The financial crisis has torpedoed the retirement planning of many seniors. Those foolish enough to have followed the advice of investment advisors who preached that homeowners should convert all their home equity into investments, now find that their home equity is negative because of declining home prices. At the same time, the value of any common stock they purchased by mortgaging their houses up to the hilt is probably way down because of the sharp decline in stock prices.
We can’t undo the past, but we can make better decisions in the future. This is a guide on how to make decisions about mortgage repayment.
The Core Principle is That Repaying a Mortgage Is an Investment: The yield on mortgage repayment is the mortgage interest rate. Repaying a 6 percent mortgage yields 6 percent, the same return as acquiring a 6 percent bond. Note: Bonds and mortgages have different interest compounding periods, which impacts their “effective return,” but not by enough to worry about.
Before-Tax and After-Tax Returns: In comparing the return on mortgage repayment with the return on alternative investments that are taxable, it doesn’t matter whether the comparison is made before-tax or after-tax. If you are comparing repayment of a 6 percent mortgage with acquisition of a 5 percent bond, for example, the before-tax comparison is 6 percent versus 5 percent. The after-tax comparison, assuming the borrower is in the 40 percent tax bracket, is 3.6 percent versus 3 percent. If mortgage repayment earns the higher return before-tax, it also earns the higher return after-tax. If income on the alternative investment is not taxable, however, returns should be compared after-tax.
The Investment Decision: In general, borrowers should repay their mortgage when their mortgage rate is higher than the return on alternative investments of comparable risk. Since mortgage repayment carries no risk, the safest application of this rule would limit alternative investments to government securities, insured deposits and other federally guaranteed assets. The returns available on such assets would usually be below the mortgage rate.
Borrowers can also compare the mortgage rate with returns on assets that do carry risk. To justify selecting such assets, they should carry a return above the mortgage rate large enough to justify the greater risk. But that is a difficult judgment to make, and it should reflect the capacity of the borrower to take the risk, which among other things varies with the borrower’s age.
For example, I usually recommend that seniors involved in this exercise limit their selections to fixed-income assets. Over long periods, investment in a diversified portfolio of common stock yields a significantly higher return than mortgage repayment, but the volatility of returns on stocks is very high and includes episodes of negative returns, such as the one we are in now. Seniors may not have the time to wait for such episodes to run their course.
Allocating Excess Cash Flows: Borrowers are faced with two types of mortgage repayment decision. In one, they invest excess cash flows each month over an indefinite future period. They should allocate excess cash flow to mortgage repayment if the mortgage rate is higher than the return, adjusted for risk that can be earned that month on newly acquired financial assets. The owner confronts a new investment decision every month.
Liquidating Financial Assets to Repay the Mortgage: Many seniors are faced with a different type of decision — whether to liquidate financial assets in order to repay the entire mortgage loan balance. In making a one-time investment decision that is irrevocable, the borrower can’t adjust to future changes in the investment rate. He has to look ahead and anticipate what these changes might be and how long he will be around.
To help deal with this problem, I developed a spreadsheet that allows a borrower to enter any scenario for future interest rates, and compare his wealth in every future month in the two cases: where he liquidates his assets to repay the mortgage at the outset, and where he retains both the mortgage and the assets. The spreadsheet is on my Web site and is titled Loan Repayment Versus Investment. Seniors confronting this decision may find it instructive to play with the spreadsheet.
Anticipating a Reverse Annuity: Seniors in modest circumstances who have no interest in leaving an estate may have a special reason to prefer mortgage repayment to asset accumulation as a way of increasing their wealth. After age 62, the equity in their house can be converted into income by taking out a home equity conversion mortgage (HECM) while they continue living in the house. If there is a mortgage balance at the time, it must be paid off with proceeds from the HECM, which reduces the income the owner can draw.