Monday, May 5, 2014

Selling Stocks to Pay the Mortgage

In my last post, Investing the Mortgage, I showed that the profit from borrowing a mortgage and investing the proceeds in the stock market is far more complicated to predict than simply subtracting the mortgage rate from the expected rate of your portfolio return. In fact, historically, this strategy would have resulted in a wide range of outcomes, the financial definition of risky.

I repeat the chart of outcomes from that post below. Note that the worst case outcome was a $37,333 loss, the best case was a $133,287 gain, and the median profit from this strategy would have been $26,937. (If you haven't read Investing the Mortgage, I suggest that you do so first. It explains the analysis in more detail.)
Once we retire and begin paying the bills from a portfolio of stocks and bonds, there are two subtle changes in our finances that can have a significant impact on the profitability of mortgage-to-invest.

The first difference is that we can't really borrow money and invest it in the market — not all of it, anyway — because we have to start paying it back almost immediately from our investments. If we borrow a 4% fixed rate thirty-year mortgage of $100,000, the payments will be about $5,724 a year and we will reduce our portfolio by that amount annually. The average amount of the $100,000 that would remain invested each year over a ten-year period would be a little more than $74,000. With less money invested, of course, our portfolio will grow more slowly.

When we pay the mortgage from future paychecks, as I modeled in the last post, we have the luxury of leaving all of the borrowed funds in the market for the entire 10-year period. If the market goes up, as we hope, holding more stocks will earn more money.

The second difference, which may be less obvious, is that spending from a stock portfolio over time, to pay the mortgage or anything else, creates sequence of returns risk. (See my posts on the topic if this is unfamiliar to you.)

Here's an example.

The following table shows the historical sequence of returns a 50/50 portfolio would have experienced from 1981 through 1990. The second row shows the least advantageous sequence of those same returns (sorted smallest to largest) for an investor spending down a stock and bond portfolio. The third row shows the best case sequence for this investor (returns sorted highest to lowest).
(Double-click to enlarge the table.)

In all three scenarios, the compound growth rate is the same, 8.7%, and that would be our return if we didn't sell stocks along the way to pay the mortgage. Without portfolio spending, there is no sequence of returns risk. The terminal portfolio value will be the same regardless of the order of the returns.

However, if we assume that the retiree has a portfolio valued at $100,000 and is spending say, 4% of the initial portfolio value each year ($4,000), then her portfolio value at the end of this 10-year period would be different in all three cases. The historical value of the portfolio would be $168,470, the best possible outcome would have been $184,820, and the worst $147,988.

This range of values that results from reordering the returns is sequence of returns (SOR) risk. It isn't "good" risk. It can't be diversified away and we aren't compensated for it by the market. And like SOR risk in retirement portfolios, early losses have a disproportionately bad impact on the mortgage-to-invest strategy outcome.

The combined impact of reducing stock exposure and adding sequence of return risk can be fairly dramatic. I altered the model from my last post such that mortgage payments are made each year by selling stocks and bonds from the portfolio, as a retiree might do, instead of paying them from salary and only selling stocks at the end of ten years, as someone still working would.

In the following chart, I compare the historical outcomes of the mortgage-to-invest strategy using a $100,000 mortgage assuming the investor is still working and paying the mortgage from salary (the blue columns from my last post) with the historical outcomes assuming a retiree pays the mortgage by spending down a portfolio of stocks and bonds (red columns).
The median profit from this strategy during the 10-year rolling periods from 1928 through 2013 declined from $26,937 to $9,374 when the mortgage is paid from stock sales instead of one's salary. This isn't surprising, given that this strategy significantly reduces the amount we have invested in the market over time. The best and worst cases are shown in the table below.
As you can see from the chart above, mortgage-to-invest can be a fairly risky strategy. You can lose a lot of money even when you pay the mortgage from salary. Even if you're still working, a $100,000 bet could have resulted in a profit of $133,287 if you executed it from 1989 to 1998, or a loss of $37,733 if you employed it from 2000 to 2009. That's pretty risky.

After you retire and begin selling stocks to pay the bills, the outcomes are even worse. You lose more in worst cases and your expected return on this strategy dropped 65% over the studied period.

The analysis is pretty much the same, by the way, if we inherit $100,000 and decide to invest it rather than pay down the mortgage, or if we simply decide to continue to hold a stock portfolio and owe a mortgage simultaneously.

A couple of observations. First, many people will find it difficult, before or after retirement, to pay off the mortgage by selling their investments. Maintaining some reserves and liquidity are important, too. We can argue that if paying off the mortgage requires converting too much of your wealth into illiquid home equity that you should consider downsizing, but life isn't always that neat. Paying off the mortgage isn't the right answer for everyone.

Second, for many households, mortgage-to-invest isn't an intentionally chosen strategy, but one that simply developed over time. You bought a house with a mortgage. You invested in a 401(k). You retired and began paying the mortgage and other bills with portfolio spending. Your risk increased unnoticed.

In either case, it is important to understand the risks and rewards and at least consider the alternatives of downsizing or paying off the mortgage if those are options for you. The analysis isn't as simple as "I have a 4% mortgage and I can earn 8% on my investments."

Regardless, as I mentioned in Investing the Mortgage, this strategy increases the chances both before and after retirement that you will lose your home to foreclosure risk, which, in my opinion, trumps any other home financing risk.

I have another basic concern with this strategy after retirement. While it makes perfect sense to borrow a mortgage when we are young, expecting to pay it back with future job earnings, it is a riskier proposition to borrow a mortgage and expect to pay it back with future stock market earnings.

I often point out that our finances change significantly after we retire and we can't view them through the same set of guidelines as before. This is a prime example.

In my next post, I'll discuss when you might want to make this bet.


  1. Contrary to the usual pattern, I upsized my home a few years before I planned to retire. I could have used the proceeds from the prior home and dipped into my retirement savings to own the new house outright. Instead, with mortgage rates at historic lows, I chose to finance 80% of the purchase price over 15 years because it seemed a reasonable way to add some inflation protection to my portfolio and have it subsidized by the mortgage interest tax deduction.

    In accordance with advice from Larry Swedroe, I treat the funds required to pay the balance owing as a negative bond balance in a fixed-income allocation that is short- to medium-term. With the bond returns and inflation of recent years, this has proven to be a mildly losing strategy thus far, but who knows what the future may bring?

    1. Howie, thanks for writing. My response is below.

  2. Howie, if you invest the proceeds in bonds with a similar duration to your expected mortgage life, that would, in fact, be "a negative bond balance in a fixed-income allocation that is short- to medium-term." (Actually, I don't see anything short about it.)

    (Of course, you can't box off a little portion of your portfolio and pretend only bonds are offsetting the mortgage-- that's mental accounting.)

    The outlook for bonds isn't great. Hard to see how you make enough profit on bonds to justify foreclosure risk, but that's a personal opinion.

    If you invest the proceeds in stocks, as you say, who knows what the future will bring?

  3. "The analysis is pretty much the same, by the way, if we inherit $100,000 and decide to invest it rather than pay down the mortgage,".

    Does this mean you are in favor of prepaying instead of investing?

  4. John, the answer depends on many factors of the household's overall financial picture. I would be more likely to recommend paying off the mortgage to someone who is retired or approaching retirement, assuming they have enough wealth to do so and maintain adequate liquidity. Most people won't have enough wealth to do this and should perhaps consider downsizing.

    If you're still working and building wealth, you have to take risk with your capital to have a chance of earning enough to meet your retirement goals. Paying off the mortgage in that case is probably too conservative. I certainly wouldn't recommend that my son pay off his mortgage instead of contributing to his 401(k).

    I think the most important point is to understand the bet that you are making, and that it changes after you retire, and then decide if it's right for you, personally.

  5. I like this blog cuz it is for those who aren't rich, like me. I am SO glad, now that I am retired, that we didn't load up on mortgage debt that we'd now have to service. Our house got paid off 6 years ago and wow, does that make a difference in retirement security.

    Folks who have lots of wealth can afford to play games with housing/investing, but I am with Dirk in wanting to play it safe. Plan ahead; see if you can't have a paid-off mortgage by the time you retire..

  6. I'm semi-retired, age 70, and paid off my mortgage a few months ago. I decided to keep enough of my retirement assets in safe investments to cover basic expenses and put the rest in the stock market. Paying off 140K in mortgage meant selling safe assets that were not earning as much as my mortgage interest rate. A no brainer since I still had funds left to cover basic expenses plus a modest stock portfolio for luxuries. Further, if we have to go into assisted living before I die the house will sell and provide funds for this.

    1. Thanks for writing, Mike.

      I'm getting ready to pay off mine, as well. You probably also reduced your withdrawal rate in the process and, as a consequence, your probability of portfolio depletion. I'm going to blog on that soon.