Should You Pay Down Your Mortgage?
One thing fashion and investment strategies have in common is that they are susceptible to fads, short-lived moments of intense collective enthusiasm. The 1970s had bell-bottoms and the Nifty Fifty; the ’80s, Mohawks and precious metals; the late ’90s, Tamagotchi pets and dot-com stocks; and the early 2000s, Dance Dance Revolution and investment properties.
The investment fad of the current decade may be unnecessarily paying down your debt. When I say the word “debt,” a number of things come to mind for the average person. Older Americans might think of European government debt and the current European turmoil or last year’s debt-ceiling debate. Underwater homeowners or victims of foreclosure might gravitate toward mortgage debt, and younger Americans might associate “debt” with their own credit card or student loan bills. All are valid and even representative to a large degree.
For the purposes of this post, I will focus on home mortgage debt—specifically, the decision-making process of home mortgage borrowers who are able to qualify for the best rates and the overall economic merits of how long a term they choose. Before digging in, I need to disclose the following assumptions:
1. The borrower has the financial and temperamental means to carry out the strategy I discuss. Unfortunately, many Americans are underwater on their homes, have a high debt/income ratio, and carry large additional debts. This post is not geared toward these individuals, only toward the borrower who meets the very strict new criteria of federally sponsored home lenders, such as Fannie Mae. So, again, this post does not apply to the average person’s situation.
2. The borrower has the ability to stomach the fluctuations of markets and could withstand a hit to principal. “Home mortgage arbitrage” is not for the faint of heart. Furthermore, I assume the borrower does not have large near/intermediate-term liquidity needs.
What the Average Person Is Thinking
Intentionally choosing a longer mortgage term or even taking out a new mortgage on a fully paid house is something that, for some reason, we don’t like to do. Many even characterize it as a sign of overextending one’s purchasing power. That may have been true for a large fraction of Americans in the early 2000s, but for the purposes of this post, I focus on the borrowers who are living comfortably within their means and are considered “high-quality” borrowers.
Some common arguments for a shorter mortgage (or fully paying off a home) are “with the lower rate of a 10/15-year term, my payments will only be marginally higher” and “I can cut 15 years off my mortgage for only slightly more per month” and even “I can have no payment at all by age x!”
What Else Could You Do?
Instead of having a lower monthly mortgage payment, you can choose to invest the money. It’s not only possible to earn a return in excess of the hypothetical mortgage rate, but also if/when rates move higher, beating the 30-year fixed rate becomes that much easier. For instance, if rates move up 300 bps, you may be able to earn an excess return with a simple product, such as a short-term Treasury bill or a bank CD.
Following are some reasons why it might make sense to take the long-term debt now, as well as some solid risk-adjusted investment options that I believe can beat the after-tax cost of a mortgage today.
Why Arbitrage Your Mortgage?
- Tax Benefits: It’s no secret that mortgage interest is tax deductible. Deducting mortgage interest from your taxable income is a powerful strategy.
- Today’s Rates: A borrower can get roughly 3.875% on a 30-year fixed or 3% on a 15-year mortgage.
- Principal Paydown: A borrower is still paying down a modest amount of principal along the way even in a 30-year term mortgage.
- Protection against Inflation: Today, many are desensitized by stagnant home prices and official inflation measures of approximately 2%; 15 years or 30 years is a long time, and the inflation outlook could easily change in the interim. For example, 30 years ago, core inflation was higher than 7.5%. If your home is fully paid for, you have no “upside” above and beyond what the home goes up. The nominal price appreciation/depreciation of the home will occur whether or not you have 0% equity or 100%. A person with a mortgage benefits if inflation picks up because inflation eats into the “real value” of the debt.
- You Can Earn a Spread: Even in bonds, I believe it is possible to earn a decent spread above and beyond the cost of the mortgage. High-performing and non-directional total return funds, such as $DBLTX and $PTIAX, are strong options in mutual fund land, with yields north of 5% and even better total returns. Aggressive investors may look toward the closed-end fund space, where dislocations are commonplace. Tax-exempt municipal funds are plentiful and include $NXZ, $IIM, and $VKQ. For instance, $NXZ has a tax-free yield over 6% and pays a monthly cash dividend. Non-agency mortgage-backed securities closed-end funds offer attractive loss-adjusted yields of 6–10%. These include $DBL, $DMO, $PDI, and $JLS.
- Tax-Deferred Earnings: If the borrower doesn’t need the monthly cash flow, investing in a tax-deferred account produces a second tax advantage.
Current Trend in Refinancing
According to a New York Times article published in June,
Almost a third of those who refinanced in the first quarter cut the duration of their mortgages to 15 or 20 years from 30, according to a recent refinancing report by Freddie Mac. The 31 percent who shortened their terms represented the second-highest level since 2002, when 35 percent took out shorter-term loans, the data showed. In the fourth quarter of 2011, 34 percent had reduced their mortgage terms. The all-time high occurred in 1992, with 42 percent refinancing into shorter mortgages.
Anecdotally, I have had countless people tell me how they are shortening (or want to shorten) the length of their mortgage from 30 years to 10 or 15 years.
Another article on the recent wave of refinancing quotes Richard T. Cirelli, a West Coast mortgage banker :
People were getting 30-year interest-only loans, and they were pulling out all the cash they could. Now it’s just the opposite—they want shorter-term loans, and they’re strategizing to get the mortgage payoff to coincide with their retirement. We’re seeing 20-year loans, 15-year loans and even quite a few 10-year loans.
This trend is hardly surprising to me. Back when both home prices and rates were high, borrowers were extending the term as far as possible. Now, with affordability at record lows (home prices down, mortgage rates at record lows), people are accelerating debt repayment.
All else being equal, this thought process is suboptimal and smells of investors who sell stocks in a falling market because they fear losing everything. These same investors buy at high prices because they are greedy and fear missing out on the rise in prices.
Think Big Picture
One of the main options for deleveraging and dealing with excessive debt is inflating the debt away. While the nominal value of the debt remains the same, a high rate of inflation can reduce the “real” burden of the debt. Despite trillions of dollars in balance sheet expansion by the Fed, inflation hasn’t ensued in force. The Fed is doing everything it can to reflate assets, and so far it’s only been moderately successful.
Having low-rate, long-term callable debt can be an extremely valuable asset over the long term and an inexpensive way to protect the purchasing power of your savings if inflation materializes.
For a variety of reasons, financially stable homeowners are choosing to shorten the terms of their mortgages after a dramatic fall in home prices and interest rates. According to “The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings” by Gene Amromin of the Federal Reserve Bank of Chicago, Jennifer Huang of the University of Texas at Austin, and Clemens Sialm of the University of Michigan, “Households leave about 1.5 billion dollars on the table annually by prepaying their mortgage debt.”
Opportunities are available that can allow borrowers to essentially cover their mortgage payments while paying down principal and maintaining a call on historically low interest rates. It’s enticing to shorten the term, but in time, doing so may prove to be a more “risky” proposition than many believe.
Post credit crisis, the attitudes about risk and debt have caused homeowners to lean in the direction of shortening the term. While decisions like this may “help people sleep well at night,” the above arguments show that this risk-averse decision is not void of its own risks (inflation) and is likely to prove suboptimal economically.
Today is a time when everyone thinks rates will stay low forever and the recent housing crisis is still fresh. Whenever you make important decisions like this, you need to think hard about the total picture and not allow a behavioral fear to unduly shape your decision making.
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“Home equity acts as a bond within a household portfolio that appreciates at roughly the rate of inflation over extended periods of time and provides a consumption stream of housing services. Large home equity as a proportion of total household assets can crowd out wealth available to invest in riskier assets, leading to a suboptimal portfolio.” João F. Coco, “Portfolio Choice in the Presence of Housing,” Review of Financial Studies, vol. 8, no. 2 (Summer 2005):535–567.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.