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April 19, 2013 | Craig Birk, CFP®

Many people own stock and also have mortgage debt. Usually they randomly fall into a certain asset allocation based on when they buy their house without thinking too much about it.

Below are two examples. They are designed to be extreme, though both are pretty common among our neighbors here in San Francisco.

 Jim Bill Stock Portfolio \$1,000,000 – Mortgage Debt \$(1,000,000) – Home Value \$1,000,000 \$1,000,000 Current Net Worth \$1,000,000 \$1,000,000

It is fairly obvious that Jim is going to do better if stocks do well and Bill will do better if stocks do poorly. Let’s assume that after the tax benefit, the effective mortgage interest rate is 4%. Therefore, if stocks average better than 4% (after-tax), Jim should be better off. Since traditional wisdom predicts higher returns, Jim’s allocation seems like the better choice.

We can quantify this by using Monte Carlo Analysis. We will use simple base assumptions of 8% pre-tax annual equity returns with a standard deviation of 20%. We assign a 15% tax rate to gains. The 4% mortgage payments are not indexed to inflation, which is important.

Time Horizon is critical. We will look at 10, 20, and 30 year periods. Because Bill has no investments, his net worth does not change at all, other than the home value. Jim gets the same effect, so we will simply look at how the risk Jim took with the stocks plays out including paying off a 4% mortgage.

This table shows the odds of each of the scenarios playing out based on the Monte Carlo run.

 Change in Jim’s Stock Portfolio After 10 Years After 20 Years After 30 Years Including Making Mortgage Payments Down >50% 10% 15% 15% Down 50% – Down 25% 10% 5% 5% Down 25% – Even 10% 5% 5% TOTAL ODDS WORSE OFF 30% 25% 25% Even – Up 50% 20% 15% 10% Up 50% – Up 100% 20% 10% 5% Up 100% to Up 200% 20% 15% 10% Up > 200% 10% 35% 50% TOTAL ODDS BETTER OFF 70% 75% 75% Median Value of \$1,000,000 Start \$    1,400,000 \$    2,200,000 \$    3,500,000

What did we learn? Using these assumptions, it is usually better to keep a high mortgage and invest the money in stocks. Sometimes it is a lot better. In fact, after 20 years, about a third of the time you will have three times more money using this strategy.

The importance of this can hardly be overstated.

And, this does not even account for the fact that a large portion of those mortgage payments will be reducing the amount of debt principle.

Still, it is not without risk. No matter what time period we looked at, there was a small, but real risk of losing more than 50% of the value of the stock portfolio.

This is a big game to play, so being conservative makes sense for most people. There is no guarantee stocks will go up.

Therefore, some balance between the two strategies is optimal. But especially for people who are working, it is a big mistake not to have a large portion of total net worth in stocks.

The same principle applies for retired people, but much more caution is warranted here for a few reasons.

First, retired people may not get as much tax benefit from the mortgage interest if their income is lower.

Second, and much more important, if they are already making withdrawals from an equity portfolio to support living expenses, the extra withdrawal for the mortgage payment can put one’s entire net worth in serious danger.

Assume you have a \$1,000,000 home that is fully paid, a \$1,000,000 stock portfolio and you are currently taking \$50,000 per year from the stock portfolio for living expenses. If you move to another million dollar home, take out a mortgage for all of it and invest the proceeds from your first home into stocks, you will now have a \$2,000,000 million dollar stock portfolio but you will need about \$100,000 for living expenses and to pay the mortgage. This is still only a 5% withdrawal rate so the probabilities suggest that the portfolio should survive for a long time. But if things go badly you will be broke and unable to pay the mortgage.

Everyone’s situation and risk tolerance is different, but as long as you believe equities will perform reasonably better than your after-tax mortgage rate, it is better to maintain a relatively high mortgage balance and invest the money in stocks. Because there is some real risk of losing a lot with this strategy, it often does not make sense to be completely leveraged like Jim is in the example. The actual ratio should be dependent on current mortgage rates, equity expectations and other risk tolerance factors such as other assets, income and personal preference.

If you refinance a home, you lose the tax break on the interest if you take on debt for the part of the house you already owned as equity, so there is less incentive to increase debt just to add to stocks, but it may still be the right move.

It is important to have a strategic plan regarding this topic, because it will have a huge impact on your eventual net worth. Don’t just leave it to chance based on when you buy or upgrade your home.