000 will earn me $50 each year.

There's a lot of things that complicate this like taxes and the duration of the mortgage and bond. But all things being equal, if the interest rates are the same, paying down a mortgage and reducing this negative bond is identical to investing in bonds.

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Re: Mortgage as a "reverse bond" in Allocation Pla

Post by YDNAL » Sat Dec 26, 2009 8:56 am

stratton wrote:A home with 20% equity is more volatile than a REIT.
Over the past 120 years, 2 significant periods (of extremes) influenced housing price volatility most. The latter (b), I believe, having the most influence.
a. WWI, Great Depression, WWII - late 1910s-1940s.
b. Recent past boom - 1997-2007

What, exactly, does any of this mean in how to account for a mortgage note? :roll:

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Post by Sunny Sarkar » Sat Dec 26, 2009 10:19 am

For those who understand how to put all of these (negative bond, house nav, implicit rent, etc.) together, can you please help me understand how this works? Let's assume this simple hypothetical portfolio/scenario and try:

--
$100k home
$80k mortgage
$10k rent saved per year

$100k in 401k
--

How should the $100k in 401k be allocated to achieve a 50/50 asset allocation?

Thanks,
Sunny

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Re: Mortgage as a "reverse bond" in Allocation Pla

Post by LadyGeek » Sat Dec 26, 2009 10:22 am

I updated the wiki with YDNAL's changes. From a person without a background in finance (me), this section is much more understandable. If there are any more comments, please let me (or a wiki editor) know.

FWIW - I'm going to update the rest of the page as discussed in this thread: better to rent or buy??

Impact on Portfolio (Negative Bonds)

As a liability, a mortgage note is a negative bond. If you have $300K in bond funds (loaning money), a $300K mortgage note (borrowing money) offsets the bonds in the portfolio.

The house's fair market value (FMV) is an undiversified and illiquid asset that counteracts the negative effect of the mortgage note. The net asset value (FMV less mortgage note) can become liquid and subsequently diversified when the asset is sold in a competitive market[5]. Implicit rent, which is the amount a homeowner would pay to rent, or would earn from renting the house in a competitive market, is also considered a real (positive) bond. The implicit rent is only like a bond in that you can think of it paying a "coupon", but that coupon is a housing voucher good for a month's implicit rent at a single address.[6]
======================================

Please see Owning vs Renting on the Bogleheads Wiki.
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Post by Kenkat » Sat Dec 26, 2009 10:36 am

I am in the minority here in that I don't consider my mortgage as a negative bond in my investment allocation. Housing is a living expense and has little to do with my retirement savings. If you want to consider your mortgage a negative bond, then I think you should consider your job a huge, positive bond. You use the "payments" from your work "bond" to pay the interest on your negative "mortgage" bond.

Think about it. Why can young people better afford the risks of stocks? Because they have this huge work bond, with a stream of future earnings, to offset the equity risk. Your job is a bond-like asset that offsets the equity risk.

On the surface, sure, you can call a mortgage a negative bond. But as soon as you bring the mortgage into the investment portfolio picture, you have to bring all the other items in as well.

To try to mix this all together into one single allocation makes no sense to me - especially if you don't consider everything in the equation.

Best regards,
Ken

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Post by qatman » Sat Dec 26, 2009 11:28 am

LH wrote:
Whoa.

Do I get you right? You will not invest in the stock market, until you have enough bonds/cash such that

bonds + cash > mortgage debt

until then, ZERO stocks???????

Thats what your take on Boglehead books is?
Yes. Suppose you have a house worth $500K, no mortgage, and no other assets. Now you want to buy $200K worth of stocks, so you purchase those stocks on margin. So you now have $500K house, $200K mortgage, $200K stocks.

How is this any different from having $500K house with $200K mortgage and $200K cash, and deciding to buy stocks with that $200K? Either way you end up with the same assets and liabilities ($500K house, $200K mortgage, $200K stocks). The two scenarios are equivalent, with the small caveat that the mortgage debt may have legal protection depending on the state. This seems clear to me. Perhaps it is correct from an asset-allocation perspective to have a negative cash/bond allocation in earlier years. I have no quarrel with people who choose this method - I simply prefer to measure them as accurately as I can.

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Post by Sunny Sarkar » Sat Dec 26, 2009 11:33 am

kenschmidt wrote:I am in the minority here in that I don't consider my mortgage as a negative bond in my investment allocation. Housing is a living expense and has little to do with my retirement savings. If you want to consider your mortgage a negative bond, then I think you should consider your job a huge, positive bond. You use the "payments" from your work "bond" to pay the interest on your negative "mortgage" bond.
I think I agree with you - it flows from the whole argument about how the primary home is not an investment, rather a consumption item. A second home / investment property is however a completely different issue - in that case it's a clear cut RE asset versus a negative bond scenario.

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Post by qatman » Sat Dec 26, 2009 11:36 am

kenschmidt wrote:If you want to consider your mortgage a negative bond, then I think you should consider your job a huge, positive bond. You use the "payments" from your work "bond" to pay the interest on your negative "mortgage" bond.
This makes sense. To me the difference is that the mortgage is a legal contract where you are obligated to pay a specified amount of money at certain intervals, while the job is an uncertain stream of future income that can be revoked at any time. If you had a guaranteed contract (e.g. baseball player) then I could see including that stream of income in your allocation. Something like an annuity or Social Security would also be a guaranteed contract with legal requirement to pay a known amount, so it is measurable.

It's definitely a consideration and there are good arguments for considering the job as a positive bond (or stock in the case of someone with fluctuating income?).

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Post by Gotadimple » Sat Dec 26, 2009 12:18 pm

All of this is very interesting, but doesn't address additional risks.

The WIKI article points to the risk involved in the overall allocation when considering this method. What I didn't see was a discussion of liquidity 'opportunity' with respect to a mortgage when compared to a bond.

Generally, (unless the bond holder is in default) one can liquidate the bond more rapidly than one can liquidate a mortgage. Liquidating either can result in losses or gains. Liquidate in this case means the time it takes to make a sale and clear the funds for other uses.

In the overall scheme of asset allocation, most consider their allocation a 'buy and hold' proposition unless the allocation drifts and then it should be reset. The purpose of allocation is to reduce portfolio risk, while providing a a probability of modest portfolio growth. At least, that's my understanding of the theory of asset allocation.

So when one advocates considering a mortgage as a negative bond, it should be stated that the investor takes on additional risks in their allocation: (1) they may be over-allocated in stocks increasing portfolio risk, and (2) their portfolio bears additional liquidity risk.

-- Rita

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Post by Kenkat » Sat Dec 26, 2009 1:42 pm

qatman wrote:To me the difference is that the mortgage is a legal contract where you are obligated to pay a specified amount of money at certain intervals, while the job is an uncertain stream of future income that can be revoked at any time.
Ah, so this is why I can't sleep at night! :D

Seriously, this is a consideration and it is a leap of faith in your own abilities and the overall economy to sign that mortgage. It helps to have a marketable skill and work for a stable company, but, as you say, there are no guarantees. It also helps to keep the mortgage small relative to your income as an additional safety net.

I remember something my uncle said at his retirement party. He said, looking back, that the thing he was most thankful of is that "he never missed a paycheck in 30+ years of work". I "get" that thought more and more with each passing year.

I have about 7 years left on my 15 year mortgage and will look very forward to paying it off on time and well before retirement age.

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Post by adam1712 » Sat Dec 26, 2009 2:49 pm

Sunny wrote:For those who understand how to put all of these (negative bond, house nav, implicit rent, etc.) together, can you please help me understand how this works? Let's assume this simple hypothetical portfolio/scenario and try:

--
$100k home
$80k mortgage
$10k rent saved per year

$100k in 401k
--

How should the $100k in 401k be allocated to achieve a 50/50 asset allocation?

Thanks,
Sunny
I can only speak for myself, but I think most of the Boglehead advice about a reasonable asset allocation assumes you're going to need a place to live and thus will either have mortgage interest payments or rent to pay in the future. So I don't worry too much about how much future rents, job income, or a mortgage affect my asset allocation. It also doesn't make since to me that the instant you close on a house your asset allocation should dramatically change. You have a new asset as well as a new set of future payments, but nothing else has really changed.

However, my mortgage interest is at a higher rate than bonds right now, so instead of buying bonds I have chose to pay down more of my mortgage.

Here is what I have done using your example. When I bought my house with 20% down, I printed out the 30 year amortization schedule. So this is the schedule to pay off the remaining $80,000. With my 401k, I start with a 50/50 split stocks and bonds. Each month I invest new money to either stocks or paying down my mortgage with an additional payment plus the standard monthly payment I owe. Any amount I am ahead of the standard 30 year mortgage schedule I consider bonds to me.

As an example, at a given time in the future, let's say the mortgage schedule says I should owe $70k but through extra payments I now owe only $50k. I count this extra $20k as bonds. If I still have only $100k in my 401k, to maintain my 50/50 split I would have $60k in stocks and $40k in bonds.

There's several other issues here. This approach is not as liquid but if I'm a long term investor, liquidity doesn't mean much to me. I also currently don't have enough deductions to itemize so mortgage interest is of no tax benefit to me. This has turned into a pretty long post and it doesn't address a lot of the theoretical issues of risk but it is my practical solution to the problem.

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Post by LadyGeek » Sat Dec 26, 2009 3:45 pm

Gotadimple wrote:All of this is very interesting, but doesn't address additional risks.

The WIKI article points to the risk involved in the overall allocation when considering this method. What I didn't see was a discussion of liquidity 'opportunity' with respect to a mortgage when compared to a bond.... -- Rita
The intent of that particular wiki page is to help understand the different aspects between owning a home and renting.

To help keep the wiki article objective and focused on-topic, I've updated the page to point back to this forum with an additional note that this thread discusses liquidity.

Also note that there is a reference to this thread: Mortgage as bond component in AA

Please see Owning vs Renting on the Bogleheads Wiki.
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Post by sscritic » Sat Dec 26, 2009 4:29 pm

Sunny wrote:Let's assume this simple hypothetical portfolio/scenario and try:
--
$100k home
$80k mortgage
$10k rent saved per year

$100k in 401k
--
How should the $100k in 401k be allocated to achieve a 50/50 asset allocation?
Better question: why would you want a 50/50 asset allocation? Because you read it on the internet?

Perhaps you should define an asset. Is your $20,000 equity in your home an asset? Or, as others have pointed out, is your $100,000 home an asset (the $80k mortgage is what allowed you to keep $100k in your 401k, instead of draining it to buy the house)?

What you want is an asset allocation that suits your needs and risk taking comfort level using the definitions that you use. If you define your house as a $100k asset, then you might have a different "asset allocation" than if you don't define it so, but the actual investments in terms of home, mortgage, stocks, and bonds should be exactly the same, whether it computes to "50/50" or "70/30" or 30/70" depending only on the definitions you use. Pick your own definitions, find the asset allocation you are comfortable with, and don't spend so much time on the internet. :)

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Post by Sunny Sarkar » Sat Dec 26, 2009 5:58 pm

sscritic wrote:
Sunny wrote:Let's assume this simple hypothetical portfolio/scenario and try:
--
$100k home
$80k mortgage
$10k rent saved per year

$100k in 401k
--
How should the $100k in 401k be allocated to achieve a 50/50 asset allocation?
Better question: why would you want a 50/50 asset allocation? Because you read it on the internet?
This AA is hypothetical. I'm trying to understand how this negative bond & primary home stuff is incorporated in a portfolio.

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Post by qatman » Sat Dec 26, 2009 10:41 pm

Sunny wrote:
This AA is hypothetical. I'm trying to understand how this negative bond & primary home stuff is incorporated in a portfolio.
Personally I do not count the house value in asset allocation, since it's not really an investment by my criteria but rather a consumer good (albeit a long-lasting one). I don't count cars, jewelry, or furniture either.

Your target asset allocation of stocks vs. bonds vs. cash might be different if you choose to count a mortgage as a negative bond. For our situation, we thought about how we wanted to invest exclusive of the house. We settled on approximately 50/40/10 stock/bond/cash since that seemed like a reasonable approach. Since money is fungible, we include all cash assets whether in retirement accounts, 529 plans, or taxable accounts, appropriately adjusted to be after-tax given current tax rates. When the situation changes (adding a mortgage, spending money for college, retiring), we reevaluate and move money as needed.

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Re: Mortgage as a "reverse bond" in Allocation Pla

Post by YDNAL » Sun Dec 27, 2009 1:10 pm

Sunny wrote:For those who understand how to put all of these (negative bond, house nav, implicit rent, etc.) together, can you please help me understand how this works? Let's assume this simple hypothetical portfolio/scenario and try:

--
$100k home
$80k mortgage
$10k rent saved per year

$100k in 401k
--

How should the $100k in 401k be allocated to achieve a 50/50 asset allocation?
Sunny,

When you own a Bond you are a lender and when you owe a Mortgage Note you are a borrower.
- Opposites, right?
- Thus, in theory, the Note is classified a "negative bond."

However, the Note is attached to a securing asset (home) that, unless sold, is undiversified and illiquid - to the extent of the time it takes to sell.
- When/if sold, the home can free-up available net asset value (NAV = Fair Market Value — Note).
- NAV can actually be negative as witnessed in the number of short sales and foreclosures in the US today.
- Only a negative NAV impacts the overall net worth (includes investable assets). But even then, right or wrong (I don't have an opinion), many Americans are choosing to walk away from such financial encumberance.

On second thought, we can eliminate all discussion if one chooses to live in a van down by the river. :)

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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by newbeginning » Sat Apr 06, 2013 3:49 am

Seems pretty simple to me. Which has a higher interest rate?

3.25% Mortgage vs 1.7% IBond? Prepay mortgage.

Thats how I see it anyway. I dont see a point to buying a bond when I can save more than I would earn by prepaying the mortgage.

Sorry I dredged up this old post, I evidently linked to it from somewhere.

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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by magician » Sat Apr 06, 2013 11:41 pm

Simplify the complicated side; don't complify the simplicated side.

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Re:

Post by momar » Sat Apr 06, 2013 11:52 pm

qatman wrote:
LH wrote:
Whoa.

Do I get you right? You will not invest in the stock market, until you have enough bonds/cash such that

bonds + cash > mortgage debt

until then, ZERO stocks???????

Thats what your take on Boglehead books is?
Yes. Suppose you have a house worth $500K, no mortgage, and no other assets. Now you want to buy $200K worth of stocks, so you purchase those stocks on margin. So you now have $500K house, $200K mortgage, $200K stocks.

How is this any different from having $500K house with $200K mortgage and $200K cash, and deciding to buy stocks with that $200K? Either way you end up with the same assets and liabilities ($500K house, $200K mortgage, $200K stocks). The two scenarios are equivalent, with the small caveat that the mortgage debt may have legal protection depending on the state. This seems clear to me. Perhaps it is correct from an asset-allocation perspective to have a negative cash/bond allocation in earlier years. I have no quarrel with people who choose this method - I simply prefer to measure them as accurately as I can.
It's different because I have now borrowed an additional 200k.
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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by grabiner » Sun Apr 07, 2013 4:20 pm

Here's one way to look at it.

Suppose you and I have identical portfolios, each including $50,000 in cash, $200,000 in bonds, and $200,000 in stock. The bonds are of varying maturities, up to fifteen years, and will pay $1381 per month in interest and principal over the next fifteen years.

Now, suppose that we buy $250,000 houses. You pay $50,000 down, and take out a 15-year mortgage for the rest at 3% interest, with a $1381 monthly payment, leaving your bond portfolio intact; you then use the bond portfolio to make your interest payments, so it will be gone when the mortgage is gone (although you may make more bond investments in the future). I sell all of my bonds and buy the house with no mortgage.

Who has the riskier portfolio? My investments are 100% stock; yours are half bonds, but you also have a fixed expense which is equal to your bond payments. If you and I invest identically from now on, we will have the same investments after fifteen years.

If you don't count the house in your investment portfolio, then you have a net investment portfolio of $200,000, which includes $200,000 in stock, $200,000 in bonds, and -$200,000 in a mortgage, so 100% of your net is in stock. If you do count the house, then your net worth is $450,000, so 44% of your net worth is in stock, the same as mine.
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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by Dulocracy » Mon Apr 08, 2013 9:14 am

grabiner wrote:Here's one way to look at it.

Suppose you and I have identical portfolios, each including $50,000 in cash, $200,000 in bonds, and $200,000 in stock. The bonds are of varying maturities, up to fifteen years, and will pay $1381 per month in interest and principal over the next fifteen years.

Now, suppose that we buy $250,000 houses. You pay $50,000 down, and take out a 15-year mortgage for the rest at 3% interest, with a $1381 monthly payment, leaving your bond portfolio intact; you then use the bond portfolio to make your interest payments, so it will be gone when the mortgage is gone (although you may make more bond investments in the future). I sell all of my bonds and buy the house with no mortgage.

Who has the riskier portfolio? My investments are 100% stock; yours are half bonds, but you also have a fixed expense which is equal to your bond payments. If you and I invest identically from now on, we will have the same investments after fifteen years.

If you don't count the house in your investment portfolio, then you have a net investment portfolio of $200,000, which includes $200,000 in stock, $200,000 in bonds, and -$200,000 in a mortgage, so 100% of your net is in stock. If you do count the house, then your net worth is $450,000, so 44% of your net worth is in stock, the same as mine.
So, if I have $200,000 in stock paying a 3% dividend, and I choose to use that to pay the mortgage instead of bonds, I should then buy only stock?

I do not like arbitrarily assigning bonds to the mortgage and deciding I need more bonds. How about this? I have an asset allocation in my account. I have a job. My job pays my bills, one of which is the debt on my house. Since that money is not coming out of my investments, I will stick to my asset allocation.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.

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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by MrMatt2532 » Mon Apr 08, 2013 10:04 am

Dulocracy wrote:I do not like arbitrarily assigning bonds to the mortgage and deciding I need more bonds.
This is the wrong interpretation. The point is that to properly asses the risk of your portfolio, debt (mortgage in this case) should be included as a negative bond.

Nobody is saying you should change your asset allocation, just that the correct way of viewing your asset allocation is with including debt as a negative bond.

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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by YDNAL » Mon Apr 08, 2013 10:34 am

MrMatt2532 wrote:
Dulocracy wrote:I do not like arbitrarily assigning bonds to the mortgage and deciding I need more bonds.
This is the wrong interpretation. The point is that to properly asses the risk of your portfolio, debt (mortgage in this case) should be included as a negative bond.

Nobody is saying you should change your asset allocation, just that the correct way of viewing your asset allocation is with including debt as a negative bond.
MrMatt,

NO ONE is forced to own a house with a mortgage - especially IF paying Rent = Cost of ownership (interest, tax, insurance, etc.).
  1. When we do decide to own/finance, there is NO such thing as negative asset (bond). Assets and liabilities are what they are, and should be treated as such in a Balance Sheet. A quick review of introductory Accounting should clear this issue.
  2. Each, the Asset & Liability, impacts Net Worth - thus both affecting Ability & Need to take risk with investable Assets.
  3. Bent out of shape to use a Liability in asset allocation computations?... use them both in such context.
Last edited by YDNAL on Mon Apr 08, 2013 10:54 am, edited 1 time in total.
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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by Dulocracy » Mon Apr 08, 2013 10:52 am

YDNAL wrote:
NO ONE is forced to own a house with a mortgage - especially IF paying Rent = Cost of ownership (interest, tax, insurance, etc.).
  1. There is NO such thing as negative asset (bond). Assets and liabilities are what they are, and should be treated as such in a Balance Sheet.
  2. Each, the Asset & Liability, impacts Net Worth - thus both affecting Ability & Need to take risk with investable Assets.
  3. Bent out of shape to use a Liability in asset allocation computations?... use them both in such context.
Thank you! The argument that a mortgage is a reverse bond only works if there is no asset being purchased. The logical argument would then be that you have a reverse bond in the event that your mortgage is upside down. Of course, that would lead way to treating the value of the house as a bond if you are NOT upside down... which is silly.

The value of my house increases and decreases over time, but it is value. Whether or not you should treat the home as an investment (I believe that you should not), it does have value.

A tangential argument that I like, however, is this: I pay rent. I have an asset allocation. Why then, when I am building equity in a house would I change the asset allocation based on the mortgage? Sure, I have a debt to pay, but I would be paying rent over time. Whether it is a set debt or not, I will be paying rent (so as not to be homeless). The fact that I exchanged my mortgage for rent is irrelevant to my asset allocation. Otherwise, I will be very heavy bonds and will never have enough growth to meet my goals.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.

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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by YDNAL » Mon Apr 08, 2013 11:05 am

Dulocracy wrote:
YDNAL wrote:MrMatt,

NO ONE is forced to own a house with a mortgage - especially IF paying Rent = Cost of ownership (interest, tax, insurance, etc.).
  • 1. When we do decide to own/finance, there is NO such thing as negative asset (bond). Assets and liabilities are what they are, and should be treated as such in a Balance Sheet. A quick review of introductory Accounting should clear this issue.
    2. Each, the Asset & Liability, impacts Net Worth - thus both affecting Ability & Need to take risk with investable Assets.
    3. Bent out of shape to use a Liability in asset allocation computations?... use them both in such context.
Thank you! The argument that a mortgage is a reverse bond only works if there is no asset being purchased. The logical argument would then be that you have a reverse bond in the event that your mortgage is upside down. Of course, that would lead way to treating the value of the house as a bond if you are NOT upside down... which is silly.

The value of my house increases and decreases over time, but it is value. Whether or not you should treat the home as an investment (I believe that you should not), it does have value.

A tangential argument that I like, however, is this: I pay rent. I have an asset allocation. Why then, when I am building equity in a house would I change the asset allocation based on the mortgage? Sure, I have a debt to pay, but I would be paying rent over time. Whether it is a set debt or not, I will be paying rent (so as not to be homeless). The fact that I exchanged my mortgage for rent is irrelevant to my asset allocation. Otherwise, I will be very heavy bonds and will never have enough growth to meet my goals.
I agree. Since there thousands of threads on this topic, perhaps there should be as many asking... Is my Lease (Rent) a negative Bond? [edit to add: I cringe typing that term]
Last edited by YDNAL on Mon Apr 08, 2013 12:36 pm, edited 1 time in total.
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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by PeterParker » Mon Apr 08, 2013 11:10 am

Who has the riskier portfolio?
Great post --- makes perfect sense to me. The guy who paid off the mortgage and is 100% in stocks has the exact same investments (and risk) as the guy with the 50% bonds that happen to be the exact inverse of the mortgage.

However, maybe most asset allocation advice is already given with this is mind (that most people will have an open mortgage at some point).

At any rate, the guy holding the bonds might be incurring slightly less risk, if you factor in that the mortgage-holder may be able to re-finance at a lower rate at some point in the future (I don't have a mortgage so am not expert).

Of course, it all comes down to whether the mortgage or the bond interest rate is higher ---- put your money towards the higher interest rate, of course.

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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by MrMatt2532 » Mon Apr 08, 2013 5:12 pm

YDNAL wrote:
MrMatt2532 wrote:
Dulocracy wrote:I do not like arbitrarily assigning bonds to the mortgage and deciding I need more bonds.
This is the wrong interpretation. The point is that to properly asses the risk of your portfolio, debt (mortgage in this case) should be included as a negative bond.

Nobody is saying you should change your asset allocation, just that the correct way of viewing your asset allocation is with including debt as a negative bond.
MrMatt,

NO ONE is forced to own a house with a mortgage - especially IF paying Rent = Cost of ownership (interest, tax, insurance, etc.).
  1. When we do decide to own/finance, there is NO such thing as negative asset (bond). Assets and liabilities are what they are, and should be treated as such in a Balance Sheet. A quick review of introductory Accounting should clear this issue.
  2. Each, the Asset & Liability, impacts Net Worth - thus both affecting Ability & Need to take risk with investable Assets.
  3. Bent out of shape to use a Liability in asset allocation computations?... use them both in such context.
Ok. That's all fine. The point is that it's a shortcut to properly assess the true risk that you are exposed to.

I will go back to an example I used before:
Person 1) Assets: 500k in stocks/500k in bonds/500k house/paid off mortgage
Person 2) Assets: 500k in stocks/500k in bonds/500k house/200k mortgage

Person 2 has less net worth and is exposing a greater percentage of their net worth to risky stock assets than person 1. It's pretty simple. After seeing threads like this over and over again, I am convinced that most bogleheads don't consider that debt has an effect on the risks they are exposed to.

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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by grabiner » Mon Apr 08, 2013 9:05 pm

Dulocracy wrote:A tangential argument that I like, however, is this: I pay rent. I have an asset allocation. Why then, when I am building equity in a house would I change the asset allocation based on the mortgage? Sure, I have a debt to pay, but I would be paying rent over time. Whether it is a set debt or not, I will be paying rent (so as not to be homeless). The fact that I exchanged my mortgage for rent is irrelevant to my asset allocation. Otherwise, I will be very heavy bonds and will never have enough growth to meet my goals.
And I am not making that argument. When you buy a house and take out a mortgage, you have a loan (which is an obligation to pay money), but you also have a house (which is an asset). If you didn't sell any stock to buy the house, then your stock as a percentage of your net worth has not changed, and your stock-market risk has not changed. It may well make sense not to change your asset allocation.

The distinction I made is between owning a home with no debt and owning a home with debt. If you own a home with a 15-year mortgage, you have an obligation to pay a fixed amount of cash every month for the next 15 years; if you own a home without a mortgage, you have no such obligation. And that obligation is very much like a bond portfolio in reverse; if you have a Treasury bond ladder, the Treasury has an obligation to pay you a fixed amount of cash over a period of time.

The debt payments exist independent of the home; you would be in the same situation if you had no mortgage but had student loans. You don't actually own an asset of "home equity"; if you own a $250,000 home, your net worth will drop by $50,000 if home prices drop by 20%, whether you have a mortgage, a student loan, or no debt. (Home equity is important for other purposes, such as the ability to refinance the mortgage.)
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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by Valuethinker » Tue Apr 09, 2013 4:16 am

grabiner wrote:
Dulocracy wrote:A tangential argument that I like, however, is this: I pay rent. I have an asset allocation. Why then, when I am building equity in a house would I change the asset allocation based on the mortgage? Sure, I have a debt to pay, but I would be paying rent over time. Whether it is a set debt or not, I will be paying rent (so as not to be homeless). The fact that I exchanged my mortgage for rent is irrelevant to my asset allocation. Otherwise, I will be very heavy bonds and will never have enough growth to meet my goals.
And I am not making that argument. When you buy a house and take out a mortgage, you have a loan (which is an obligation to pay money), but you also have a house (which is an asset). If you didn't sell any stock to buy the house, then your stock as a percentage of your net worth has not changed, and your stock-market risk has not changed. It may well make sense not to change your asset allocation.

The distinction I made is between owning a home with no debt and owning a home with debt. If you own a home with a 15-year mortgage, you have an obligation to pay a fixed amount of cash every month for the next 15 years; if you own a home without a mortgage, you have no such obligation. And that obligation is very much like a bond portfolio in reverse; if you have a Treasury bond ladder, the Treasury has an obligation to pay you a fixed amount of cash over a period of time.

The debt payments exist independent of the home; you would be in the same situation if you had no mortgage but had student loans. You don't actually own an asset of "home equity"; if you own a $250,000 home, your net worth will drop by $50,000 if home prices drop by 20%, whether you have a mortgage, a student loan, or no debt. (Home equity is important for other purposes, such as the ability to refinance the mortgage.)
David

I do not disgree with your views.

I would add though: liquidity.

The key issue with home equity is that it is not as liquid as cash or bonds. It's more difficult to tap home equity (perhaps less so in USA where HELOCs are frequent?). For example if you were unemployed it would be difficult to negotiate a HELOC?

That's the problem with home equity-- illiquidity.

The strategy to pay down mortgage in preference to owning fixed income is sound. It's separate from the home equity you have/ value in your home. It's simply another form of fixed return investment-- which usually looks pretty good on an after tax basis.

However it is an illiquid investment. You also lose the inherent inflation protection of a long term fixed rate debt (assuming the inflation premium when you borrowed that money was not too high, ie the expected real interest rate).

In an environment of variable labour income (ie you can lose your job!) there is a rationale for keeping more mortgage than otherwise, because this gives you liquidity.

I compromise and suggest middle aged working people should have cashable investments (ibonds, ST bonds, MMFs, CDs) worth at least 12-18 months of expenses. Even as the US economy recovers.

For systemic risk reasons as well as low interest rates, I suggest relatively little in MMFs at this point.

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Re:

Post by Valuethinker » Tue Apr 09, 2013 4:26 am

stratton wrote:Geoff Considine paper from early 2007:

Investing in Real Estate: REIT’s and Your Home

A home with 20% equity is more volatile than a REIT.
Next, we need to calculate the rates of return and the volatility that a home owner can achieve when he/she finances part of the purchase price. Imagine that you wanted to buy a $500K house and you put $100K down. Your debt-to-equity ratio would be 4 because you are borrowing $400K and have $100K in equity in the house. Please note that I am using the term debt-to-equity in an ad hoc way, rather than in a strict accounting sense. Used in this way, putting 20% down on a house means a debt-to-equity ratio of 4, and putting 50% down on a house means a debt-to-equity ratio of 1. If you can finance the debt for 6.5%, we can calculate the effective rate of return and effective risk using the adjusted Case-Schiller data. The idea here is that we achieve leverage by borrowing money and then paying interest on the debt and getting the returns achieved by an increase in the value of the house. It is straightforward to approximate the annualized return and risk for varying levels of debt.
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Accounting for leverage allows us to see a continuum of risk and return from residential real estate all the way up to the levels seen from REIT funds, and beyond.
Paul
Underpinning all this, that was trailing 5 years to 2007!

For most Americans, the trailing 5 years on residential real estate, unlevered, to 2012 was probably about -20% to -30%?


Now imagine gearing/ leverage on that!

It's one thing to keep your mortgage larger to:

- maintain a liquidity reserve for 12-18 months of unemployment (not an unusual length of job search for a professional)
- take advantage of tax deadlines ie if you don't make the contribution this year, you lose it forever (not sure whether I'd count ibonds in this, but maybe because you can count those as liquidity instruments)

But to *speculate* on residential property increases, well just move the end dates on that 5 years-- you really will experience volatility then.

There are cities where houses always pay off: San Francisco, New York, I was going to write Boston but I remember the early 90s slump, Washington DC (right location), Seattle? Zoning plus economic growth drives a permanent scarcity of desirable accomodation (but remember, Buffalo NY once had more millionaires than any other city in North America-- economic centrality is not for-ordained by history).

But basically housing is a form of consumption, and it's wise to treat it as so. With luck, after inflation, your house pays for your nursing home care.

You can get lucky on the cycle. Gearing up now is likely to pay off in the 10 year view in the USA. There's an absolute shortage of new homes in most metropolitan areas of the USA I believe. Particularly in cities where zoning and geography constraint supply (basically what economist Edward Gleaser has dubbed 'Coast Land' and 'Zone Land' for the big central cities like Dallas FW where supply responds to increased demand) and where the local industries are doing well (Securities for NY, tech for SF etc.).

If you look at Vancouver CA and Toronto CA you can see the downside: what looks like unsustainable housing bubbles about to hit the wall, hard. At least in the condo markets there is likely to be impressive wreckage.

But it's not wise to count on housing wealth as the route to retirement comfort.

YDNAL
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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by YDNAL » Tue Apr 09, 2013 6:53 am

MrMatt2532 wrote:
YDNAL wrote:NO ONE is forced to own a house with a mortgage - especially IF paying Rent = Cost of ownership (interest, tax, insurance, etc.).
  1. When we do decide to own/finance, there is NO such thing as negative asset (bond). Assets and liabilities are what they are, and should be treated as such in a Balance Sheet. A quick review of introductory Accounting should clear this issue.
  2. Each, the Asset & Liability, impacts Net Worth - thus both affecting Ability & Need to take risk with investable Assets.
  3. Bent out of shape to use a Liability in asset allocation computations?... use them both in such context.
Ok. That's all fine. The point is that it's a shortcut to properly assess the true risk that you are exposed to.
No, MrMatt, that is all correct (not just fine), and there shouldn't be shortcuts.
Valuethinker wrote:But it's not wise to count on housing wealth as the route to retirement comfort.
Many (most?) people I know bought a home to live in good/safe neighborhoods to raise families, good school districts, to grow old. This is typically the most expensive purchase of their lives - they borrow to be able to afford this purchase - and eventually paid the mortgage in full. These folks have as much home equity as 401K value, is 401K wealth the route to retirement comfort?... see, all subjective!

Now, on topic with this 2009 thread (for those that don't know), these folks I describe - whom may not be too different than lots of Bogleheads who write otherwise - are NOT in position to make lumpsum payments to eliminate mortgage debt UNTIL the time (or near) when they no longer owe on a mortgage. In the meantime, the risk they take on the 401K is measured mostly by the size of Equity risk exposure. :beer
Landy | Be yourself, everyone else is already taken -- Oscar Wilde

MrMatt2532
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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by MrMatt2532 » Tue Apr 09, 2013 8:18 am

YDNAL wrote: No, MrMatt, that is all correct (not just fine), and there shouldn't be shortcuts.
Yes...thanks for the clarification. YDNAL: I'm confident that almost everyone here knows how to construct a balance sheet and calculate a net worth.

The point is this is an investment forum and we care about the behavior of our assets (minus liabilites). If you have money coming in, you can put it towards stocks/bonds/debt. Adding towards bonds/debt has roughly the same affect on your risks you are exposed to. Additionally, all else equal, the guy with more debt is taking more risk. It's very simple, and there is no need to remind me how to construct a balance sheet.

YDNAL
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Re: Mortgage as a "reverse bond" in Allocation Plannin

Post by YDNAL » Tue Apr 09, 2013 8:48 am

MrMatt2532 wrote:
YDNAL wrote:No, MrMatt, that is all correct (not just fine), and there shouldn't be shortcuts.
Yes...thanks for the clarification.
OK.
MrMatt2532 wrote:YDNAL: I'm confident that almost everyone here knows how to construct a balance sheet and calculate a net worth.
No, MrMatt, I wouldn't be so "confident" especially with the large number of new and inexperienced Forum participants.
MrMatt2532 wrote:The point is this is an investment forum and we care about the behavior of our assets (minus liabilites).
Assets [plural] including fair market value of real estate.

You speak for yourself, but I try to refrain from speaking for "we" (investment Forum). As far "me," I don't believe in negative assets (bonds), don't accept one-side Accounting, and DO believe others should consider total Net Worth in making THEIR financial decisions.
Last edited by YDNAL on Tue Apr 09, 2013 9:31 am, edited 1 time in total.
Landy | Be yourself, everyone else is already taken -- Oscar Wilde

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