Should You Pay Off Mortgage Debt or Change Your Asset Allocation?

TL;DR

Paying off mortgage debt and increasing the remaining portfolio’s equity allocation can produce risk and return characteristics similar to keeping a mortgage alongside a conservative portfolio. In the example, a 50/50 portfolio with mortgage leverage is compared with a mortgage-free 95/5 portfolio, revealing nearly identical expected outcomes and similar crisis losses. Read on to understand how leverage, interest costs, taxes, and fixed cash flow affect the choice.

Transcript

Do you have a mortgage? Based on  2016 census data, 61.7% of Canadian   families owned a principal residence, and  57.3% of those families had a mortgage. If you have both a mortgage and an investment  portfolio you might have wondered if it makes   sense to use some of your investments  to pay off your mortgage. This is a   very common question, a... Read More

Key Insights

• 🥺 Paying off mortgage debt while increasing the portfolio's equity allocation can lead to equivalent risk and return characteristics while eliminating a fixed expense.
• ✳️ Keeping both a portfolio and a mortgage creates leverage, which increases risk.
• 🌸 Comparing the outcomes during the 2008 financial crisis, a 50/50 portfolio with a mortgage incurred a greater loss than a 95/5 portfolio without a mortgage.

Questions & Answers

Q: Should you use investments to pay off mortgage debt?

It may be sensible when the investment portfolio is not allocated entirely to stocks. The transcript argues that paying off the mortgage and increasing the equity allocation of the remaining portfolio can offer similar risk and return characteristics while eliminating mortgage interest and fixed outgoing cash flow.

Q: Why can keeping a mortgage and a conservative portfolio be misleading?

Keeping the mortgage creates leverage, which increases overall risk even if the portfolio itself looks conservative. In the example, investing $900,000 while carrying a $400,000 mortgage effectively means investing $500,000 of personal capital plus $400,000 of borrowed money.

Q: How do the mortgage and mortgage-free strategies compare in the example?

One strategy keeps a $400,000 mortgage and a $900,000 portfolio invested 50% in stocks and 50% in bonds. The other pays off the mortgage and holds a $500,000 portfolio invested 95% in stocks and 5% in bonds; both begin with the same $1 million net worth and have nearly identical expected one-year outcomes.

Q: What returns and mortgage rate are assumed in the comparison?

The example assumes a 4.68% annual return for the 50/50 portfolio and a 3.00% annual mortgage cost. After paying off the mortgage, the 95/5 portfolio has a higher expected return of 6.09%.

Q: How did the two strategies compare during the 2008 financial crisis?

During the worst 12 months, the leveraged 50/50 strategy produced a total loss of 39.44% after including mortgage interest. The mortgage-free 95/5 portfolio lost 38.92%, giving it a slight advantage in the example.

Q: How did a 20.58% portfolio decline affect the leveraged investor?

A 20.58% decline caused the $900,000 portfolio to lose $185,220. Because only $500,000 represented the investor’s own money, that loss equaled 37% of personal capital before adding the 3% mortgage interest cost.

Q: What are the cash-flow benefits of paying off the mortgage?

Paying off the mortgage removes the guaranteed mortgage interest cost and the fixed outgoing cash flow. It also avoids the potential challenge of renewing a mortgage if lending practices become stricter during a crisis.

Q: What does it mean to be short fixed income through a mortgage?

A mortgage is described as effectively selling a bond to the bank and making interest payments with after-tax dollars. Holding bonds simultaneously makes the investor long fixed income, while their interest is fully taxable in a taxable account, so being both long and short fixed income may not be sensible.

Summary & Key Takeaways

• Many people believe it is more logical to keep their investment portfolio intact and benefit from the higher expected returns of financial market investments compared to the relatively low cost of mortgage debt.

• However, if the investment portfolio is not allocated 100% to stocks, paying off the mortgage and increasing the portfolio's equity allocation may lead to higher expected returns.

• A comparison is made between keeping the mortgage and a 50/50 portfolio and paying off the mortgage while increasing the portfolio's risk level to 95% stocks and 5% bonds, showing similar risk and return characteristics.