Gyroscopic Investing

A few weeks ago, I posted with the idea that if 30-year treasury rates go significantly lower than your mortgage rate, that it may be a good time to liquidate that portion of the PP and pay down your mortgage, given the right circumstances... some pretty heavy tinkering, to be sure.

On that note, I've been thinking of the implications of paying down one's mortgage with a windfall or with a bunch of money that they no longer want in the market.  This probably is a strong temptation by many people on this board or elsewhere.

With LTT rates at 4.2%, and incurring no tax in my roth IRA, and the marginal tax-adjusted rate on my mortgage at 3.9% (5%x(1-(.15+.07)), I decided that it would be stupid for me to pay down my mortgage (or would be if I didn't have PMI).  If I have room in my Roth, where contributions are available for withdrawal tax-free, that would be a much better option, considering that 1) liquidity is better than illiquidity, and 2) depressed home prices could make a very large chunk of any mortgage paydown not able to provide you any realizable benefit for a decade or more, if ever (if you go through foreclosure or walk away).  Depending on your interest rate (tax-adjusted) on your mortgage, and your room in a roth to purchase LTT's, you may want to make the move.

There was a day, before I valued liquidity, that I viewed paying down your mortgage as an investment in a long-term bond at X%.  If you can get the same/better interest and still keep most of your liquidity (roth contributions) or at least do it in your IRA or 401(k) and know that whatever's in your roth can be liquidated, and the LTT's (VP) in your IRA can be sold and repurchase whatever was in your roth, then I see that as a much better play.  Keep in mind (assuming you're able to contribute this windfall to a tax-deferred account), even if your VP LTT's aren't in your Roth, but instead are in an IRA or 401(k), you can still do a little musical chairs with your investments where you can reap the liquidity of your VP LTT's.  If you're holding the VP LTT's in an IRA, sell them, buy whatever PP assets you have in the roth with that cash, and then liquidate what you can or need to out of the roth.

This is all assuming you have cash (or whatever) outside the PP waiting to do something with, and one of those things is pondering paying down your mortgage.  The question might be "how do I buy LTT's within my Roth or 401(k) or whatever when all my cash is in my savings account and I'm already maxing out my contributions to tax-deferred accounts??"

At that point I'd probably say "ok, is there anything in my tax-deferred accounts within my PP that I can hold relatively tax-efficiently outside tax-deferred accounts?"  Any gold etf's would probably be first, cash second (in this environment) and stocks at a close 3rd.  You'd then sell the gold (or whatever) in your roth or 401(k), buy the VP LTT's, then take your cash and buy a gold etf or physical (or whatever PP asset you're willing to "relocate" to your taxable funds).

Just thought I'd illustrate that with a little musical chairs, one who otherwise viewed paying down their mortgage as a good use of their money might do themselves justice by buying LTT's, especially if you can wiggle them into a tax-deferred account.  Assuming you're lucky enough to have a 4.5% mortgage on a mortgage or home equity loan picked up today, and you get an inheritance windfall tomorrow, at 4.2% in a tax-deferred account you can beat that mortgage rate, keep the liquidity (most of it, anyway) and safety, and even get a nice big positive value swing if LTT rates tumble... at that point you can use those liquid funds to help pay for a refinance, pay down your mortgage, or keep you afloat while you are taking the credit-score-hit of walking away from your mortgage.

I'm not condoning stiffing the bank by walking away, but we all know paying into a black hole of debt isn't in our best interest, and we didn't agree to indentured servitute by signing mortgage documents... I'll leave those moral/financial decisions to you gentlemen (and ladies).

PS, somehow I think intelligent, reserved uses of a 401(k) loan could be used with this strategy as well to give you liquidity and tax-deferral, without the risks of paying down your mortgage.  Obviously, look into the risks/rewards of doing that.

Just to clarify something, anyone who takes on a 30-year mortgage today can get about 4.5% if they are credit-worthy... maybe better but I'm trying to be conservative.  Tax-adjusted, assuming a 25% federal rate and 5% state income-tax rate, that's 3.15% (marginal... not taking into consideration the possible use of a standard deduction after a certain amount of paydown).

Interestingly, at 4.2% (about the going rate for 30-year treasuries), but no state tax (same 25% federal rate), tax-adjusted is exactly 3.15%.  You don't even need a tax-deferred account.... but even better if you have one, because 4.2%-3.15%=1.05%.  You can actually beat your mortgage by over 1% for the same term (30 years) with the safest bond in the universe, keep it somewhat liquid in a roth or (yikes) 401(k) loan, and even benefit from the price moves if rates drop.  This money is protected from bankruptcy claims, and you can use it to stay afloat if you are forced to walk away from your home.

Now imagine that someone with a PP buys a house today at 4.5% and no PMI, and 3 months from now, home prices are still falling... Like me (bought 18 months ago), this might worry that person... they might start wondering if they want to pay down their mortgage as a "guaranteed return," that even their PP might not produce in a deflation.  I'm sure thousands if not millions of people are in some form of the same situation this hypothetical one is (other than the owning of a PP...  unfortunately).

Assuming rates are the same, even if kept in a taxable account, I say DON'T do it... invest in LTT's, or at least evaluate your options.  If housing deflation continues, it's likely rates will continue to drop... so not only will you have liquidity, but you'll have some capital gains to boot.  This can be a great way for people who are nervous about the housing market to sleep a little better at night without throwing money into a black hole.

Moda, one thing you should consider before mortgaging to the hilt and purchasing LTTs is the interest rate risk - if rates go up, you could lose a lot of money.

I wasn't thinking "mortgaging to the hilt," but I see what you're saying.

Yes, you are "losing money," and I've tried to ponder the implications of this.... but really, if you think about it, paying $10k down on your mortgage, assuming it's not looked at as a tool to refinance, but a way to make long-term 5% (for this example... also, let's assume rates are the exact same for treasuries and for mortgages) returns, you are not just "investing in a $10k bond at 5%," instead, you are investing in the bond and also agreeing to remit the interest as principal repayment at that same 5% benefit (implied by you keeping the same mortgage payment after the contribution).  If rates rise to 7%, 1) you still bought in on what is effectively a 5% bond over 30 years (or whatever the duration of the mortgage is... for this example we'll assume 30 or close to), and 2) you're also reinvesting your interest back in at 5% when you could invest at 7% in the market.  So you still kind of took a "value hit" by paying down your mortgage at 5% just as you did by buying a LTT at 5%.

If you buy a treasury at 5% and rates go up to 7%, your bond value might drop, but you're still earning 5% on your initial contribution every year that you can now reinvest at 7% over about the same period, or take in cash, or whatever.  With the mortgage, you've agreed to remit that at the original 5%.  Lastly, looking at the cash-flow, at 5% interest, even if it loses out in value, it's still paying you interest in the same amount every year, while your mortgage will stay the same amount every month since you have a fixed rate on that... of course there's principal payment involved.  Seems to me you can ignore the value in some ways since you're concentrating on the cash-flows... the following might be an exception:

If you were to pay $10k down on your mortgage instead of invest in long-term treasuries, by the end of the year, at 5%, you'd have another $10,500 of equity you MAY be able to tap... but using the 80% LTV principal, an extra $10,500 in equity will result in $8,400 in additional liquidity unless you want to pay PMI.  If rates rise 1%, and we assume a 15% decrease in value in a 30-year bond (about correct, I believe) and instead you invested in treasuries, that $10k would now maybe be $8.5k, but you earned $500 in interest so about $9k... so lets make this even more crazy just for fun... if rates go to 7%, let's assume a 25% price drop (not sure if that's right but just humor me) plus a 5% payment, so you'd have $8,000.  So our choices are $8,400 in maximum possible additional equity-based liquidity, or $8,000 in value after a huge hike (about 2%) in interest rates.  But hold on here, the $8,400 is "earning" 5%," while your $8,000 (assuming you reinvested into the long-term bond again) is earning 7%.  If you take that $8,400 out it's going to cost you higher interest (now 7%... probably more for a Home Equity loan than a mortgage), plus fees, hassle, etc.

So unless you're in a position where rates rise extremely fast and you want to somehow tap that little extra amount in home equity in short-order, and assuming it's even accessible equity (remember, part of my planning is around the idea that you aren't necessarily deepening your accessible equity by paying down your mortgage), I don't see paying down your mortgage as being that great of an option.  Especially since home equity loans are such a clumsy, expensive way of accessing liquidity.

Of course things get more complicated when you assume different rates for mortgages than for treasuries, and the fact that they'll spread/contract over time.

The worst thing that could happen is that rates tighten, meaning your value of your bonds drop and your ability to take on cheap mortgage (or heloc/equity) debt increases... but even so, treasuries will never yield more than a mortgage, and they're pretty tight now, so I don't see that as much of a threat.

The BEST thing that could happen (for this strategy, not people in general) is a spread increase, where mortgages stay around 4.5, but treasuries, due to a flight to safety, go down to 3 or something... in this case, it's also likely that one may be losing any of the equity they might have had, as deflation may be continuing.

Overall, I see huge opportunities with minescule risk.

It sounds like you've done a lot of calculation here.  One other thing to keep in mind when considering LTTs for a VP is that you don't just need to beat the "cost of capital", which in this scenario is like beating the juice on a margin account (sort of), you also need to beat inflation.

So, let's take that hypothetical, 3.9% tax-adjusted mortgage, which, rather than paying down, you invest in 4.25% LTTs.  You are only making a 0.35% return on your investment, which is not enough to offset inflation.

I guess it's kind of a wash since it's not like paying down the principal on your mortgage will lower your financing charge (except at the end if you pay it off early), but I think it would be more important to take that extra money that you're not using to pay down your mortgage and stick it in the PP, so you could at least get an inflation adjusted positive return.

Storm,

The PP is an option, but I was thinking for someone who was too nervous about that and wanted the same type of guaranteed (long-term nominal) return that paying down a mortgage gives.  With the PP there's always the risk you can lose some.  Most people, with some of their money, will sometimes like to play a safe guaranteed long-term rate of return.

Also, yes, that .35% is your net ROI given your two options with the money.  But I think of looking as that amount as having to beat inflation is flawed.  If you take on debt (or refuse to pay down a loan), it doesn't matter if you beat inflation with the difference... as none of it is your money to begin with.

Like if someone loaned you $1 Billion at 4% and you borrowed it to the treasury for 1 year at 4.01%, it doesn't matter if inflation was 5% that year, you made $100,000 out of none of your money... that's .01% net return in a year of 5% inflation, but you didn't lose purchasing power since you had zero to begin with.  This is just the opposite, as we're choosing whether to pay down something previously loaned to at a fixed rate.

So I know it'd be nice if the spread were larger... but a margin account by it's very nature isn't even money you've set aside... it's money you were borrowed, and therefore the net of the two absolutely doesn't have to beat inflation, or anything but zero or negative return.

Better yet, think of $10k of cash (the same $10k you were wondering whether to pay down your mortgage with) and 4 different savings accounts you could put it in, yielding 1%, 2%, 3% and 4%.  If inflation is 2% that year, that doesn't mean that by chosing the 4% account (only 1% better than the 3%) you've lost 1% to inflation... You've beaten inflation by 2% by investing in the 4% savings account... you've just only beat the spread on the next-best account by 1%.  By investing in a 4.2% bond in a year of 1% inflation, you've beaten inflation by 3.2%... period.

Ok... probably enough of that.

Either way... what I'm saying is may be moreso pointing out a flaw in paying down your mortgage than the greatness in investing in LTT's.  I just feel like paying down your mortgage carries many of the bad traits of LTT's, with few of the benefits... at least at current rate spreads

This does beg the question, is it worth it, depending on your situation, to take out a mortgage on a fully-paid-down home and invest in long-term treasuries.  Since your payment includes principal, that means that you'd be losing, cash-flow wise, a bit, and if rates move unfavorably you may be in a position where your treasuries are yielding too little interest at their current price to beat the mortgage anymore... or the tax laws change.... lots of moving parts, but with steady mortgage payments and steady interest payments at favorable rates, LTT's and a mortgage are the same and different in just the right ways where I think they can be arbitraged a bit.

Very good point, Moda, I forgot about the fact that since it's margin you only need to beat the "juice", not inflation because there is no wealth to preserve.

I tend to want to follow HB's rule about not margin investing, which I think applies in this case, but I do believe you're right about paying off your mortgage rarely being worth it when rates are this low.

Yeah, I'm not trying to say to people go buy a house so you can not pay down the mortgage fast and instead invest in LTT's...

More acknowledging the jam a lot of people may be in, and their initial responsible instinct, to pay down their mortgage for a guaranteed return, may not be the best thing to do.

FYI, I made a similar decision - I have a car loan with about $20K left on it at 2.89% interest.  I could pay it off with money from the PP right now, but I decided it makes more sense to just make the payments and keep the money in the PP.  9.3-9.8% beats 2.89% every time.

One could always lose faith that the PP will return xx% per year, and would want to pay down ANY debt of ANY interest rate.

I think what this brings us to is the point that if you can find a safe bond or CD of a similar duration as your (fixed rate) loan, and if the rates are better, then go for it... the risks of doing so are minescule.

Storm, I likewise would not rush to pay down a 2.89% loan , even if not tax deductible.  I'm just saying that there is still some risk there, and only finding a risk-free (or close to) interest-bearing instrument of the same duration and better rate will provide you with what I tend to think of as a risk-free interest-rate arbitrage.

PS, I'm assuming you got this loan through the dealer, correct?  If not, share your secrets... or your credit score.

Storm wrote: FYI, I made a similar decision - I have a car loan with about $20K left on it at 2.89% interest.  I could pay it off with money from the PP right now, but I decided it makes more sense to just make the payments and keep the money in the PP.  9.3-9.8% beats 2.89% every time.

Agreed.  Likewise, you can get 30 year money at 135bps over inflation at the moment (housing).  Assuming you elect not to pay down the debt and have an equal amount in a PP, you should expect 400-600 bps real return by comparison (with all the standard caveats about the past not predicting the future, of course).  That 300-500 bps spread is healthy and meaningful to a middle class investor over 30 years. 

My problem with car loan debt is this:

I don't believe that 2.89% is ever the going-rate for a car-loan.  It's a phantom rate based on an increased sales price and what is probably more likely a realistic 6-8% loan.

I'm not trying to say you made a bad decision, Storm, or that paying down the 2.89% loan is a good decision at this point... just that I'd have trouble purchasing a car at $xx,xxx and 2% because I'd know that I paid too much to basically "buy down" the interest rate.

For this reason I feel like I should never take on debt to buy a car... because by the time I've worked them down to the market price, I'm now obligated to pay the market, non-deductible, 6-8% interest.

I could be wrong on this, and I probably will end up taking on debt to buy my next car... it's just something that will give me a bit of pause.

moda0306 wrote: PS, I'm assuming you got this loan through the dealer, correct?  If not, share your secrets... or your credit score.

Actually the loan was through Citizens Bank, but the dealer financing person got me the rate.  Interestingly enough the dealer was not making any money, except maybe a couple hundred from the bank for referral.  I was purchasing a vehicle off lease, so the payoff was already determined 2 years earlier.  The prior lease had a 0.00001 money rate so again that one was like free money for 24 mo.

By the way, I'm probably not going to buy any 40K cars any more.  I leased this one before I got into the PP and it seems a bit excessive - luxury is nice but this is a little too much.  For the lease payoff it was only 25k for a car that was worth over 30 blue book.

A little known fact is that now, there is even cheaper auto financing.  All of the QE2 fountain of money has been finding it's way into the banks for auto loans.  Many are now 1% or less.  This is pretty much a stealth bailout of the car companies, or perhaps propping up of GM share price so the fed doesn't look like it just lost it's shirt when it sells.

I am a fan of paying off your house.  I know plenty of people that will say you're crazy for paying off low interest mortgages right now, but it seems like it is a good strategy for someone that is conservative by nature, which I believe most HBPP'ers are.

Once you own your home outright, you know you'll never be homeless....

I tend to agree with Clacy. I have not bought a home yet, but when I eventually do, I will want to pay off the mortgage as quickly as possible--independently of what the financial markets or the PP are returning.

The emotional premium I place on being debt-free is very high. For example, my wife and I just made our very last payment on her student loan last week, so we are now 100% debt-free: no student loans, no auto loans, no credit card debt, no mortgage... nada. It's a great feeling.

I love that feeling of freedom from debt so much, in fact, that I will probably always choose to pay down debt instead of holding onto it and investing where I can earn a return higher than the interest on the debt. I guess what I'm effectively doing is placing certain "prices" on certain emotions and factoring them accordingly into the financial equation.

clacy wrote: I am a fan of paying off your house.  I know plenty of people that will say you're crazy for paying off low interest mortgages right now, but it seems like it is a good strategy for someone that is conservative by nature, which I believe most HBPP'ers are.

Once you own your home outright, you know you'll never be homeless....

You never really own your home - you merely have a temporary right of use granted by the government.  If you stop paying your taxes, you'll find yourself homeless soon enough, regardless of ownership status.

No matter what the interest rates, consider one thing...  No partial pay off or pay down.  Either pay off your mortgage entirely, or keep the money in hand.

Why?  Because for example, if you pay 99% of your mortgage and are unable to pay that last 1%, the lender still gets to take 100% of your house.  If you instead keep the extra money available you can continue to make payments, which satisfies your contractual obligation and keeps the bank off your back.

If you are at all cynical, you might consider that if you have trouble making your payment and if you have paid 99% of the mortgage then the bank is more likely to take your house because they can easily sell it for more than that 1% and come out ahead.  Whereas if you still owe 99%, especially now that prices/values have dropped, they are less likely to take your house as long as they have hope you will resume making payments.

Storm wrote:it makes more sense to just make the payments and keep the money in the PP.  9.3-9.8% beats 2.89% every time.

Indeed.  Because as long as you have the money, and have the loan, you can pay it off any time.  Once you have paid off the loan you have neither the money nor the loan, just a title.  And you will almost certainly not find anyone to make you a loan at similar terms on your title.

clacy wrote: Once you own your home outright, you know you'll never be homeless....

Do you live somewhere without property taxes?

Even if I did not owe the bank, I only rent my property from the local mesne lord and the Crown, both of whom are more than willing to step in and evict me if I do not pay my annual rent.  And of course the Crown in D.C. has and continues to show willingness to step in and place puppet governors over the states should they fall out of line.

AgAuMoney wrote:

clacy wrote: Once you own your home outright, you know you'll never be homeless....

Do you live somewhere without property taxes?

Even if I did not owe the bank, I only rent my property from the local mesne lord and the Crown, both of whom are more than willing to step in and evict me if I do not pay my annual rent.  And of course the Crown in D.C. has and continues to show willingness to step in and place puppet governors over the states should they fall out of line.

Of course you have to pay your property taxes.  This is completely irrelevant to the question at hand because property taxes have to be paid whether you have a mortgage or not.

Even if you are renting, you're paying a rent that reflects this cost.

The fact is that anyone with any sort of ability to earn even a modest living, will always be able to pay their property taxes on a paid for house, unless we're talking a very extravagant home.

Storm wrote:

clacy wrote: I am a fan of paying off your house.  I know plenty of people that will say you're crazy for paying off low interest mortgages right now, but it seems like it is a good strategy for someone that is conservative by nature, which I believe most HBPP'ers are.

Once you own your home outright, you know you'll never be homeless....

You never really own your home - you merely have a temporary right of use granted by the government.  If you stop paying your taxes, you'll find yourself homeless soon enough, regardless of ownership status.

I'm not sure how you took my post to mean that I would stop paying my property taxes.  Regardless of whether I have a mortgage or not, the local government wants their cut.

clacy wrote:

AgAuMoney wrote:

clacy wrote: Once you own your home outright, you know you'll never be homeless....

Do you live somewhere without property taxes?

Even if I did not owe the bank, I only rent my property from the local mesne lord and the Crown, both of whom are more than willing to step in and evict me if I do not pay my annual rent.  And of course the Crown in D.C. has and continues to show willingness to step in and place puppet governors over the states should they fall out of line.

Of course you have to pay your property taxes.  This is completely irrelevant to the question at hand because property taxes have to be paid whether you have a mortgage or not.

It is all in response to your "own your home outright" malarkey.

Since you have to pay property taxes, you can never own your home outright.  Property taxes are simply another name for rent and function just as the feudal system has always functioned.  If you don't pay your rent, the lord will take your property and give it to another more compliant/productive vassal.

There was a brief time in U.S. history when we weren't under a renamed feudal system, but that time is gone.

If one can borrow at a tax-deductible, callable 30 year mortgage at 4.5% and invest in (among other diversifiers if one wishes) a 30 year non-callable treasury bond at 4.2% for the same duration, especially in a roth ira, I think that definitely calls into question whether attempting to quickly pay down one's mortgage is in your best interest...

Obviously this depends on your situation and future tax policy might significantly reduce the tax-benefits of having mortgage debt, but I definitely not so completely debt-averse that I'd avoid almost fool proof arbitrage opportunities.

AgAuMoney wrote:

clacy wrote:

AgAuMoney wrote: Do you live somewhere without property taxes?

Even if I did not owe the bank, I only rent my property from the local mesne lord and the Crown, both of whom are more than willing to step in and evict me if I do not pay my annual rent.  And of course the Crown in D.C. has and continues to show willingness to step in and place puppet governors over the states should they fall out of line.

Of course you have to pay your property taxes.  This is completely irrelevant to the question at hand because property taxes have to be paid whether you have a mortgage or not.

It is all in response to your "own your home outright" malarkey.

Since you have to pay property taxes, you can never own your home outright.  Property taxes are simply another name for rent and function just as the feudal system has always functioned.  If you don't pay your rent, the lord will take your property and give it to another more compliant/productive vassal.

There was a brief time in U.S. history when we weren't under a renamed feudal system, but that time is gone.

Ok, so you have a political issue with property taxes, I get that.  However, that has no relevancy to the question of whether to pay off a mortgage or not.  I think we can all accept the basic truth that you have to pay to live somewhere, correct?  If that assumption is correct, your options are a) rent, b) own a home with a mortgage or c) own a home with no mortgage.  In any of those three cases, if the property taxes aren't paid, you are out on the streets.  In the case of renting, you are paying a rent to reflect the taxes.

Back to the original question. There are two choices.  Own with a mortgage, or own outright.  EITHER WAY THE OP MUST PAY HIS PROPERTY TAXES, so your political rant adds no value to the argument either way. 

The question comes down to safety versus a financial calculation.  You can certainly make an argument that it is better to keep a mortgage from a financial standpoint.  But from a safety perspective, owning a home with no mortgage is without question the safest form of housing options you have.