The Money Commando

How to calculate if you should pay off your mortgage early

TheMoneyCommando

Over the last year I’ve read a variety of posts from various personal finance bloggers discussing the merits of paying down their mortgage. These articles usually go something like this:

We have a mortgage at 5% interest. The stock market averages 10%/year. Thus, we should allocate money to the stock market rather than to paying down our mortgage.

The end

This is ridiculous. After all, as of August, 2017, 10-year US government bonds are paying 2.3%, 30-year US bonds are paying 2.8%, and investment grade bonds are paying 3.27%. Those rates are all lower than 10%, so using TBL (Typical Blogger Logic), nobody should buy bonds. In fact, 10-year treasury rates have been below 8% since the early 90’s. Using TBL we could conclude that no individual investors should have purchased any 10-year treasuries in the last 25 years.

This is an incredibly simplistic analysis. It doesn’t factor in taxes. It doesn’t consider projected returns based on current stock market valuations, and it doesn’t consider how a mortgage fits into existing asset allocation.

We don’t allow that sort of superficial analysis here at TheMoneyCommando, so let’s dig into the issue a bit more.

Our story

When we bought our house in 2012 paid for the house with a combination of down payment, a first mortgage, and a second mortgage. The split was roughly 55% first mortgage/22% second mortgage/23% down payment. In dollars this was roughly $625k/$250k/$255k on our $1.13M house.

A more typical financing scheme would have the first loan account for 80% of the value of the house. We were limited to a loan of up to $625k because that’s the maximum size of a jumbo loan in our area of California. Any larger than that and the loan is no longer a conforming loan and the interest rate will be higher.

Here is what the second mortgage looked like:

The required payments of $1,361.22 would pay of the mortgage in 30 years. Our plan was to have the second mortgage totally paid off within 15 years. The idea was that it would be tough to pursue early retirement if we had this monthly payment.

To pay down the mortgage faster we decided to pay $2,000/month. Using the NPER() function in Excel/Numbers we get the following:

Nothing too surprising here. By paying an extra $638.78/month on our mortgage we’d cut the term from 30 years to just under 15 years.

The loan funded on April 18, 2012, so with the accelerated payment schedule it will be paid off in April, 2027.

I’m writing this in 2017, which means that if we continued to make payments of $2,000/month we’d have 10 more years of payments.

Here’s the question – how do we determine if these prepayments are the best expected use of our money over the next 10 years?

Expected returns in the market

When determining where to allocate your money, you should always compare the expected return of the investment in question to the best alternative. Charlie Munger has talked extensively about this idea.

In more “normal” times, I assume that over a 10+ year time period I can get returns in the stock market of approximately 8%/year. If I think that a prospective investment (real estate, bonds, paying down the principle on a mortgage, etc.) will provide a higher return than 8% then I should buy the investment. If the expected return is less than 8% then I should put my investment dollars towards the stock market instead.

Again, this is TBL.

As of the middle of 2017 we are in anything but “normal” times. The valuation of the stock market is sky-high. And, as I’ve written about before, current market valuation is an excellent predictor of returns over the next 10 years. When the Schiller CAPE is 30 (which is where it is today) the expected real returns over the next decade are somewhere between 0% and 2.5%/year. Assuming long-term capital gains/dividends tax of 15%, this would be 0%-2.1% annually after taxes.

Now the question is – can we get higher than 0% to 2.1%/year by investing somewhere other than the stock market?

Let’s look at potential investments.

Alternative investments

These are non-traditional investments in things like education, improving efficiency so we can make more money or incur lower expenses, etc.

The first investment we analyzed was solar. My calculations showed a 12.9% return on a solar investment, which far exceeds any other investments I have on my radar right now. Unfortunately, installing solar is a one-time investment. Once we have enough solar capacity to lower our electricity bill to $0 there’s very little value in additional investment. So, while we are moving forward on solar for the house, we can really only invest about $20k in solar at a 12.9% return.

The next investment we analyzed was education. I did some quick calculations and estimated that it would cost $10k (and 3 years of time) to pursue a CFP (R) certification. This was a small investment with a big payoff – a potential future income stream and/or career change in case I ever lose my current job.  I estimate that we are saving about $1,000/year through a combination of things I learned from the CFP curriculum, which means we are getting a roughly 10% annual return. Not bad.

Traditional investments

After we’d exhausted our prospective alternative investments it was time to compare a mortgage prepayment to more traditional investments.

Bonds

I don’t particularly like bonds today. Interest rates are near all-time lows. This means that interest rates are much more likely to be higher in 10 years than lower. So, not only are you locking in historic lows for your interest income, you’re pretty likely to have the value of your bond decrease in the meantime (higher future interest rates mean the value of existing debt decreases).

I’d like to increase our bond allocation but not at today’s risk/reward tradeoff.

Stocks

The good news is that there are a few specific areas of the stock market that look interesting. Oil prices are low which means oil stocks are low (Exxon, Chevron, BP, etc.). Of the oil majors I’m most interested in Exxon – I already own some BP and Chevron and I think Exxon is better run than either of them. In fact, the only reason I don’t already own some Exxon is because it’s always been much more expensive than the other options.

Bank stocks are still selling at relatively interesting valuations. Some REITs (including my favorite, OHI) are selling at low valuations because everybody is concerned that REITs’ borrowing costs are going to go through the roof when interest rates eventually rise. Bank stocks are especially interesting because their profits should increase when interest rates eventually rise. Higher future profits combined with lower valuations today means they should be a solid investment.

I might nibble at some of the options listed above, but I don’t feel like any of them are enough of a screaming deal to warrant significant investment.  I believe there is a significant amount of risk in the stock market today.

The after-tax return from paying our mortgage

Here’s how I ultimately made the decision to pay off our second mortgage – paying the mortgage means I’ll save the 5.125% in annual interest on the loan. That’s the same as getting a 5.125% return before taxes. In an average year we pay a combined 40% federal and state tax rate. This means the after-tax return on paying down our mortgage is (1-40%)*5.125 = 3.075%. Not great, but still better than the expected return from the stock market over the next 10 years (which we discussed is 0-2.5%/year).

However, the key to paying down the mortgage is that it’s a GUARANTEED 3.075%. Federal debt instruments like T-bills and T-bonds are considered risk-free investments but they aren’t really risk-free. After all, the US government has racked up a LOT of debt over the last few decades. There is a small chance the US government won’t be able to pay its debts. Paying down your mortgage is a truly risk-free investment. There is no risk of default.

How does a 3.075% after-tax return compare to other low-risk investments? As of August, 2017 the rate on 10-year treasuries is around 2.3%. federal debt is exempt from state taxes, so assuming 33% federal taxes we’d have an after-tax return of 1.5%.

My Vanguard California intermediate muni bond fund (VCAIX) is currently yielding around 1.6%. That’s a tax-free return, which matches up pretty closely to the 1.5% after-tax return from federal debt.

So the after-tax return from paying off my mortgage (3.075%/year) is higher than the expected return from federal bonds (1.5%) or munis (1.6%) AND is lower risk than either.

Analyzing asset allocation

The general consensus is that asset allocation explains the vast majority of an investor’s returns. By “vast majority” I mean 90-100%.

It’s clearly important to get your asset allocation correct. But most people aren’t calculating their asset allocation correctly.

One difficulty is that there’s no “correct” asset allocation. Various people have various requirements, depending on age, stage in life, risk tolerance, etc. But let’s use a common and very simple rule of thumb – you should have your age in bonds and the rest in equity.

So if you’re 70 years old you should have 70% of your investments in bonds and 30% in equity. If you’re 25 you should have 25% of your investments in bonds and 75% in equities.

Let’s take a 30-year-old with a $100,000 portfolio that looks like this:

Looks good, right? The investor is following the rule-of-thumb and has a reasonable asset allocation.

Now what if that person sold $50,000 of the investor’s portfolio and used it for a 50% down payment on a house? Assuming they kept the same ratio of stocks/bonds this is what they’d have:

This makes sense – the net worth is unchanged but the asset allocation has changed. Most people would consider the real estate portion of the portfolio to be the value of the house less the mortgage: $100,000 – $50,000 = $50,000.

Most people would look at this investor and say the asset allocation is 35/15/50 stocks/bonds/real estate.

This is wrong.

Why?

Because of a very key point that few people realize:

A mortgage is not a real estate investment. A mortgage is a negative bond.

The correct way to think of a mortgage payment in terms of asset allocation is as an investment in the bond/fixed income portion of your portfolio. It’s a zero volatility, zero risk investment.

The reality is that the investor’s financial statement now looks like this:

The actual asset allocation is 35%/-35%/100% in stocks/bonds/real estate. This investor is substantially underweight in bonds.

This is important because, in general, the higher your bond allocation the lower the risk in your portfolio, and the lower the bond allocation the higher the risk in your portfolio. A negative bond allocation is obviously more aggressive and riskier than a positive bond allocation. This means that most people have a mortgage probably have a significantly more aggressive portfolio than they think they do.

Paying down a mortgage reduces risk, and in the late stages of a bull market you should be reducing risk.

The steps to evaluate prepaying your mortgage

Here are the correct steps to follow to analyze whether or not you should prepay your mortgage:

Step 1: Calculate the after-tax return from paying down your mortgage

Since you receive a tax deduction for the interest on your mortgage you must discount the interest rate by your combined federal and state (assuming you itemize deductions).

Step 2: Evaluate expected after-tax return from other investments

Stocks: estimate stock market returns over the next 10 years, based on current valuation. Investing in the stock market should be your “default” investment option that you compare other investments to. Today, with the Schiller CAPE at >30, you can estimate returns of 0%-2.1%/year after taxes over the next 10 years.

Bonds: your return over the life of bond (assuming you hold it to maturity) will be the interest rate. As of August, 2017 that means you’re looking at around 1.5-1.8% after-tax returns from 10-year treasuries and muni bonds. Corporate bonds are higher and junk bonds are even higher.

Alternative investments: education, starting a business, improvements/investments in efficiency to reduce future costs, etc. Calculate the expected after-tax return.

Step 3: Determine your actual asset allocation and, if you are dramatically underweight in bonds, prioritize prepaying your mortgage

Run your asset allocation numbers using your mortgage as a negative bond. If this puts your bond/fixed-income allocation in negative territory then you should strongly prioritizing a mortgage prepayment unless an alternative investment is likely to provide significantly higher returns.

Our analysis

I went through the steps above to determine if we should pay our mortgage early. We decided that solar and additional education were better investments than prepaying our mortgage, so we made those investments first. After those investments were made I determined that paying down our mortgage was the next best investment.

As a result, over the last month or so we’ve paid the remaining $180k on our second mortgage. That will improve our cash flow by $2,000/month (as I mentioned, we were making larger than required payments to accelerate payment on the mortgage) and provide the equivalent of an annual 3.075% bond.

Calculating our remaining first mortgage ($563,624.09) as a negative bond still leaves us with a negative bond allocation, but paying the second mortgage puts us closer to 0% than we were previously.

 

Questions for you

Do you consider your mortgage to be a negative bond when calculating your asset allocation?

Have you prepaid your mortgage? If so, did you do an analysis like this to determine if you should prepay your mortgage?