Few areas of such importance are as largely ignored as the subject of when to pay off mortgage debt and how to think about it in relation to other investments.
First, it is helpful to think about what a mortgage is. A mortgage is debt. It is a loan that a bank is willing to give you because you post your home as collateral. It is nearly impossible for most people to mentally separate their home from their mortgage, but once you sign on the dotted line to buy the house, in many important ways they are no longer related (in some ways they still are).
Once you buy a property, a mortgage does not leverage the return of the house. The house remains leveraged at 1:1 on your balance sheet regardless of the level of your mortgage. If a one million dollar house appreciates or depreciates by 10%, you still make or lose a hundred thousand regardless of the size of your mortgage.
A debt is the opposite of an asset, and borrowing money for an interest rate is the opposite of lending money for an interest rate. So, essentially, having mortgage debt is the same as being short loans (a.k.a. bonds). If you own bonds paying 5% and you have a mortgage loan paying 5%, they effectively cancel each other out (let’s ignore tax implications for the moment).
Once we accept that, it becomes easier to make better decisions about mortgage debt.
The obvious first question is does it make sense to own bonds and have mortgage debt?
If the interest rate on the bonds is meaningfully lower, the answer is probably no. This depends a lot on the specific bonds you own. Let’s say your bond exposure comes from an ETF representing the Barclays Aggregate Bond Index. As of this writing, the yield on this bond fund is just under 2% and most 30 year mortgages are just under 4%. So by owning the bond fund and having the mortgage, assume you are giving up about 2% per year.
It gets more complicated because of taxes. The 4% mortgage rate is probably effectively in the 3% range for most people because of the allowable deduction on mortgage interest rates. Make sure you consider that you lose your standard deduction if you itemize, so the benefit may not be as large as you think.
Also, you may be paying taxes on the bond investment. If the bond fund is owned in a taxable account, the 2% yield becomes more like 1.5%. If you hold it in a tax-deferred account, there is no direct loss to the yield, but it probably means your stocks can’t be in the tax-deferred account so there is opportunity cost.
No matter how you look at it, in this hypothetical case, it seems we are likely paying at least 1% more in effective mortgage interest than we are collecting on the bond investment. So we should sell the bonds and pay down the mortgage loan, right?
Maybe. The primary reason not to is liquidity. In the current market environment, acting as a store of value is often more important for bonds than income generation. Having liquid assets available can be important to take advantage of other investment opportunities or for life’s surprises. You may be able to re-leverage your mortgage with a home equity loan in the future, but this can be costly.
Obviously, many types of bonds pay higher yields than current mortgage rates. This creates the opposite scenario but introduces default or currency risk.
Most investors own bonds and have a mortgage, and this is acceptable. But it doesn’t make sense to have a high allocation to bonds which pay significantly less than your mortgage rate. This includes low paying CDs and Savings accounts that are not part of your emergency cash cushion. Don’t forget transaction costs and management fees when considering bond yields.
There is no magic number, but to give up a 2% yield spread per year now means a lot of things have to go right in the future to compensate for it.
If we do reach a point in the future where your bonds are paying more than your mortgage, this is a great situation. Never pay down your mortgage more than necessary if this occurs.
Does This Force Me into Owning too Much in Stocks?
If you back out real estate, many people have higher stock allocations than they realize.
As we said above, a mortgage is the equivalent of a short position on bonds. When you make a new real estate purchase with a mortgage, you are shifting your allocation from bonds to real estate – sometimes in a big way.
If your bonds are paying well below your mortgage, and you sell them all to pay down your mortgage, it may seem this will mess up your stock/bond allocation strategy and leave you with too much in stocks. Really, it does not change it because your mortgage was a short bond position to begin with.
Imagine you start like this:
Home Value: $500,000
Your net worth is $1,000,000 and your stock portfolio is 60% of your net worth.
If you sell the bonds and reduce the mortgage to $100,000, stocks are still 60% of your net worth, but since you will not be selling your home for some time, they are in some ways 100% of your investment portfolio. If you decide this is too high (which it might not be depending on your savings rate and time horizon), you could sell some stocks and pay down even more of the mortgage.
All of this seems to lead in the direction of not having a mortgage. This is not the intention. Home mortgages, especially because the government subsidizes them with tax breaks, can be a great source of cheap money. They are the biggest source of leverage in America. Leverage is sometimes considered a bad word, but used properly it can do wonders for your net worth in retirement. Just make sure you don’t borrow money and then turn around and invest it in something that will pay a much lower yield than you are paying.
Craig Birk, CFP®
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