Monday, May 12, 2014

Pay Off the Mortgage, Right?

My last two blogs, Investing the Mortgage and Selling Stocks to Pay the Mortgage, delved into the mechanics of holding a mortgage and simultaneously holding an investment portfolio. My intent wasn't to advise that you should or should not pay off the mortgage, but rather to explain the bet, and to show that it changes after retirement.

The proposition is essentially this:

"I bet that I can earn enough money investing in stocks and bonds to equal my mortgage payments and, further, to provide enough profit in excess of those payments to adequately reward me for exposing my home to greater foreclosure risk."
History shows this isn't a great bet, that it certainly isn't easy money, and that it becomes a worse bet after retirement.

So, everyone should rush to pay off the mortgage, right?

Not necessarily.

If a wealthy client asked me if she should take out a mortgage on an unencumbered home for the sole purpose of leveraging her stock portfolio, I would not hesitate to say, "Absolutely not." Had she already retired, there is an even stronger case for forgoing a mortgage.

On the other hand, for a less wealthy household, paying off an existing mortgage might convert most of her liquid assets into illiquid home equity. Freeing up cash from home equity can be challenging. (A fixed rate mortgage, it should be noted, is a temporary solution to that problem.) Maybe I would recommend keeping the mortgage.

But, maybe I wouldn't.

Lawrence Kotlikoff, who built E$Planner, says that he has analyzed many mortgage payoff scenarios and he most often sees an improvement to the household's standard of living, though not always. This is more of a cash flow than a profitability analysis and I would see what consumption smoothing says about the client's finances before making that recommendation.

Regardless, many retirees will eventually pay off their mortgage and have to face the illiquidity problem. They may find that most of their wealth is tied up in home equity. Better to plan for it up front. The most effective solution may be downsizing or relocating. It may not be a mortgage issue, at all.

Should you pre-pay the mortgage instead of investing? I wouldn't advise my son to pre-pay instead of investing in a 401(k). The amount of money we need to save to retire comfortably is so large that investing in risky assets is the only realistic way to get there. Pre-paying the mortgage is too conservative an approach. You have to take the risk. But, once you feel that you have saved enough for retirement, or you actually retire, you no longer need that risk.

After you retire, however, if you hold investments that could pay off the mortgage, you're relying on future stock returns instead of a paycheck to pay the mortgage and that's riskier. You're betting your home that you will succeed in exchange for a net expected return that is lower than your expected portfolio return by the amount of your mortgage. Your net expected return will be sharply lower than that of your portfolio return, but your risk will be the same1.

As sustainable withdrawal rates studies showed, the higher the spending rate from your portfolio, the greater your risk of outliving your savings. Paying off the mortgage will probably reduce your withdrawal rate and thereby decrease your risk of depleting your savings. (I'll go into this "lifestyle leverage" in greater detail in a future post.)

Taxation may also be a consideration, though frequently a second-order problem after retirement. Consider taxes part of the calculation, not a certain justification for keeping a mortgage.

Lastly, there is a risk tolerance issue to consider. While many retirees will be comfortable with a higher withdrawal rate and more exposure to foreclosure risk, many will not. To quote a recent commenter on this blog,

"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. "
As you can see, there is significantly more to consider than expected portfolio returns and current mortgage rates when you consider paying off the mortgage. I would want to answer the following questions:
  • Will paying off the mortgage significantly improve my standard of living?  (Calculate with E$Planner.)
  • Will I have adequate liquid assets after paying it off?
  • What is my foreclosure risk before and after a payoff?
  • What is my portfolio withdrawal rate and risk of portfolio failure before and after payoff?
  • Will I sleep better knowing my home is paid off?
  • What are the tax implications of paying off the mortgage and of not doing so?
  • If I am still accumulating retirement savings, will paying off the mortgage leave me with too little market risk to achieve my goals?
When is the right time to concurrently hold a mortgage and investments that could pay off that mortgage?

If you're very wealthy, paying off the mortgage seems like a no-brainer. If you insist on portfolio leverage, open a margin account. 

If you can't afford to pay it off, I suppose that's a no-brainer, too.

It's always the group in between that has the tough call. Investing the mortgage may not be the best bet, but sometimes it's the best bet on the table.


1 Mathematically, we are subtracting a constant mortgage payment from a random variable representing our portfolio return. That random variable might have an expected return of 8% and a standard deviation of 12%, for example. The result of the subtraction is another random variable with an expected return of 8% minus the annual mortgage payment, but the standard deviation (risk) of the initial portfolio return random variable will remain unchanged. Lower return, same risk.


  1. Dirk,
    This is a very nice series of posts. Thank you for making me reconsider this issue. I just got a 30 year mortgage and was initially thinking of it as cheap money since it is at 3.5 %. But now I realize the inherent riskiness of the strategy.

    1. It IS a cheap loan. But the strategy has the same risk as the stock market with a lower expected return and that isn't "cheap money."

      Glad I helped with your thought process. That's my goal. Not to tell you whether or not to make the bet, just to make sure you understand it.

      Thanks for writing!

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  3. I get your point, which is to say that borrowing money to buy stocks makes an already risky investment more risky. But there can be a different and valid reason, I think, for a retiree to maintain a mortgage even when he or she could afford to pay it off. That would be someone highly dependent on income from a fixed pension or fixed annuity that provides no inflation adjustment. In that case a historically cheap 30 yr mortgage might make sense as an inflation hedge. In my case, I consider my 4% mortgage payments to be a kind of inflation insurance premium paid for out of my bond portfolio. Yes, this is a net loser today in our low interest and low inflation circumstance. But if high inflation comes roaring in, with fixed pensions and fixed annuities losing real purchasing power, then a low fixed rate mortgage will be a wonderfully uncorrelated star in an otherwise dreary sky. William Bernstein mentions this idea in passing when he discusses the perils of high inflation and how to mitigate that risk. Perhaps someone fully invested in TIPs and stocks might not need to pay this kind of premium. But with the cost of inflation adjusted flooring so expensive now, might this not be a reasonable if only partial alternative for those significantly dependent on fixed rate income?

  4. I wonder how many households significantly dependent on fixed income have the wherewithal to pay off their mortgage, but there are several good reasons for a retiree to hold onto a mortgage, maintaining liquidity being more important than inflation protection. Using your home solely as a margin account is not a good reason.

    And, yes, a fixed rate mortgage protects the principal and interest component from inflation. However, you can also protect yourself from inflation with stocks, TIPs bonds and inflation-protected life annuities without exposing your home to foreclosure risk, and you can protect more than just your mortgage payment.

    A close friend lost his million-dollar home to foreclosure in 2008. He and his family moved away. We have gotten together several times since then and not once has a said, "Throughout our crisis, I took great comfort from not having to worry about inflation."

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