Oblivious Investor

A reader writes in, asking:

“We bought a home recently, when rates were high though not as high as they are now. Without having any idea of whether home prices and interest rates will decline or continue to rise, how does one determine whether it’s a worthwhile tradeoff to sell some or all of our bond funds to payoff, or pay down, our mortgage?”

Changes in the Home’s Value Don’t Matter (For This Decision)

Firstly, the decision of whether to prepay the mortgage has nothing to do with the price of the home.

Example: Bob borrowed $400,000 to purchase a $500,000 home (i.e., making a 20% down payment of $100,000). If the home goes up in value by $50,000, Bob’s balance sheet will now include a $550,000 home. And that’s true regardless of whether he prepaid his mortgage or not. Similarly, if the home declines in value by $50,000, it’s now a $450,000 home, regardless of whether he prepaid the mortgage.

If you bought a home, you now own that home. You will experience 100% of the home value fluctuations, even if you only have, for example, 20% equity in the home. Point being, the amount by which the home goes up or down in value is unaffected by the decisions you make about the mortgage. And in turn, the decisions you make about prepaying the mortgage should be unaffected by your expectations for how the home’s value will change over time.

Yield on Bonds vs. Mortgage Interest Rate

The comparison to make is the interest rate of the bonds you would be selling as compared to the interest rate of the mortgage. Specifically:

• For bond funds, we want to look at the SEC yield.
• For individual bonds, we’d look at the yield-to-maturity.
• If the bonds are in a taxable account (as opposed to a retirement account such as a 401(k) or IRA), we need to calculate their after-tax yield.
• Similarly, for the mortgage, we’re concerned with the after-tax interest rate (i.e., after accounting for any tax savings you get as a result of the itemized deduction for home mortgage interest).

As of this writing, Vanguard Total Bond Market ETF (BND) has an SEC yield of 4.82%. If you owned that ETF in a taxable account, we’d have to multiply by [1 minus your marginal tax rate] in order to find the after tax yield (e.g., 4.82% x 0.75 if you have a 25% marginal tax rate).

If your mortgage is from several years ago and has a 3% interest rate (which is likely less than 3% after accounting for the itemized deduction for mortgage interest), selling bonds that yield 4.82% in order to pay down a 3% mortgage doesn’t seem all that appealing, from a purely financial point of view. (Some people may still choose to do it, because eliminating the mortgage gives them psychological benefits.)

On the other hand, if your mortgage is newer, with a 6% or 7% interest rate, selling those 4.82% bonds does look pretty attractive.

A complicating factor is that interest rates change over time. If for some reason you are convinced that interest rates are about to fall or rise, that would have an impact on whether or not you should sell your bonds at this time. (Bond prices move in the opposite direction of interest rates. So if you are convinced that your bond values are about to rise or fall in the near future, that would be either a point in favor or against selling right now.)

Personally, I have not seen any evidence that interest rate movements are easier to predict than short-term stock market movements. So rather than making guesses, I prefer to make decisions based on today’s rates.

Other Tax Considerations

Another important factor is: what type of account is it that you would ultimately be drawing these assets from, in order to prepay the mortgage?

If you would be using assets from a taxable brokerage account, we want to account for the capital gains tax (if any) that you would have to pay as a result of selling the holdings in question.

If you would be using dollars from a traditional IRA, what tax rate (including 10% penalty, if applicable) would you be paying on the distribution? And how does that compare to the tax rate you expect to face in the future (i.e., whenever these dollars would come out of the account later, if you don’t take them out now)? The higher the current tax rate that you would pay is, relative to the future tax rate that you anticipate, the less desirable it is to tap this account for any reason, including prepaying a mortgage.

If you would be using Roth IRA dollars, would you be paying tax (or penalty) on any of the distribution?

Risk Considerations

One point that trips many people up is the idea that by selling bonds to prepay the mortgage, they’ll be increasing their financial risk (because the portfolio will now have a higher percentage allocated to stock). In most cases, that’s not true. In most cases, it will not be a significant change in risk.

When you buy the home, you increase your risk. In our example above (Bob uses $100,000 of cash and a $400,000 mortgage to buy a $500,000 home), he now has $500,000 additional dollars of exposure to real estate (risky). He has a new $400,000 liability (risky). And he has $100,000 less cash (also an increase in risk). He has increased his economic risk in three different ways.

But once he has bought the home, those things have already happened. He has already taken on all of that additional risk.

Selling bonds to prepay a mortgage doesn’t affect how much exposure you have to real estate volatility (see the beginning of this article). Nor does it affect how many dollars you have exposed to stock market volatility. What it does do is:

• Reduce your liabilities (thereby reducing your risk), and
• Reduce your safe assets (thereby increasing your risk).

Net change in risk: roughly zero.

People often latch on to the percentage change in the asset allocation. But that’s a distraction. In our example above, imagine that after buying the home, Bob’s portfolio is $1,000,000, of which 60% is stocks and 40% is bonds (i.e., $600,000 in stocks, $400,000 in bonds).

If Bob were to use all $400,000 of his bonds to pay off the mortgage, he’d go from a 60%-stock portfolio to a 100%-stock portfolio. If we just look at the percentage, that’s a huge increase in risk. But in reality, he still has exactly $600,000 exposed to stock market risk. He didn’t increase his allocation to stocks at all. We just have a smaller denominator in our fraction ($600,000 total portfolio rather than $1,000,000).

Selling bonds to pay down a mortgage does not typically change the household risk level by very much. It is, mostly, just a decision of interest rates (after accounting for the various tax considerations).