This previously published article is part of 12 Days of Wealth Management: The Year in Review.
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.
Another argument holds that, if rates go up, clients will be glad they own a cheap mortgage and wish they had borrowed more. To examine this, assume that rates rise by three percentage points.
It's true that the Smiths would, in theory, be able to earn 5% on BND while only paying 4% on the mortgage. That's only part of the picture, however, because rising rates are usually bad for bonds and bond funds. A three-point rate increase over a one-year period would cause a bond portfolio with a 5.55-year duration to lose about 12.8%, according to Chris Philips of Vanguard's Investment Strategy Group. This potential scenario would make paying off the mortgage even more compelling, as the clients would make 4% paying off the mortgage versus losing 12.8% amid rising rates.
The only way the clients can emerge better is if they bought riskier bonds. For example, long-term municipal bonds can yield 3.3%, offering a slightly higher after-tax rate than the mortgage (which has an after-tax rate of about 2.6%). Or the client could buy high-yield junk bonds. But these alternatives are far from risk-free; municipalities face $2 trillion of unfunded pension liabilities, and junk bonds crashed alongside stocks in 2008, just when investors needed bonds to serve the role of shock absorbers.
DEFENDING THE MORTGAGE
There are, of course, reasons to keep a mortgage. The example of the Smiths was more clear cut than for many clients. My theoretical couple had plenty of money, and liquidity wasn't an issue.
Obviously, it's important that clients have enough liquidity for emergencies, including a job loss. The right amount of liquidity depends on each client's situation. Some jobs are more stable than others; consider tenured professors or U.S. government employees.
Liquidity can come from having either cash or low-risk investments in a taxable account, but it can also come from having the right to borrow. A home equity line of credit can serve as that emergency reserve, although it's important to verify whether the bank or credit union has the unilateral right to cancel the line or lower the amount of credit. (For more on HELOCs, see page 89.)
One could also argue that no taxes are due on the bonds in the tax-deferred accounts. While it's true that investments taxed at the highest rates are best located in IRAs and 401(k)s, these are tax-deferred rather than tax-free; taxes will have to be paid eventually. Although this makes any negative spread between the bonds and the mortgage a bit less significant, it doesn't turn that spread positive.
Finally, there is an argument that a mortgage injects some financial discipline by forcing a client to make a monthly payment. If a client would otherwise spend the money they would have used for a mortgage payment, the mortgage turns out to be a pretty good idea. (Although I suspect clients would likely spend the taxable money in the bond funds at least as quickly as the newfound extra cash flow from eliminating a mortgage payment.)
Paying off the mortgage is the equivalent of a corporate financing decision, says Venkat Reddy, dean of the College of Business at the University of Colorado at Colorado Springs. The one difference, he says, is that individuals may react more emotionally than corporations. Individuals may sell bonds or bond funds after interest rates rise.
Morningstar data support Reddy's view, reporting that investor returns have lagged taxable bond fund returns by 1.42% annually over the past 10 years, as investors have bought after rates dropped and sold after rates increased.
ROLE OF INCENTIVES
Why do so many people have mortgages when they don't need to? One clear answer: The system of incentives set up to encourage people to have home loans. Banks profit from lending out money at a higher rate than what they pay depositors. And financial planners also profit from clients having mortgages.
Whether charging commissions or a percentage of AUM, advisors collect less when they have less money to manage. An advisor who charges a 100-basis-point management fee would lose out on $4,000 a year by advising the client to pay off the $400,000 mortgage.
Some planners have adapted their fee structure to avoid a perceived conflict. Martin Kurtz, a former FPA president, says his Moline, Ill., firm charges clients based on a model that considers total net worth and income - not just AUM. Doing the right thing for clients increases referrals, he says, which ultimately benefits his firm.
Advisors have few ways to help clients simultaneously lower their risk while increasing returns. Paying down or paying off a mortgage is often one of the easiest ways to do so.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct instructor at the University of Denver.