Your Home Is Like A Bond

You’re doing well. You’ve got your emergency fund, you’re maxing out your 401(k), and you don’t have any credit card debt. At this point, a common question is: Should I send extra payments to my mortgage? And with markets near their highs, maybe you’re even wondering, Should I pay off my mortgage?

There are a lot of emotional reasons to pay off your mortgage. You could own your house free and clear and never have to worry about a mortgage again. You could reduce your bills in retirement. Investments carry uncertainty, whereas paying down a debt is a sure thing. Those are typical thoughts, but that’s not necessarily a rational answer.

Maximize Your Net Worth

In financial planning, our goal is to determine the solution which maximizes utility. Will I have a higher net worth if I pay off my mortgage or invest the money?

The answer, then, is it depends. It depends on the rate of return on your investments compared to the rate you are paying on your mortgage. If your mortgage is 3% but your cash is earning 0.5%, you would be better off paying down the mortgage. (Assuming you still kept sufficient liquidity for emergencies). On the other hand, what if your mortgage is 3% and you could be making 7%? Then, you would maximize your net worth by staying invested and not pre-paying your mortgage.

Most people would prefer to be debt free. However, if you can invest at a higher return than you borrow, you will grow your net worth faster. I don’t think of a home as being a great investment. Houses generally keep up with inflation, but have returns similar to bonds, or slightly less.

Home Versus Bonds

Looking at the Case-Shiller 20 City Home Price Index (which includes Dallas), the overall rate of return since 2000 was 4.02%. Let’s look at an actual bond fund, not just hypothetical indexes. An investor could have earned 5.15% a year in the Vanguard Intermediate Term Bond Index fund, since fund inception in 2001. 

The money you put into your house, will likely behave like a bond, although possibly with more volatility. Over a long period, it should keep up with inflation, or if you’re lucky, a little better than inflation. (See below for my concerns about home prices, or thinking of a home as an investment.)

I do believe it is realistic, based both on historical returns and projected returns, to anticipate a return of 5-8% from a diversified portfolio containing 60% or more in stocks. That’s not guaranteed, but if your time horizon is twenty or thirty years (i.e. same as a mortgage), it’s a reasonable assumption. And the longer the time period we consider, the greater likelihood of a positive outcome from stocks.

While it is important to consider the overall levels of risk and return of your portfolio, a portfolio is made up of specific segments. Today, the yields on high quality bonds are very low. With the 10-year treasury yielding only 1.25%, there’s not much return to be had in bonds.

Using Cash or Bonds to Pay Down Mortgage

Let’s consider an example, using round numbers for simplicity. Let’s say you have a $1 million portfolio in a 60/40 portfolio: $600,000 in stocks and $400,000 in bonds. You also have a $200,000 mortgage at 3.5%. The expected returns (hypothetical) for stocks is 7% and for bonds 2.5% today. That would give the overall portfolio an expected return of 5.2%, which is higher than your mortgage rate.

On the bonds, though, the expected return of 2.5% is less than your mortgage cost of 3.5%. If you believe that today’s low yield environment is likely to persist for a long time, it might make sense to take $200,000 from your bonds to pay off the mortgage. That would leave you with a portfolio containing $600,000 of equities and $200,000 in bonds, a 75/25 portfolio. 

The new portfolio would be more volatile than the original 60/40 portfolio, but the dollar value of your stock holdings would remain the same. And your net worth will grow faster, since we paid off debt at 3.5% with bonds that would have yielded only 2.5%.

Provided you are comfortable with having a more volatile portfolio, you might maximize your net worth by withdrawing from bonds but not from your equities. This means increasing your equity percentage allocation. However, I wouldn’t sell stocks to pay down a long dated mortgage. Consider the math on that decision carefully.

Additional Considerations

There’s a lot to evaluate here, so it is important we discuss your individual situation and not try to simplify this to some type of universal advice or rule of thumb.

1. If your choices are to send in extra mortgage payments or do nothing, then yes, send in extra payments. That’s better than spending it!
2. Are you choosing between extra payments versus another investment? Then, consider the long-term expected rate of return of the investment versus the interest rate of the mortgage.
3. While bond yields are low today, it is possible they could rise in the future. If you have short-term bonds you might gradually reset your yields to higher levels. A fixed mortgage, however, will stay at the same rate for the full term of 15 to 30 years. Now is a great time to borrow very cheaply. If we have higher inflation in the future, it will benefit borrowers and penalize savers.
4. You can invest outside of a retirement account. In fact, if your goal is to retire early, become a millionaire, or create a family trust, you need to do more than just a 401(k). Some people stop after funding a 401(k) and think they don’t need to make any additional investments. Paying down a mortgage is not your only option; consider a taxable account.
5. A mortgage is a form of forced savings. If you have a monthly mortgage of $1,500, maybe $500 of that is interest and the remaining $1,000 is building equity in your home. If you pay off your mortgage from investments, you will save $1,500 a month. You will feel wealthier because you improved your cash flow. But if you don’t invest that $1,500 a month going forward, you will likely just increase your discretionary spending. Be careful to not miss that opportunity to increase your saving.

On Home Values

• Your home value will increase the same whether you have a mortgage or own it free and clear.
• There are significant expenses in being a home owner which make it a poor investment, including property taxes, insurance, utilities, and repairs or improvements. These costs are not included in a home price index. Read more: Inflation and Real Estate
• Selling costs can also be significant, such as a 6% realtor commission. I bought a house for $375,000 in 2006 and sold it in 2017. After paying closing expenses, I received $376,000. That’s not a good return, and those amounts don’t include the improvements I made to the house. 
• If your primary goal is to grow your net worth, consider your home an expense and not an investment. If you aren’t going to stay for at least five years, rent.
• After the Tax Cuts and Jobs Act, most people cannot deduct their property taxes and mortgage interest. This is especially true for married couples. So, forget about having a home as a great tax deduction; most taxpayers will take the standard deduction.

At best, you might consider home equity to be a substitute for a bond investment. Given today’s very low yields, you could reduce bond holdings to pay off a mortgage. Your home is significant part of your net worth statement. It’s often one of your biggest assets, liabilities, and expenses. Think carefully about how you manage those costs. Genuinely analyze how different decisions could impact your net worth over ten or more years. That’s the approach we want to use when asking, Should I pay off my mortgage?