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, and I think that the common answer to the question is flawed.
I’m Ben Felix, Associate Portfolio Manager at PWL Capital. In this episode of Common
Sense Investing, I’m going to tell you how to think about mortgage debt.
When we are talking about using investments to pay off debt,
I think that the most common advice out there, and probably the most common thinking,
is that it makes sense to keep the portfolio in tact to benefit from the higher expected
returns of financial market investments compared to the relatively low cost of mortgage debt. This
has been especially true in the period of low interest rates that we have been living through.
This approach might seem logical from the perspective of maximizing expected returns,
and for some people it might be logical. The important nuance is that if your investment
portfolio is not allocated 100% to stocks, paying off the mortgage and increasing the portfolio’s
equity allocation may be a more sensible approach to increasing expected returns.
Let me explain with an example. I will use the PWL Capital expected portfolio
returns to illustrate the differences in expected returns for portfolios,
and I will use a 3% interest rate in my example.
Let’s imagine someone with a $500,000 home with a $400,000 mortgage, and a
$900,000 investment portfolio currently invested in 50% stocks and 50% bonds.
The portfolio could easily pay off the mortgage balance. I think that most people in this
situation would prefer to have the larger portfolio. Let’s look at the two options.
If we keep the mortgage and the fifty percent stock / fifty percent bond portfolio the total net
worth ends up being one million dollars. That’s the $500,000 home minus the $400,000 mortgage
plus the $900,000 portfolio. If we pay off the mortgage, then there is a $500,000 house and a
$500,000 portfolio. Same net worth. The difference will show up when we project out one year.
Note that for this example we are ignoring mortgage pre-payment penalties and the tax
implications of selling the portfolio. We are also going to ignore the impact of mortgage
payments to keep things simple. In reality the payments would decrease the mortgage balance,
but for an apples to apples comparison they could also be assumed to be added
to the portfolio. It is easiest to ignore them on both sides.
If we assume that the 50/50 portfolio earns 4.68% per year and the mortgage costs 3.00% per year,
as we would expect, the scenario with the mortgage and the larger portfolio
results in greater wealth. This is exactly the idea that people have
in mind when they choose to keep both a portfolio and a mortgage.
The problem is that this is not a fair comparison. Keeping the mortgage
results in a substantial amount of leverage. Leverage increases risk.
Based on this, it might be more reasonable to compare keeping the mortgage and a 50/50
portfolio to paying the mortgage off and increasing the portfolio risk
level to 95% stocks and 5% bonds, with an associated higher expected return of 6.09%.
In this case, when we fast forward one year, we get a nearly identical expected
outcome whether we keep the mortgage or not. Despite the appearance of taking more risk,
with the more aggressive portfolio, I would argue that your overall risk has decreased.
Let me explain. If you do not think you could handle a 95% equity portfolio, it might help to
think about this another way. In either case you have a $500,000 home. Keeping the mortgage and
investing $900,000 effectively means investing $500,000 of your own money and borrowing the
remaining $400,000. When we push aside the mental accounting bias, this is a leveraged investment.
Let’s think about how these two portfolios might have played out in the 2008 financial crisis.
In the worst 12 months of the financial crisis, a 50/50 portfolio dropped by 20.58%,
so a $900,000 portfolio lost $185,220. In our example only $500,000 of that was your
own money. A $185,220 loss on $500,000 equates to a 37% loss, but you also paid 3% in mortgage
interest on your $400,000 mortgage that year for a total loss of 39.44%. Not to mention the
possibility that stricter lending practices in a crisis could make renewing a mortgage a challenge.
Alternatively, owning a 95/5 portfolio through the financial crisis resulted in a portfolio loss
of 38.92% for the year, with no interest costs. You should be almost indifferent with a slight
preference for the riskier portfolio with no mortgage debt. Whether you actually have the 95/5
portfolio, or you have a 50/50 portfolio with the mortgage, you effectively have the 95/5 portfolio.
In either case, having a mortgage and a conservative portfolio,
or having no mortgage and an aggressive portfolio,
the risk and return characteristics are very similar. Paying off the mortgage has the added
benefit of eliminating the guaranteed mortgage interest cost and the fixed outgoing cash flow.
Another way to think about this is that when you have a mortgage you are short fixed income. You
have effectively sold a bond to the bank, and you have to make interest payments with
after-tax dollars.. When you have bonds in your portfolio, you are long fixed income,
and your interest is fully taxable in a taxable account. Being both long and short in an asset
at the same time is not sensible, especially after the tax implications that I just mentioned.
As opposed to being short fixed income with the mortgage and long fixed income with the portfolio,
it might be sensible to close out the short fixed income position with the long position.
In both cases your exposure to fixed income is the same, but paying off the mortgage frees up
cash flow and eliminates mortgage interest that has to be paid with after-tax dollars.
If you do not have a large enough portfolio to pay off your mortgage,
you can still use the logic. For example, rather than saving $1,000 per month into a taxable 60/40
portfolio while also making regular mortgage payments, you might choose to put $600 per month
into a 100% equity portfolio while adding $400 to an accelerated mortgage payment. Again, your
risk/return tradeoff is similar in both cases, with the added benefit of getting rid of debt.
Mortgage debt is usually thought about in isolation. I believe that it should be
considered when evaluating the risk and return characteristics of a portfolio. Where possible,
paying down mortgage debt while increasing the portfolio’s equity allocation can result in
equivalent risk and return characteristics while eliminating a fixed expense..
Have you considered your mortgage in the asset
allocation decision? Tell me about it in the comments.
Thanks for watching. I’m Ben Felix of PWL Capital and this is Common Sense Investing.
I will be talking about a new common sense investing topic every two weeks,
so subscribe and click the bell for updates.