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November 3, 2003
"Should not your analysis of when
mortgage repayment is a good investment distinguish between two different sets
of circumstances? One is where you pay off the mortgage in one fell swoop by
liquidating assets. The other is where you allocate surplus income each month
between mortgage prepayment and asset acquisition."
Yes, it should, I have been remiss. This
article will make the distinction.
Repaying a mortgage is an investment that
yields a return equal to the mortgage interest rate. The portion of the monthly
payment that consists of principal is such an investment, but it is required.
Additional payments, including repayment of the entire balance, are
discretionary. In deciding whether to make them, the borrower should compare the
mortgage rate with the yield available on other investments.
It doesn't matter whether the comparison is
made before-tax or after-tax. If you are comparing repayment of a 6% mortgage
with acquisition of a 5% bond, for example, the before-tax comparison is 6%
versus 5%. The after-tax comparison, assuming the borrower is in the 40% tax
bracket, is 3.6% versus 3%. If mortgage repayment earns the higher return
before-tax, it also earns the higher return after-tax.
What I failed to do in previous articles on
this subject is distinguish two quite different situations: case 1 involves
investing cash flows over an indefinite future period; case 2 involves investing
a lump sum right now.
A young homeowner is most likely to be faced
by case 1, where the question is how to allocate excess current cash flow.
Should the cash be used to make additional payments to mortgage principal, or to
acquire financial assets?
The answer is that the owner should allocate
excess cash flow to mortgage repayment if the mortgage rate is higher than the
rate that can be earned that month on newly acquired financial assets.
The owner confronts a new investment decision every month, and the action taken
could change from one month to the next.
For example, the borrower with a 6% mortgage
who has excess cash flow would do well to use it to pay down the mortgage
balance if the alternative is investment in assets that yield 2%. But if two
years down the road the same assets yield 7%, the borrower can stop allocating
excess cash flow to the mortgage and start accumulating financial assets.
A senior is most likely to be faced with case
2, where the question is whether to liquidate financial assets in order to repay
the entire loan balance. The owner makes a single investment decision that is
irrevocable. Either the assets are liquidated to pay off the mortgage, or they
aren�t.
While the principle, that the decision should
be based on comparison of the mortgage rate and the investment rate, is the
same, the borrower can�t adjust to future changes in the investment rate. He
has to look ahead and anticipate what these changes might be. He also has to
anticipate how long he will be around.
To help deal with this problem, I developed a
spreadsheet which 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. To access the spreadsheet, click here.
For example, assume the mortgage rate is 5%
while the current investment rate is 3%, but the borrower assumes that in two
years it will jump from 3% to 7%, and stay there. The spreadsheet shows that for
the first 51 months, the borrower�s wealth would be greater in the case where
he repaid the mortgage. After 51 months, his wealth is greater in the case where
he didn�t. The borrower then must decide whether he is likely to be around for
more than 51 months.
In general, the sooner that interest rates
increase, the larger the increase when it happens, and the longer the borrower
expects to live, the weaker the case for liquidating assets to pay off the
mortgage. Seniors having to make this decision may find it instructive to play
with the spreadsheet.
Copyright Jack Guttentag 2004
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