The 10th Man

Is a Hot Dog a Sandwich? (Part 2)

August 30, 2018

Last week, we said we were going to talk about prepaying mortgages. So let’s talk about prepaying mortgages.

Every mortgage comes with an embedded option—the option to prepay1. That may take the form of sending smaller prepayments every few months or so. Or, more commonly, it takes the form of prepaying the whole thing at once.

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Naturally, you can pay off the mortgage if you move and sell the house. But even if you don’t move, you can pay off the mortgage and get another, cheaper one (if interest rates go down). This, of course, is known as refinancing.

There are calculations you can do to figure out if it makes economic sense for you to refinance your mortgage—we won’t go into that here. Basically, there is some paperwork involved, and you have to pay for an appraisal and a few other things. It takes a little time. Anyone who has refinanced has probably discovered that it is more work than they thought.

Anyway, it makes sense to refinance your mortgage if interest rates go down. If you have a 4.5% interest rate on your mortgage, and rates decline to 3.5%, you can probably save a few hundred dollars on your monthly payment.

To Prepay or Not to Prepay

The same decision matrix applies to prepayments. It makes sense to send in additional principal when rates go down, because you are technically earning 4.5% by prepaying your mortgage. And because interest rates have declined, opportunities to make 4.5% elsewhere have disappeared.

It can also make sense to prepay your mortgage when interest rates go up, for safety reasons, which we will talk about in a second.

I’m sure many readers of this newsletter think that earning 4.5% is not very sexy. Au contraire. It is the sexiest thing I have ever seen. That 4.5% is a sure thing2. It’s like a T-bill yield. There aren’t many opportunities to earn 4.5% risk-free anywhere these days. If you think there are, you are probably spending too much time hanging out on StockTwits.

So the question is: When should I prepay my mortgage, and when should I invest? Should I pay off all my debt before I invest a dime?

Answer: You should pay off all debt except for your mortgage (which is tax-advantaged). You should chip away at that over time. Liquidity is important, too—if you pay off your mortgage but have no cash for emergencies, that isn’t very smart. Once you have paid off your car loan and your credit cards and your student loans, you can do these three things:

  1. Prepay your mortgage
  1. Save cash
  1. Invest

Your goal should be to be completely debt-free (including the mortgage) in 5-7 years.

Caveats

Let’s talk a little bit about asset allocation.

Most people want an asset allocation that looks like this:

  • 60% stocks
  • 40% bonds

We will talk about the wisdom of 60/40 another time. Now, are you diversified if you have stocks and bonds? Not really. To help with diversification, you can instead have an asset allocation that looks like this:

  • 55% stocks
  • 35% bonds
  • 10% commodities

But we are leaving out one big thing. We are leaving out…

… real estate. In particular, your own home!

I think real estate should make up about 20-30% of your portfolio, for diversification purposes. Then, your asset allocation looks something like this:

  • 40% stocks
  • 30% bonds
  • 20% real estate
  • 10% commodities

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Now, the allocation to real estate isn’t the notional value of your home; it’s the equity in your home. So a typical asset allocation might look like this:

  • $80,000 in stocks
  • $60,000 in bonds
  • $40,000 in real estate
  • $20,000 in commodities

The $40,000 here represents equity in your home. If you have a $200,000 home, and you have $40,000 in equity, you have 20% equity.

All easy enough.

But Debt Is Still the Enemy

Overriding all of this is that you should have a bias to pay down debt. As we have said in previous issues, we like mortgage debt better than other kinds of debt. But it is still debt. And the bank can still foreclose on you even if you have a one penny balance on your mortgage3. So paying down your mortgage is about eliminating risk.

What if you have a debilitating injury and you can no longer make payments on your mortgage? What if you die and your spouse (who may not work) is stuck with the mortgage payments? Etc. Nobody thinks about this stuff. Wouldn’t it be better to be rid of your mortgage once and for all?

So even though we want to think about our asset allocation, we also should have a bias to pay down debt. This may result in you having a higher allocation to real estate than you would otherwise have. It may also result in you prepaying even when interest rates are going up.” Work on paying off the mortgage, and after that, work on investing. You will have plenty of time.

One of the coolest things in the world is having a house that is paid off. If your house is paid off, and you sell it, you get all the cash. It actually happens! At the closing, they will wire a million bucks or whatever into your account.

People have a hard time thinking about their house or their mortgage as saving or investing, but it really is. If you sell your house and rent somewhere, you can then take that million bucks and invest it.

If your house is paid off, all you really have to pay is the property taxes (and the cable bill, and stuff like that). You don’t even have to pay for the insurance, but you probably should.

I practice what I preach. I have about a 25% allocation to real estate and my mortgage should be paid off in a year or two. I bought a bigger house about 3.5 years ago partly because I wanted a higher allocation to real estate. It has been an excellent trade (even though a house shouldn’t be a trade).

If you really need a reminder as to why this is the best advice out there, go watch the John Goodman speech in The Gambler4. Sometimes I think I need to watch that every day of my life.
_______________

1 Most corporate bonds have this option as well—they are known as callable bonds.
2 More accurately, you’re earning 4.5% on an after-tax basis (since you can deduct interest payments), but the math behind that has become a lot more complicated, so best to ignore for now.
3 There were stories about Steve Mnuchin, as CEO of IndyMac, foreclosing on people in this manner after he was named Treasury Secretary.

4 I can’t link to it here—it’s an R-rated movie. But the speech is on YouTube.

Jared Dillian
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Comments

jack goldman

Aug. 31, 10:24 p.m.

People are very confused. No one has money, gold bullion and silver bullion. What people have is currency, legally counterfeited currency debt notes and computer credits worth nothing. We are playing a fake let’s pretend game. Debt is not money. Mortgages are not money. People who work for debt notes are free slaves. 1n 1800, 1% of the world were slaves. In modern times, today, 100% of employees are slaves, working for free, for counterfeit currency. Only people with gold bullion have money. The US Treasury issues MONEY but a real silver dollar costs 17 fake Federal Reserve debt notes. Plus I have to pay income taxes on my labor at about 50% of my life, an extreme high form of debt slavery, paid with debt notes worth nothing. Gold and silver eagles are money. All the rest is just credit.

If you want your real dollar value divide all assets by 17, the cost of a real silver dollar. $170,000 debt note dollars is really only $10,000 in real dollars. Of course the population believes in faith based let’s pretend fake currency but that could change on a dime. Protect yourself. No one else can or will. Good luck to us all in the next reset.

dltucker2@gmail.com

Aug. 31, 2:30 p.m.

Hi Jared,

Your logic makes sense, unless you think there’s a chance of future spike in interest rates and/or debt foregiveness.  Many commentators feel the current US National and Corporate debt cannot be paid off without printing a lot of inflation which of course benefits debtors.  If the US government, big business and a large portion of the population hold debt that they cannot repay, there will be a lot of political pressure to inflate or otherwise relieve debt. 

Care to comment on the likelihood of this possibility in the next ~10 years?

Thanks for all the great insights.

Jim Johnson 34645

Aug. 30, 1:19 p.m.

If varies with disposable income, but just paying the mortgage to the next even hundred dollars will get one on the way to paying it off or at least reducing the interest paid on the remaining balance.  If the contracted mortgage payment is $1343.21 just send them a check for $1400.00.  Hey, if you can afford $2000 a month, go for it.  There is no rule, usually, about paying down the principal and increasing your equity.

Glenn Mulno

Aug. 30, 10:23 a.m.

Good article to read. I have some questions though.

I’m approximately 15 years away from retirement, my goal is to have no mortgage when I get there. So, no matter what is happening with rates I want to pay off my mortgage faster than normal. I get if interests go way up the math says invest, but todays rates, and the general market outlook, dont inspire me to invest. The longer term security of being mortgage free is much more attractive than making 1% more in the market. Is this ok? or insane?

You talk about real estate equity being a factor in your portfolio and suggest a ratio of:
40% stocks
30% bonds
20% real estate
10% commodities

Using fictitious number here but if your portfolio looked like this, would you suggest something different be done?
250k stocks
200k bonds
300k real estate

or $400k in real estate? or $600k? Is there a point where your equity is “too high” and you’d suggest a different action plan? 

Controlling the ratio of your stocks to bonds is not too hard. But your home equity is not something you can control unless you intentionally take money out in loans and spend it. If you’re trying to pay off the mortgage, how should that factor in?

The other side is - why factor it in at all? If you’re not planning on going anywhere for 30 or more years - its just numbers on a piece of paper. Useless until you sell and depending on what you do next, maybe not even useful then.

hsinvest@att.net

Aug. 30, 9:55 a.m.

First, any of those allocations could have beneficial results - unless the asset classes used are too highly correlated. We are seeing high correlations among and between “traditional asset classes” leading to not obtaining risk/rewards posited by MPT;
Second, IMHO, cash continues to be a better portfolio volatility dampener than bonds, especially since 2007;
Third, buying bonds at the rates of interest currently available is almost as ill advised as buying annuities. Interest rates only have one direction to go after they end their languishing, and that direction is a contra-indication to bond prices.


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