When I meet with clients, I usually identify one area where they can lower risk and increase returns in a can't-lose scenario. This seemingly too-good-to-be-true proposition? Advising them to either pay down or pay off their mortgages.
For clients, this is counterintuitive. Mortgages are cheap, tax-deductible money, they might protest. And if the house goes up in value, that greater leverage will result in a greater percentage gain.
To examine these arguments, let's look at an affluent couple - the most clear-cut case and the most traditional kind of planning client.
The Smiths, as I'll call them, are both 50 years old. They own a $600,000 house with a $400,000 30-year mortgage, recently refinanced at 4%. They have a taxable portfolio of $1.6 million, and each has a $200,000 IRA. All accounts are split evenly between stocks and bonds. (You can see their investment portfolio in the chart below.)
At first glance, it appears the Smiths have $1 million in stocks and $1 million in bonds, plus the $200,000 equity in their house, for a total net worth of $2.2 million. But I don't see it that way - because a mortgage is merely the inverse of a bond.
* Mortgage: Borrowed money in which a client pays an entity principal and interest.
* Bond: Money lent by the client for which an entity pays them principal and interest.
As I see it, it's really that simple.
As a result, I'd argue that this requires some rethinking of the portfolio. Using this analysis, the Smiths still have a total net worth of $2.2 million - but with very different asset allocation. In addition to the $600,000 house, there's a $1.6 million net portfolio that is 62.5% in equities and 37.5% in bonds. (See the revised investment portfolio chart, below.)
HOW MUCH RISK?
As with most new clients, one of the first questions a planner might address with the Smiths is how much risk they should take. Like many of my clients, the Smiths might be surprised to find that I view their asset allocation as far riskier than the 50% stock portfolio they believe they have. But let's assume that they are comfortable at 62.5% in stocks and don't want to change the allocation. (The argument to pay off the mortgage would be even stronger if they did want the 50% stock allocation.)
Typically we would look at the total expected return of the portfolio. Assuming that stocks have an 8% expected return and bonds have a 2% expected return, the $2 million in investment assets would produce an overall 5% expected return, or 1% more than the 4% mortgage. And the mortgage is tax-deductible to boot.
So: Why pay off the mortgage?
George Parker, professor emeritus at the Stanford Graduate School of Business, points out what I learned in business school more than three decades ago - that one must compare equity to equity and debt to debt. For that reason, compare the mortgage costs not against the returns of the whole portfolio, but against the fixed-income allocation.
Further, since the the financing of the home has no bearing on its future appreciation, compare the mortgage to a risk-free bond. Put another way, the money used to pay off the mortgage would earn a guaranteed 4% return.
Now consider the Vanguard Total Bond Market ETF (BND), with an SEC 30-day yield of 2.09% as of a month ago. (While it's not risk free, it has low default risk, in that 70% is backed by the U.S. government.) Basic financial theory tells us it's foolish to lend money at 2.09% when you are borrowing at 4%.
Assuming the Smiths are in a 35% marginal tax bracket, they would make $5,200 annually after taxes from the $400,000 investment in the bond fund - but they pay about $10,400 a year after taxes in interest on their $400,000 mortgage. (The actual mortgage interest would be a tad less since the mortgage is self-amortizing.)
If the Smiths don't pay off the mortgage, they can earn a low-risk, after-tax expected return of $5,200, but they will pay $10,400 in interest, after taking into account the interest deduction. That answer comes out the same irrespective of whether the house goes up or down in value that year. The point is clear: Paying $10,400 to make $5,200 is not in anyone's best interest.
In fact, the net savings from paying off the mortgage could be much greater if either the client is not able to use the full interest deduction because of tax phase-downs, is subject to the passive income 3.8% Medicare tax, or both. Note that all of this analysis would be only moderately less compelling for clients in the 39.6% bracket and living in a high-tax state.