As you might have seen in my first post, my paper assets (cash, stocks, and bonds) now exceed my remaining mortgage debt. Pretty neat to think that I could be debt-free and own my house outright today if I so desired. Instead, I’ve been making prepayments and continuing to invest at the same time, and basing the amount of money directed at each activity on my asset allocation plan. Am I on the right track? If home ownership is part of your FIRE strategy, how fast should you pay off the mortgage?
My Current Situation
- House purchased for $172,500 in Autumn 2017 with 20% down.
- Took out a 25-year mortgage of $138,000 at 2.98% 5-year fixed.
- Mortgage payment: $325, twice a month.
- Allowed to make prepayments totaling up to 20% of starting principle annually, at any time during the mortgage year.
- I’ve been making prepayments of between $1000-$1500 each month.
- As of February 15, 2019, there is $112,708 remaining on the mortgage.
Why I Still Want a Mortgage
Aside from the fact that I’d have to pay a penalty to terminate my mortgage prematurely, there are three big reasons why I want to hold on to it: liquidity, diversification. and growth. Let’s dig into those a little further.
In most cases, buying and selling real estate is costly and time-consuming. There was a span of a couple of months between when I first saw my property and the day I moved in, and mine was a very simple transaction! There’s never a guarantee that I’d be able to sell my house that quickly at an acceptable price in the future. There’s also no way to liquidate a fraction of my house. On the other hand, any proportion of my paper assets can be turned into cash at the click of a mouse.
As an additional bonus, part of the growth from my portfolio comes in the form of dividends, interest, and distributions. Right now I re-invest everything my portfolio kicks off, but if needed the portfolio can improve my cash flow without my actually selling assets. (Although this doesn’t apply to me, you could get some cash flow from your house in the form of roommates or a home business).
I should mention that you can get money back out of your home using a reverse mortgage. I considered the Smith Maneuver: selling investments to pay off the mortgage, than borrowing against the house to buy back the investments. The rationale for this is that borrowing money to invest is a tax deduction in Canada, while interest paid on a mortgage on your primary residence is not. In my case, the difference between my mortgage interest rate and the rate I’d have to pay to borrow the money was larger than the tax break I’d get.
If I paid off my house today, my portfolio might look something like this:
- Personal residence: $175,000
- Cash: $2000
- Stocks: $3000
- Bonds: $1000
- Having almost 97% of your entire net worth in one asset is risky – doesn’t matter whether we’re talking about one property, one business, one stock, or even a group of stocks from a single country or sector. Whether it comes down to a collapse of the local economy in my one-industry town, or a broader real estate decline in Canada, having the vast majority of my net worth in one single property in one single place is more risk than I’m comfortable with.
Growth is the big one. This is the major determinant for how long it will take someone to attain financial independence. Putting nothing on my mortgage but the regular payments, and piling every last available dollar into investments is arguably the fastest path to the highest net worth.
Consider asset appreciation. In the long run, the stock market as a whole outperforms the broad real estate market. In the last 30 years, average annual growth in Canadian real estate prices was around 4.7% while the TSX offered annual returns of 8.3%. Might seem hard to believe given the crazy appreciation of Vancouver and Toronto home prices, but I’ll place my faith in historical averages over bubbles any day.
Bonus: a mortgage offers potential additional growth through leverage. Let’s say the $200,000 property you bought last year has increased 5% in value, and you’ve only put $10,000 on it so far. Congratulations, you just made $10,000 (if you sell the property and pay off the loan), giving you a 100% return on investment. Someone with $100,000 in equity can only claim a 10% ROI, and that drops to 5% for the owner with no mortgage. Debt can be a powerful tool for building wealth, and a mortgage is pretty much the best interest rate you’ll ever get. Caution – leverage in any form is a double-edged sword and losses are magnified to the same extent as profits.
Ultimately, keeping the mortgage provides the best protection from inflation. First, there’s all that extra growth being generated from the stock portfolio that you’re building instead of making extra mortgage payments. Secondly, there’s the fact that the principle component of your mortgage is fixed in today’s dollars, while we expect the property to appreciate at at least the rate of inflation. (Then again, it might not. Real estate and stock markets crash. But again, we’re talking averages over long time-frames here.) Think of this as a gift to your future self – ten years from now when a dollar will buy you less food, fuel, toys, etc. than it does today, that dollar will still buy you the same amount of equity in your home as the day you moved in. And should the inflation rate exceed your mortgage’s interest rate, you’d actually be making money just by having a loan.
Why I Make Prepayments
If having a mortgage is so great, why do I make prepayments at all? Well, there’s the obvious argument that prepayments reduce the total interest that I’ll pay over the life of my mortgage. The amount of interest I am paying each month is getting smaller a lot faster than it would be with regular payments alone. My books therefore look better – more money going toward assets and less toward expenses every month. But those of us doing early retirement extreme shouldn’t care about freeing up cash or making our statements look better. In the building stage, the work is just that – maximizing net worth to create passive income for the future.
I will warn you that this side of the argument is coming more from a place of emotion than reason. Paying off the mortgage and eliminating debt feels good. I like knowing that I’m getting closer to owning something as big and tangible as my house outright. Maybe I have been a bit indoctrinated by the stereotypical Canadian dream, but I like having my own property and owing as little on it as possible. I feel very fortunate to have found a place close to work that I love living in now, and would be happy to stay in once the 9-to-5 is ancient history. If I’m going to spend money on anything, my little homestead that offers shelter, security, and an ever-growing portion of my food supply is going to be it.
And you know what else? It’s an easy way to build wealth. Paying down the mortgage requires almost no effort at all compared to the trepidation and decision-making that comes with picking stocks. Hell, I still find purchasing a low-cost ETF in line with my asset allocation to be more stressful than throwing cash at my mortgage. The interest savings on my mortgage are a guaranteed rate of return, and that 2.98% is better than I can get from a high interest savings account. (There are now some 3-year GICs with better rates, so I will likely start plunking cash earmarked for prepayments in there – arguably a similar loss of liquidity as paying down the mortgage but with a smidgen more growth).
Houses and stocks are both susceptible to market downturns and subsequent decreases in value. That market value really only matters when you go to sell. Here’s the difference. If the resale value of my house plummets by 20% overnight, of course I’m not going to be thrilled regardless of my debt-to-equity on it. However, unlike any of my paper investments, my house still provides me with something of very high personal value regardless of its market value: a safe and comfortable place to live.
The Compromise: Asset Allocation
Taking the above into account, I settled on a compromise and simply added home equity into my asset allocation model. Just as I have target proportions of Canadian, US, and international equities in my stock portfolio, I set my home equity at a maximum of 33% of my total net worth. Is this a somewhat arbitrary number? Definitely. But that’s OK – the beauty of asset allocation is that as long as the proportions are fixed, more cash will flow into equities that are undervalued. Once my house is paid off, that magic number of 33% will decline as I continue to build net worth outside of my residence, which is why I call it a maximum instead of a target.
Before I wrote this post, I googled “asset allocation invest vs. mortgage” to see if anyone else had hit upon a similar strategy. Instead, I found discussion centered around what a mortgage actually is in the context of a personal portfolio. Most notable is the idea that holding a mortgage negates the need to hold any bonds or fixed income at all. This is best detailed in a recent article in the Globe and Mail by Benjamin Felix. In short, he explains that taking out and holding a mortgage is the equivalent of issuing, or selling, a debt instrument. Following this train of thought, holding a mortgage is the opposite of, and therefore cancels out, buying debt instruments such as bonds. In terms of cash flow, the interest earned from your bond holdings cancels out the interest you pay on the equivalent portion of your mortgage.
Huh. Makes sense. I keep 15% of my stock portfolio in bonds. Would it be logical to exit my bond position entirely, and apply these funds to my mortgage? If buying bonds in my portfolio is really equivalent to holding a mortgage (selling a debt instrument) then the answer would have to be yes. But when I thought about it, my conclusion is that they’re really not.
The logic holds when you look at an isolated transaction – sell your bonds and use the cash to make a mortgage prepayment. But I wanted to work out how my whole financial picture would change over time as my portfolio increases and my mortgage decreases. I tried to plug in some hypothetical numbers that would allow me to keep my asset allocation constant while plunking money into stocks and onto my mortgage, and ignoring bonds completely. The results were non-nonsensical. Adding $10,000 to my net worth and distributing it between 85% stocks and 15% mortgage prepayments increased my stock holdings, and therefore the weighting of stocks…but nothing else. Suddenly the reason was clear. The big problem with equivocating bonds and mortgages is that the mortgage lives on the opposite side of the balance sheet. Bonds are assets, but the mortgage is a liability.
This realization changed my thinking. Eliminating my mortgage won’t actually change the asset side of my personal balance sheet one bit – the entire value of my home is still sitting there – but it would decrease my liabilities, and eliminate leverage for better or worse. The bonds have their own job. They exist to cushion the asset side of the balance sheet against heavy losses during the next bear market. My home may or may not contribute to that end as well, but the presence or absence of a mortgage is inconsequential.
If a mortgage doesn’t change my asset allocation, then I also need to change the question. I started by asking “How much home equity should I have?” but the question should be “How can I best distribute my pool of resources among my assets to strike a balance between returns and safety?”
My perspective has changed, but my process really hasn’t. I’m still making prepayments – and limiting them to keep my home equity at a maximum of 33% of my total resources. My asset allocation model tells me where my incoming cash goes. It is a guideline to ensure that I continue to invest and build a diverse portfolio instead of over-doing the easy and feel-good mortgage prepayments.
In the end, my answer to the whole pay-off-the-mortgage or invest debate is a resounding “both.” How about you? What is your strategy – hold that mortgage for as long as possible or pay it down? Would you consider paying down your mortgage in lieu of having bonds in your portfolio?