March 29, 2013

Do you Pay Down Your Mortgage or Invest?



Question: you have an extra $200 per month...do you pay down your mortgage or invest in the markets?

This is a controversial issue with no *right* answer. But let me tell you how I approach this question by first explaining my frame of reference.

I value independence, control and security. I recognize that the markets have provided roughly 6-10% pre-tax returns (depending on asset allocation) over the long run. My mortgage cost runs at a post-tax 4.5% (in some countries mortgage interest is tax deductible and the rate should be adjusted accordingly).

First, it's helpful to calculate expected after tax returns on my particular asset allocation, given my marginal tax rate. Let's say those returns are still higher than the cost of my mortgage. Does it make sense then for me to invest the $200/mth?

(Of course, there are other tax considerations, such as tax sheltered accounts, when evaluating after tax returns on a portfolio. The point of this article is not to show how to calculate after returns...the point is to help you make a decision once you know what numbers you're dealing with. Regardless of what you estimate your expected after tax returns on your investments to be it is critical not to compare this number directly with your after-tax mortgage interest rate.)

Comparing apples with oranges:
As with any investment opportunity, one must consider return and risk. An 'investment' in my mortgage is a guaranteed 4.5% return (really, its the guaranteed avoidance of a 4.5% loss). What alternatives provide a guaranteed after-tax return anywhere close to 4.5%?

Sure, over the long run markets have provided many investors with a post-tax return above 4.5%, but one must understand these averages smooth out major volatility over the years. And that volatility could temporarily or permanently impede my ability to meet mortgage payments (explained in the section below called 'Income Shortfall Risk').

When comparing options one should also distinguish between average market returns and average personal returns. Research shows that the average investor actually performs far worse than the market averages. This is because the average investor is emotional and tends to buy-high and sell-low. Market averages are meaningless if you're  only achieving 2-3% personal returns on your investments.

Income shortfall risk:
Exacerbating the problem with comparing a mortgage interest rate with expected returns is the mis-match between incoming and outgoing cash-flows, something those in the actuarial world are familiar with. Essentially, when a known fixed liability is paid using an unknown variable cash flow risk is introduced into the equation.

The 4.5% mortgage expense (plus principal repayment) must be paid every month of every year - there's limited flexibility to adjust the payment with the fluctuations of income derived from assets. In practice, I can use income generated from assets, which includes intellectual capital (i.e. job), to meet debt service obligations. While my average income from all sources throughout my life may be well above the amount required to meet my debt payments, a single bad year (or bad few months) could lead me to default on the mortgage. When evaluating my ability to pay debt, instead of looking at long-term average return on assets I should look at worst case portfolio returns and employment income (e.g. during a bear market or period of unemployment - which, unfortunately often happen at the same time) rather than long term average income. If the worst case scenario analysis shows that during such an event I would be unable to meet fixed mortgage obligations I would probably be best served by using any extra available cash to pay down my liabilities.

Wait, there's more.

Loss of control:
Debt isn't only about the hard numbers. Even if the numbers favor the investment, should I? While some are entirely comfortable with being in debt others aren't. Personally, I don't feel comfortable living with a contract that controls my financial - and indirectly, my non-financial - life. 'Mort' 'gage' is French for death pledge; somewhat telling of the gravity of default. Although debtors prison (or worse) is no longer recourse for lenders, terms and conditions of most loans are such that the borrower is in a weak position. While everyday practice is usually less sinister, the possibility that my family could get thrown out on the street is alone cause for my 'mortgage-aversion'.

Others may not be as paranoid. I've never personally had a negative outcome to my personal indebtedness, but I partly blame my aversion to my childhood experiences. When I was young I never had a sense of financial security. Because of this, I've spent a good portion of my working life squirreling away money and paying down debt.   Perhaps I'm an extreme example, but I believe everyone can benefit from adopting a little prudence.

Some will contradict what I'm saying by pointing to research out there suggesting many millionaires made their fortunes by using debt. True, one way to make a fortune is to find a profitable idea and use other people's money to execute it. But research that shows this is how millionaires made their money suffers from survivorship bias. For every millionaire who borrowed his way to success, the are many others that lost everything because they remortgaged their house for a dream that failed. (By the way, its a myth that an entrepreneur can limit liability by incorporating. Anyone lending to a small business - incorporated or not - will ask for a personal guarantee from the owner.) Contrary to what some research implies, the evidence I've seen suggests that most successful entrepreneurs avoid debt financing in the early stages, only to borrow when their idea has proven itself.

Others will say that fully-mortgaged houses have historically been a no-lose proposition. Given the U.S. experience over the past several years, do I really have to bother writing a rebuttal to this?

Finally, some will suggest that there are times when 'strategic default' is the best

Getting back to the original question...what should you do with an extra $200 per month? I'll summarize my answer:

1. Apples with oranges risk: First understand that the tradeoffs must be evaluated in terms of risk and reward.

2. Shortfall risk: Realize that debt payments aren't flexible, whereas returns are. Don't let long run averages hide the true variability of cash flows from investments, including your investment in yourself.

3. Control risk: Remember that, for most of us, loan contracts work in the lender's favor. By being in debt you give up a portion of your freedom.

Most importantly, determine and face your true comfort with, and capacity for, risk. What losses on your investments could you handle, given your indebtedness. What if you lost your job? Do you have dependents? Are you comfortable moving to a tiny apartment or inviting renters if you had to?