Should You Pay Off Your Mortgage?

In my last post, I note that there's some really bad advice out there about a difficult decision: Do you or do you not pay off your mortgage.  "Ordinary Bob" asked for more help.  I'll try.

Disclaimers: This is a complicated question.  I do not give financial advice, I am not qualified to give financial advice.  I don't know you or your circumstances.  I'm going to highlight my personal concerns, which could be very different from yours.

Before I begin, an apology: I referred to Kelly Campbell as a woman.  Kelly Campbell is male.

Campbell states the obvious, and he says nothing particularly unique about a mortgage: If you can borrow money at a rate below the rate at which you think assets will appreciate, you can expect to make more money by borrowing to invest than if you didn't borrow.  Note the word expect.  This strategy involves leverage and more risk around uncertain outcomes.

He assumes that your house and investment portfolio increase in value by 5% and 8%, respectively.  I'll go out on a limb and assume he told his clients more or less the same thing in 2006.  Unclear if those people remain his clients.

In other words, he forgot to mention that investment returns are not guaranteed.  (Interesting that a Certified Financial Planner who touts his clean FINRA record on his website can make statements in a U.S. News column he cannot legally make in a client conversation.  If you're curious about that one, ask him to mail you a re-print of the article.  I'll bet $1 the re-print he sends has multiple disclaimers!)

Buying a house with a mortgage is just a leveraged investment. Yes, you live in it, enjoy it, yada yada yada.  But, you can borrow cheaply against stocks and mutual funds too.  It's called a margin loan, and that interest is also tax deductible.

So, you have to ask yourself if you can stomach the risk of more leveraged investing.  Most people cannot.  You probably could not cope with the volatility of your house price if you watched it.  (Check Zillow's monthly marks on your house.  I'll be you another $1 you rationalize that Zillow is just wrong, that they don't know your house.)  

For me, liquidity is the next issue to consider when thinking about paying off a mortgage.  Liquidity provides financial flexibility.  A pile of cash that could pay off your mortgage provides liquidity.  Pay off your mortgage, your liquidity disappears with your loan.  Suppose after you pay off your mortgage, you lose your job, so you can't get a new loan and your short cash.  Or, you want to move to a great new job, and you can't sell the old house.  You have no cash to buy another.  Heck, what if the stock market really crashes, and all of a sudden Campbell's risky 8% becomes a not so risky 20% and you have no cash to invest??

Lastly, I think about inflation.  Everyone's talking about inflation these days.  Did you buy gold for the end of the world yet?!?  Seems pricey, right?  Many logical inflation hedges seem uncomfortably priced.  I hold a relatively large amount of TIPS.  But even they aren't perfect.  If you own a house, you're already "long" a real asset, albeit in a completely undiversified and illiquid way.  With a 30 year mortgage, however, you're short a long duration bond.  That's very convenient if you think interest rates are going to rise dramatically due to inflation.  That's right, you pay off the mortgage with depreciated dollars after inflation strikes. 

So you ask, have I paid off my mortgage?  Not yet.  But, my circumstances are very different from yours!

Government Sponsored Leveraged Equity Bets...On College??

I've explained before why I think 529 Plans should go away.  They only benefit the very wealthy, and probably they feed the ever increasing costs of college education. 

Melissa Bean of Illinois, has introduced HR5030, which seeks to allow the use of 529 Plan assets to cover student loan interest payments.  From her website:

"With one daughter in college and another to follow, I keenly understand the financial challenges parents face to fund college education,” Bean said. “This bill allows those who’ve saved in 529 accounts and played by the rules to allow their investments to recover before using them to finance those costs."

This bill reflects a fundamental misunderstanding of just about every aspect of finance, from investing through tax.

Let's make this very simple.  Bean bought a risky portfolio to save, tax free, for her daughters' college costs.  This portfolio went south. 

H.R. 5030 would allow her to use the risky plan assets to finance student loan debt, not just direct educational expense.  If she were a Goldman instead of a Bean, we'd call this proprietary trading. 

She believes she can invest her 529 Plan assets in such a way as to earn a spread above the borrowing rate on student loans.  That's a bold assumption.

We could just stop there.  Why should the government encourage more leveraged risky bets than they already encourage? 

New Jersey's pension crisis...Congress's fault? First take.

This is so cliche that the state of NJ has a pension problem. It's like saying Illinois has a governor problem. Here's the latest word.

Why is it Congress's fault? Well, not entirely of course, but here's a convoluted start. UBIT. Unrelated Business Income Tax. What, you say? UBIT is a federal tax that prevents retirement plans (pension plans, your 401(k), etc.) from using leverage. In a nutshell, if these typically not taxed investment entities use leverage (that is, borrow money to fund their investing) they suddenly become taxable. Because, apparently, financing investments is an unrelated business to investing, which is the business of a pension plan.

What does this mean? In order to juice returns via leverage, rather than borrow money themselves, pension plans make investments in partnerships that may use leverage. These leverage using partnerships are normally called "hedge funds." The hedge funds hide the leverage within the partnership so everyone can comfortably say "this pension plan uses no leverage."

How does this work in practice? Suppose you are a completely competent pension plan manager who does not invest in hedge funds. You invest in a diversified, globally balanced portfolio of lots of different assets. You manage to earn, over time, for your pension plan 6%-9% annually with not very much volatility. Remember, you are highly diversified across asset classes and geographies.

Guess what: You don't exist! If you did exist, you'd do the following: You'd take your same investment strategy, leverage it up 2x-3x, making it riskier, but still attractive, you'd call yourself a hedge fund, and you'd own a 20% performance fee on what you used to do for $250k/yr.

Let's look at the math: Say the strategy has a 7% expected return, with 4% volatility. That's not bad. Suppose you borrow at 3%. Thus, you leverage the portfolio 3x, you now have a 7% + 2 x (7%-3%) = 15% expected return strategy. Yes, you have 3x the risk too. But, you've just hit the hedge fund sweet spot. Anyone who has ever met with a hedge fund manager knows they have to claim 15% gross returns to get in the door. It's in the hedge fund marketing manual. You now have a hedge fund with "higher expected returns than the equity market, and lower risk."

How's that you say? Well, the 20% performance fee means your performance, net of 2% management fee and 20% performance fee is still 10.4% [=(15% - 2%)x 0.80]. This easily beats the target your old pension plan guys need to meet their goals, so they are in! And, it gets better. That 20% performance fee, (or, as I like to say 20% at the money call your investors give you) actually reduces the volatility of the outcomes, which makes your 3x leveraged strategy not really look quite that volatile. (The performance fees "dampen" the upside volatility you see.)

Now, suppose instead you could use leverage without having to hide it in a hedge fund. Well, if that not particularly credit worthy hedge fund can borrow at 3%, say whatever you like about NJ, but it is more credit worthy than that fund. So, let's say it borrows at 2.5%. Oh, and it doesn't have to pay hedge fund fees anymore to get it's leverage. Let's go crazy and say the management fees are cut in half (only) and the performance fees are cut in half (only!) That makes for seriously well paid, highly qualified pension staff, trust me! (Remember, good investment people all HATE their clients, no matter what they say. They like investing, they don't like talking to clients. So, one big client beats many small ones...especially when the one big one is captive!)

Do the math again: 7% + 2 x (7% - 2.5%) = 16% gross return, and a (16% - 1%) x 0.9 = 13.5% net return. So, same strategy, same risk, generous fees to boot, picks up 3.1% incremental return. Assuming no UBIT.

Oh, and as a side effect, hedge fund fees come down, as HFs lose their lock on providing leverage to pension plans and the landscape becomes more competitive.

In another post, we'll go into why this same analysis should apply to pension plan's evaluation of their decisions to invest in hedge funds.