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Considerations in Paying Down One's Mortgage

The question of whether to pay down debt or to invest is a perennial one for a great many investors. There are several factors that should likely be considered in the decision. In this post, I explore the most prominent of these factors as they relate to potentially paying down (or off) one's mortgage.


All Debt is Leverage


It's absolutely vital to understand that in the context of paying down debt or investing, all forms of debt are leverage. By retaining a debt to make an investment instead, we are effectively using borrowed money to buy the investment (i.e., leverage). And leverage magnifies the returns of the investment, whether those returns are good or bad. For instance, let's assume that an investor buys a $500,000 investment with a $50,000 down payment. If the property appreciates in value by 10%, it's now worth $550,000, which represents a 100% return on the investor's $50,000 investment (ignoring closing costs, interest expenses, and taxes). Conversely, if the property declines in value by 10%, the investor's return on the property will be -100%.


No matter how complicated an investment strategy that utilizes leverage might be, there is no getting around this simple fact: leverage increases both upside potential and downside risk. That does not make leverage good or bad; rather, it merely describes the situation. In some situations, leverage is very logical (e.g., for an aggressive and young investor), while in other situations, leverage is very illogical (e.g., a risk averse retiree). In most situations, the value of leverage is at least a bit murky, though I suspect that if many investors understood that their debt is creating leverage in their investments, they would at least reconsider whether this was a good approach to take.


Note that essentially risk-free arbitrage of debt, that is, borrowing to invest at a lower rate than can be obtained from a 'guaranteed' investment, is possible. This is discussed more below.


Make an Appropriate Comparison


When evaluating whether to invest funds or pay down debt, it is crucial that one make an apples-to-apples comparison. For this reason, comparing paying down debt to investing in stocks is not most appropriate. When debt is paid down, the return is guaranteed, whereas the returns from a volatile asset like stocks are far from guaranteed.


In most situations, the most appropriate investment to compare to paying down debt are nominal U.S. Treasury bonds (aka 'Treasuries') for two reasons. First, securities issued by the U.S. Treasury provide the closest thing to a guaranteed return available to investors. Second, nominal Treasuries should be used for this comparison rather than Treasury Inflation Protected Securities (TIPS) because debt is virtually always priced in nominal terms, rather than inflation-adjusted terms as TIPS are.


Also, to make an appropriate comparison, one must take taxes into account as well. Unless you are able to deduct some portion of your mortgage interest for tax purposes, your mortgage interest expense is after taxes. By comparison, the yield on U.S. Treasuries is before taxes. To get the after tax yield, simply reduce the yield by your marginal tax rate. For instance, the after tax yield on 10 year U.S. Treasuries yielding 3.71% (the yield as of this writing) for an investor in the 12% federal tax bracket is 3.26%, and for an investor in the 22% bracket, the after tax yield is 2.89%. Assuming they are unable to deduct their mortgage interest, that means that these investors would be better off by paying down their mortgage rather than buying Treasuries if their mortgage rate is higher than these after tax yields and vice versa. Note that this example assumes that the maturity of the bonds matches the maturity of the mortgage (i.e., there are 10 years remaining on the mortgage).


This is definitely not to say that the only logical choices people have are to pay down their mortgage or buy U.S. Treasuries. Certainly, they can consider buying any investment they wish. But it is important to keep in mind that other investments do not come with guaranteed returns, and investors need to be prepared accordingly. In many ways, the decision as to whether one pays down one's mortgage or buys stocks is very similar to how much of one's portfolio one allocates to stocks and bonds.

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Increased Risk


As noted above, apart from risk-free arbitrage, debt is leverage, and leverage increases risk. This means that it makes the good times better but also makes the bad times worse, and this is particularly true for retirees who are making withdrawals from their portfolio.


A very simple but valid demonstration of this point is to examine what would have happened if you were a retiree with a $100,000 mortgage that was paid for from a $100,000 investment portfolio. If you started in the year 2000 and paid an average of 5% mortgage interest*, refinancing along the way, and no PMI, resulting in an P&I payment of $537/month that is not indexed to inflation (i.e., nominal, not real dollars), a 60/40 portfolio with global stocks and intermediate-term Treasuries would have had $22,429 dollars remaining at the end of 2022, which is fewer than 42 months of mortgage payments remaining. Retaining the mortgage in order to invest the funds would have led to a much worse outcome than paying off the mortgage before retiring.


(*Note that mortgage rates were actually averaging about 8% in the year 2000, but the retiree could have refinanced along the way. Average rates didn't drop below 5% until late 2009 and averaged about 4% from 2012 until about 2020, so 5% seems like a rather conservative fixed rate for this purpose. Also, refinancing costs would have had to be paid as well.)


In this example, the problem is not only stemming from the mortgage interest rate. It might seem incredible at first, but even a mortgage with a 0% interest rate in retirement can increase sequence of returns risk. The reason for this is simple. A mortgage must be paid every month, regardless of how one's portfolio is performing. To the extent that a retiree's withdrawals are fixed, sequence of returns risk increases. Therefore, being forced to make withdrawals to pay one's mortgage, by definition, increases sequence of returns risk.


Now if you are able to arbitrage your mortgage interest rate with U.S. Treasuries, that's a different story and does not increase sequence of returns risk. But this requires that you hold an amount of U.S. Treasuries that is of equal size and maturity to your mortgage, besides any other fixed income component to your portfolio.


And as hinted at above, it can be prudent for young investors with several decades of accumulation left to retain a mortgage with a historically low interest rate in favor of investing in assets like stocks. While this does entail some risk, it may easily result in lower total risk over the investors' lifetime.


Liquidity


Perhaps the biggest argument against paying down debt, including a mortgage, early is the loss of liquidity. Once funds are used to pay down a debt, those funds cannot be directly used for any other purpose.


To be sure, almost everyone needs some quantity of liquid assets to account for unexpected expenses. But this does not mean that everyone needs the same type of liquid assets, nor does it mean that everyone needs all their assets to be liquid. While their value can go down over time, investments like stocks and bonds are liquid, particularly if held in a taxable account, where they can be sold and transferred to one's bank account in a week or so. There is certainly no 'rule' that says one must hold X amount of something as liquid as cash, though many use mental accounting to justify significant cash holdings.


Back to the point here, it is true that you cannot ask your mortgage lender to return funds you used earlier to pay down your mortgage. But there are ways that you can regain at least some of this lost liquidity if needed and even if you still have a mortgage. One of these is recasting your mortgage. Borrowers who have made significant principal payments can often request that their lender recast their mortgage, where the principal and interest portion of the mortgage payment is reduced to pay off the mortgage within the original time frame. For instance, if in 2015 a borrower took out a $100,000 mortgage scheduled to be paid off in 15 years but paid down the principal balance by an additional $30,000, recasting the mortgage would reduce the monthly principal and interest payment so that the mortgage would still be paid off in 2030. Reducing one's mortgage payment in this way can be beneficial to those who need to increase their cash flow.


Another more common means of regaining funds used to pay down a mortgage is to take out a home equity loan, which has a fixed interest rate, or a line of credit, which has a variable interest rate. Both of these options can be used to regain liquid funds. It's true that the interest rates of these options are likely higher than what could be obtained via a traditional mortgage at that moment in time, but they carry the potentially sizable advantage of you being able to borrow only the amount that you genuinely need. Retaining a $50,000 mortgage at 4% interest, for instance, when you could easily borrow $10,000 at 6% interest is not a sound decision.


A middle-ground approach that some have taken is to build a sinking fund for the purpose of paying off the mortgage in one fail swoop. This enables them to retain control of the funds that will eventually be used to pay off the mortgage until they are ready to do so. Depending on the investor's situation, this sinking fund could be at least partially invested in comparatively volatile assets such as stocks, assuming the investor is willing to take on the risks of doing so.


An important point here is that once a mortgage is paid off, your need for liquidity goes down. The size of a household's principal and interest payments relative to a its total expenses can easily be 20% or more, and eliminating that expense frees up cash to be used for other purposes, such as investing.


Final Thoughts


Interest rates have increased significantly over the past year, meaning that some who took out mortgages when interest rates were significantly lower have the opportunity to arbitrage their mortgage with U.S. Treasuries. Some were able to obtain 15 year mortgages with 2% or even lower interest rates not long ago. Those holding mortgages with such low rates can take advantage of an arbitrage given that 10 year Treasuries are currently yielding 3.71% before taxes.


But for those with significantly higher mortgage rates, there may be no such opportunity, and they may well be better off paying down their mortgage rather than investing the funds. This is especially true for those in or nearing retirement as sequence of returns risk is likely a much bigger concern for them than those who still have decades of accumulation before they can retire.


This also underlines the reality that whether it is financially worthwhile to pay down one's mortgage can change over time. Market conditions are certainly a big part of the decision, but individual circumstances can be important also.

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