Let me start by saying that early mortgage repayment doesn’t really make sense for most people.
Oh, sure, I know how the math looks. Add a modest amount to each month’s payment and, viola, the interest compounding seems super-attractive. Add an extra $25 a month to a 4%, $200,000 mortgage, for example, and you pay off the mortgage nearly two years early and save almost $8,000 in interest. Sounds great, right?
The problem for a typical middle-class homeowner, though, is better investment options often exist. (Like an employer’s 401(k) plan if it’s got a generous match.) Furthermore, the typical middle-class homeowner gets a tax deduction from the mortgage interest he or she pays, and that makes early mortgage repayment less compelling, too.
For high-income investors, however, early mortgage repayment often does look attractive—for three simple reasons.
Reason #1: Your Asset Allocation Probably Includes Bonds Anyway
Let me make the subtlest argument first.
So right now (according to today’s Wall Street Journal), you can borrow mortgage money at about 4%.
And what people will say when you contemplate repaying a 4% mortgage is this: “Well, I know I can beat 4% by sticking with the stock market.”
But this compares apples and oranges. What you and I ought to do is compare a mortgage rate to what the bonds in the portfolio pay. And here, the 4% doesn’t look so bad. In fact, the 4% return is the market rate of return.
What’s more, you or I can with a mortgage repayment program put money into something that’s probably very safe and which works very simply. (Mechanically, all you or I need to do is add extra to the mortgage check.)
Let me also point out something about the safety angle, too. If you’re borrowing money which you would have to pay back in any sort of worse-case scenario—a recourse loan—you may be earning 4% on a bond-like investment that’s very safe. In fact, if you borrowed money on a recourse mortgage, I think early mortgage repayment looks a lot more like a treasury bond or FDIC–insured CD than a corporate bond in terms of investment risk.
But anyway, that’s my first point: Make an apples to apples comparison, and paying down a mortgage compares favorably to the bonds that should be in your taxable portfolio if you’re employing common-sense asset allocation tactics.
Reason #2: Avoid the Investment Advisor Fee
And now a second quick point which applies to any investor who is paying an outside advisor: You won’t have to pay an investment advisor his or her fee for your “mortgage repayment” investments.
And this may mean the mortgage repayment option is noticeably better than putting money into bonds.
Say you would pay a 1% asset management fee on bonds held in your portfolio. That totally chews up the return you earn with a regular bond or bond index fund.
If you have two investment choices that both pay 4% interest, yet one forces you to pay a 1% fee, you want to avoid the fee.
Why accept 3% (the 4% return less the 1% fee) if you can go with some other option that pays 4% yet doesn’t force you to pay the fee?
Reason #3: Phase-out of Itemized Deductions
If one only looked at reasons #1 and #2, I think the case for early mortgage repayment would still be relatively weak.
I’ll acknowledge that, sure, you and I want a chunk of bonds in our portfolios, but we can (most of us anyway) deal with that in our retirement accounts. (Just buy a bond index fund or invest in a good target retirement fund.) Further, I’ll admit the investment advisor fee doesn’t add up to that much if balances are small.
But if you’re someone who’s subject to the phase-out of itemized deductions, early mortgage repayment looks shockingly different as a “de facto” investment.
Here’s why: Starting in 2013, taxpayers with incomes above specified thresholds lose some or all of their itemized deductions. For a married filing joint taxpayer, for example, the itemized deduction phase-out begins at $300,000 of adjusted gross income. For a single taxpayer, the itemized deductions phase-out begins at $250,000.
I want to provide two descriptions of how this phase-out works: a simple one and a precise one.
Here’s the simple description: If you make in well in excess of the threshold amounts, you lose a big chunk—maybe even all—of your mortgage interest itemized deduction. In many cases, you may even end up using a standard deduction on income tax return. (Unless you’re interested in the gory details, go ahead and skip the next paragraph.)
If you are interested in a precise description of how the itemized deduction phase-out works, here are the formulas: You lose 3% of the amount by which your adjusted gross income (AGI) exceeds the threshold. For example, if your AGI exceeds the threshold by $300,000, you lose 3% of $300,000 or $9,000. But you can’t lose more than 80% of your itemized deductions. What all this means in practice, though, is that people with high incomes often lose most or even all of their itemized deductions and so just use the standard deduction.
So now let me return to the case where you’re trying to figure out how early mortgage repayment stacks up again the idea of having bonds in your portfolio.
Again, let’s say you could pay off a mortgage and earn 4% on your extra principal payments. Again, that doesn’t sound all that great.
But what if your income is high enough that you can’t itemize?
In this case, you probably need to have either a tax-free municipal bond paying around 5% annually. Or you need a taxable bond paying around 10% annually to end up with just as much money.
Let me put these numbers in perspective. As I write this, municipal bonds are paying 2% to 3% and mortgage-backed bonds are paying maybe 3% to 4%.
Wow, right? Early mortgage repayment looks pretty dang good.
I’m assuming, by the way, that your combined federal and state income tax rate equals about 50%. This is a bit rough, but I’m guessing that you’re paying a 39.6% federal income tax rate, the 3.8% Obamacare surtax, and then (partly for simplicity) state taxes that add up to another 6.6%. Add these three numbers together, and you end up with a 50% combined tax rate.
Let me step you through the math just in case you don’t believe the numbers work this way or in case you’re, oddly enough, someone who is interested. I assume in the examples below that you lose all of your mortgage interest deduction.
If you were investing in municipal bonds or municipal bond funds, you would need to earn 5% so that after paying the 1% investment advisor fee you were left with the 4% tax-free interest income equal to the 4% not-tax-deductible interest expense related to your early mortgage repayment.
And then if you were investing in taxable bonds or bond funds, you would need to earn 10% so that after paying the 50% income tax (this uses up half of the 10% leaving you with 5%) and the 1% investment advisor fee you were left with the 4% after-taxes-and-investment-fees interest income equivalent to the 4% not-tax-deductible interest expense interest savings.
By the way, if you didn’t lose all of the mortgage interest deduction, the case for mortgage repayment weakens a bit. But not that much. If you ended up losing, for example, half of your mortgage interest deduction, you might need to earn around 8% on a taxable bond in order to equal the return earned when you simply repay a mortgage. This 8%-ish return still greatly exceeds the 3%-4% return you’d actually have available.
Three Quick Caveats
Three quick caveats in closing: First, if you think you want to look at this mortgage repayment idea, make sure that you’re comparing bonds outside of your retirement accounts to repayment. (This keeps things apples to apples.)
Second, you would not want to use early mortgage repayment as your “only” or even as your “major” bond investment. Equity in a home or other real estate doesn’t provide you with an easy way to rebalance your portfolio (and you want to rebalance in order to stay smart about your asset allocation). Furthermore, you and I want and need more liquidity, probably, in taxable accounts than additional home equity provides.
Third, I respectfully suggest that early mortgage repayment will for the coming decade be a much better investment for high-income taxpayers than almost any other practical option. The models used by many sophisticated investors suggest very modest returns from stocks and bonds over the coming decade. (Google or Bing the phrase “expected stock market returns next 10 years” to get a sampling of the commentators saying this.)