With today’s rock-bottom interest rates, refinancing a mortgage intrigues many borrowers. It’s not always a slam-dunk — not all slam-dunks work out swimmingly; ask George Tenet.
Wealthy people miss one of life’s great pleasures, making the final payment on a house, a car or even a business loan. Don’t discount the psychic value of not having a mortgage especially during retirement but even for pre-retirees. You get a liberating mental freedom when you know your home is debt-free. A terrible misconception exists by many in the financial planning community who ignore this value. Financial advisors have Grand Canyon-sized conflict of interest since any money directed toward principal reduction means less funds to manage and less fees to the manager.
While our standard recommendation is to pay off a mortgage prior to or shortly after retirement, we look at each person/family’s case individually. The current interest environment had me second-guessing myself. The inspiration for today’s column came from a situation where a client looked at paying off their mortgage versus investing. Michael Kitces’ well-respected blog, Nerd’s Eye View, offers commentary on financial planning topics and points out the misconception regarding refinancing versus investing.
The logical fallacy making the rounds generally follows if stocks have higher expected return than the interest rate on the loan, you should not prepay your mortgage — simple, neat, yet wrong. For decades, stock investors have demanded roughly a 5 percent interest rate premium over the risk-free return guaranteed by holding government bonds to maturity.
Intermediate to long-term government bonds have historically produced 5 percent returns versus stock market returns of 10 percent. Stocks are inherently risky, ask Bobby Lauder, War Damn Eagle. His Colonial Bank stock went to zero. As Kitces points out, “investors only buy at a price that implicitly meets their demand for higher return.”
If the question comes down to prepaying your mortgage versus investing, you should not look solely at the mortgage’s interest rate but add the historical risk premium of stocks. According to bankrate.com, current re-fi rates hover around 4 percent. Regions offers 10-15 year loans south of 4 percent, in any case the expected return would be north of 8 percent. Even the SWFD pension shoots lower. It’s not sufficient to merely clear whatever interest rate bar you choose, but you must include an equity risk premium.
Take a risk-averse investor who owns a basket of CDs or insured municipal bonds because of their risk-free returns. As the CDs mature or if the issuer calls the bonds (municipal bonds often have a feature where the issuer can prepay or call the bond before maturity), a risk-averse investor has a dilemma with respect to risk-free income. If they prepay their mortgage at 4, 5 or 6 percent, they earn what they don’t pay.
Yes, mortgage interest is tax-deductible so calculate whatever benefit you get by itemizing and adjust your interest rate appropriately. Don’t overlook the standard deduction. In 2013, a married couple can claim a $12,200 standard deduction.
A $250,000 mortgage with a 4 percent interest rate only chalks up $10,000 in deductible interest. With small mortgage balances, you don’t pay enough interest to itemize. Prepaying the mortgage is the equivalent earning a risk-free rate of return based on the loan’s interest rate.
With one year T Bills at .14 percent, paying off or avoiding a 4 percent mortgage improves your return 30 times — and that is a Louisville Cardinal slam dunk.
Buz Livingston, CFP offers hourly financial planning and fee-only investment management to clients along Florida’s Emerald Coast. Contact him at 267-1068, Buz@LivingstonFinancial.netor www.LivingstonFinancial.net.