**Update 12/4/2020:** I’ve been getting a lot of inquiries lately: Has my assessment changed in light of the record-low interest rates? My answer: Not really. Mortgage rates are low but so are my equity expected returns and bond yields. Right now I see 2.375% for the 15y and 2.75% for the 30y mortgage, so we’re about 1.0% lower on the mortgage rate. But with the CAPE>30 we also have a 1% lower equity expected return. It’s almost a wash. So, the gist of the article is still intact: Ask yourself, are you comfortable with a mortgage and 100% equities? I would not. If you do have bonds and a mortgage, is the bond yield lower than the mortgage rate? (Currently, it is: <1% for the 10y bond used in my simulations.) So, you’re better off paying off the mortgage with the bond portfolio.

Welcome back to the newest installment in our Safe Withdrawal Rate Series! If you are new to our site please go back to Part 1 to start from the beginning. Or check out the designated landing page for the SWR Series here.

But back to the topic at hand. It’s been on my mind for a long time. It’s relevant to our own situation and it’s come up in discussions on other blogs, in our case study series and in numerous questions and comments here on the ERN blog:

### Should we have a mortgage in Early Retirement?

The case for having a mortgage is pretty simple: You can get a 30-year mortgage for about 4% right now. Probably even slightly below 4% when you shop around. Equities will certainly beat that nominal rate of return over the next 30 years. Open and shut case! End of the discussion, right? Well, not so fast! As we have seen in our posts on Sequence of Return Risk (Part 14 and Part 15), the **average return** is less relevant than the **sequence of returns**. Having a mortgage in retirement will exacerbate your sequence of return risk because you are frontloading your withdrawals early on during retirement to pay for the mortgage; not just interest but also principal payments. In other words, if we are unlucky and experience low returns early during our retirement (the definition of sequence risk) we’d withdraw more shares when equity prices are down. The definition of sequence risk!

How badly will a mortgage mess with sequence risk and safe withdrawal rates? That’s the topic for today’s post…

### Our situation

Our situation is a bit unique in that we will move from our current location in a high cost of living area in an extremely high marginal tax state to a low cost of living area in a low or even no income tax state. Hence, we will certainly pay off our **existing** mortgage when we sell our apartment. We should be able to pay cash for a modest house in our new location and still have money left over to invest. But should we get a mortgage and invest even more money? It’s so tempting! And remember, I’m not foreign to the concept of leverage and I have praised it many times (see, for example, Seven reasons in defense of debt and leverage: Yes, you CAN have too little of a bad thing!). But that was when we were still saving for retirement. This time is different, though:

**Taxes:**In retirement, we expect to use the standard deduction. No more itemized deductions, hence, our mortgage interest is no longer tax-deductible.**The equity glidepath slope reverses in retirement!**As we detailed in the previous two installments of the series (Part 19 and Part 20), a glidepath shifting from a moderate bond allocation at the commencement of retirement to a mostly equity portfolio later in retirement can serve as a hedge against Sequence Risk. But with a mortgage, we’d do the opposite. Having a mortgage is similar (though not identical, I know) to a**short bond position**, and paying off the mortgage means we shift money out of equities and into bonds. The wrong direction! That can only exacerbate Sequence Risk!**Dynamic Withdrawal Rules:**Another tool we recommended to deal with Sequence Risk is to adjust the withdrawal rates according to how the portfolio performs. We like a CAPE-based rule (see Part 18 for more details) but others prefer the Bogleheads VPW (see Part 11 for a comparison of different dynamic rules). But using variable rules becomes harder when faced with the fixed expense of a mortgage. Imagine you follow the VPW rule and you have to cut your $4,000 monthly withdrawal by 50% in response to a 50% market drop. That’s painful. But with a $1,000 mortgage and a $5,000 initial monthly withdrawal, you’d cut your withdrawal to $2,500. After paying for the mortgage you’re left with only $1,500 in discretionary spending compared to $4,000. That’s a 62.5% drop in consumption! Thus, the**mortgage will magnify the consumption impact of market volatility!**

### Simulations and Limitations

The 30-year mortgage as we know it today didn’t even exist before the Great Depression. What’s worse, I don’t have a very long time series of 30-year mortgage rates. Even if I had a time series for mortgage rates I’d have to make assumptions, lots of assumptions, about if and how each of the cohorts since 1871 would have handled changing interest rates and potential prepayments and/or refinancing of mortgages. A can of worms!

So, studying the pros and cons of a mortgage-free early retirement would have to take a few shortcuts and hacking of my simulation engine. And once you start hacking, always keep in mind one of Big ERN’s fundamental rules:

### There is a fine line between **doing** a hack and **being** a hack!

So for full disclosure, today’s simulation results are mostly a thought experiment with the following assumptions:

- I calculate the mortgage payment of a 30-year and 15-year mortgage with today’s market rates and assume that the real, inflation-adjusted mortgage payments decay due to a projected 2% annual inflation rate going forward, see chart below.
- Given the mandatory real mortgage payments, what would be the experience of a retiree today if the real stock/bond returns of all the past retirement cohorts were to repeat themselves?

In other words, I don’t simulate how a retiree in 1929 with a mortgage in 1929 would have experienced the 1929-1989 equity and bond returns. I calculate how a retiree **today** with **today’s mortgage** parameters would fare if we hit him/her with the 1929-1989 real, CPI-adjusted stock/bond returns. And the 1928-1988 returns and the 1927-1987 returns, and the 1930-1990 returns, and so on.

You be the judge if this crosses the line. But remember, before yelling at me, please keep in mind another one of Big ERN’s fundamental rules:

### It takes a model to beat a model!

In other words, unless you have a better way of evaluating the mortgage vs. no mortgage tradeoff please don’t call me a hack. 🙂

### Simulation Assumptions:

- 60-year horizon, capital depletion target.
- We run monthly simulations through our Safe Withdrawal Rate Google Sheet. See Part 7 of this series for more information.
- We assume a 2% annualized inflation rate, so the mortgage payments, in real inflation-adjusted terms will decline over time.

We look at eight different models/parameter assumptions. They all have the same initial net worth but different assumptions about the mortgage, mortgage term and stock/bond allocation:

**Model 1 (baseline):**$1,000,000 portfolio, no mortgage, 80% Stocks, 20% Bonds.**Model 2:**$1,000,000 portfolio, no mortgage, 100% Stocks.**Model 3:**$1,200,000 portfolio, $200,000 mortgage, 30-year term, 3.875% interest. 100% Stocks.**Model 4:**$1,200,000 portfolio, $200,000 mortgage, 15-year term, 3.250% interest. 100% Stocks.**Model 5:**$1,200,000 portfolio, $200,000 mortgage, 30-year term, 3.875% interest. 80% Stocks, 20% Bonds.**Model 6:**$1,200,000 portfolio, $200,000 mortgage, 15-year term, 3.250% interest. 80% Stocks, 20% Bonds.**Model 7:**$1,200,000 portfolio, $200,000 mortgage, 30-year term, 3.875% interest. 67% Stocks, 33% Bonds. Why 2/3 Stocks and 1/3 bonds? That’s because $800,000 in stocks and $400,000 in bonds netted with a $200,000 mortgage brings us exactly back to the 80/20portfolio allocation in the baseline!**Model 8:**$1,200,000 portfolio, $200,000 mortgage, 15-year term, 3.250% interest. 67% Stocks, 33% Bonds.

### Results

To warm up, let’s start with a simple time series plot of the safe withdrawal rates of the 8 different models. All numbers are percentages of the initial Net Worth to account for the fact the models with a mortgage obviously have a larger portfolio value! I plot this just for the record because you can’t really make out the relative performance of the different rules. But notice how all 8 models drop below the ostensibly safe 4% mark for quite a few unlucky retirement cohorts.

Let’s see when the models do better than the baseline. In the plot below I display the difference between models 2-4 (Model 2 = 100% Stocks, no mortgage, Model 3 = 100% Stocks, 30Y mortgage, Model 4 = 100% Stocks, 15Y mortgage) and the baseline SWR. Notice how most of the time, models 2-4 do better than the baseline (lines above the zero line). Substantially better, in fact, by about a full percentage point on average. So, on average you can withdraw $10,000 more when you leverage your 100% equity portfolio with a mortgage. Nice! Unfortunately, the outperformance comes at a high price. You underperform when it hurts the most, namely, when the Safe Withdrawal Rate is low: During the Great Depression, the late 1960s and around the dot-com bubble.

Below is the same chart for the other four Models. Models 5 and 6 (80/20 portfolio with a 30Y and 15Y mortgage, respectively) have qualitatively the same features as models 3 and 4: outperform substantially most of the time thanks to leverage, but do worse when it hurts the most, i.e., when the SWRs are low during the major market events. Models 7 and 8 have a completely different pattern. They would have helped slightly during the Great Depression and dot-com bubble when bonds offered great diversification benefits. But that’s not thanks to the mortgage. It’s entirely due to the higher bond share. For example, a 67/33 Stock/Bond portfolio without a mortgage would have handily outperformed Models 7 an 8. Also notice that in the 1960s, Models 7 and 8 would have underperformed the baseline because bond returns suffered so badly during the 1970s, due to the inflation surge.

And finally, here’s a summary table of the safe withdrawal rates in the 8 different models. Same story again: Model 1 offers the best failsafe withdrawal rate but the mean/median/max look very mediocre compared to the others. Likewise, the models with the highest mean and median (Models 3,4) have atrocious failsafe withdrawal rates in the low-2%!

### Results conditional on an elevated CAPE Ratio

The unconditional distribution of safe withdrawal rates is interesting but it obviously ignores the fact that in light of today’s elevated CAPE Ratio equity returns could be slightly below average going forward. Let’s look at the safe withdrawal amounts when targeting different failure probabilities conditional on the CAPE between 20 and 30, see table below. The way to read this table: For example Model 1 (80/20 portfolio, no mortgage), an initial withdrawal amount of $33,262 (subsequently adjusted for CPI) would have been the failsafe. With $34,791 you would have run out of money 5% of the time, with $44,658 you would have run out of money half the time, etc.

According to this table, no mortgage and an 80/20 portfolio would have done the best if targeting a failsafe withdrawal amount and all other failure probabilities up to 10%. If you want to maximize the withdrawal amount to target 25% and 50% failure rates (which seems way too risky for my taste), then the 100% equity portfolio with the mortgage become the most attractive. But Models 3 and 4 with the most leverage also have the worst failsafe withdrawal amounts.

The lesson from this exercise: If you are risk-averse and like to hedge out the tail risk it’s best to have no mortgage and a moderate bond allocation. If you are a risk-taker (degenerate gambler?) then you might as well go all-in: Have a mortgage and 100% equities in the portfolio as well. Having both a mortgage and a bond portfolio doesn’t make any sense. And there is a reason for it: the bond return is likely inferior to the mortgage yield. This is beautifully consistent with an old vintage post from last year. If you want to use the mortgage as leverage to juice up your equity returns, that’s fine. It’s a matter of risk tolerance. But make sure you don’t use the mortgage to buy low-yielding bonds; leverage only works when your asset returns more than what you pay for your liabilities!!!

### Exceptions to the no-mortgage recommendation

Our case is special and probably not applicable to everybody in the FIRE crowd. I can think of at least a few scenarios where folks might want to keep their mortgage. For example, you might have a hard time paying down the mortgage all at once because you’d realize too much in capital gains. This could put you into the 15% tax bracket for capital gains and that additional tax burden would negate the mortgage paydown idea.

Another scenario: some early retirees simply don’t have enough in after-tax savings. This is a frequent issue in some of the case studies I have seen where people have saved a huge pile in tax-deferred accounts but have only very little in after-tax accounts. If your small taxable accounts barely last until age 59.5 (to avoid tapping tax-deferred accounts before the cutoff age) you probably can’t afford to pay off the mortgage.

Finally, I can see how at some point down the road interest rates could be much higher than today. If you retire in 5 years and still have 20 years left on your 3.25% fixed rate mortgage but bond interest rates are now 3.5 or 4%, then by all means, hold on to that mortgage. Now the mortgage vs. bond leverage works beautifully!

### Conclusion

The decision whether or not to keep a mortgage in retirement is not trivial. The comparison “expected equity return > mortgage rate” is just too simplistic. The median/average retiree will clearly benefit from the leverage but also remember that the median retiree never runs out of money either. For us, not having a mortgage might hurt us in the long-run but only in the scenarios where we’d become fabulously rich anyway. Who cares if we end up with $6 million instead of $7 million when we’re in our 80s? We are willing to pay that cost for the hedge against Sequence of Return Risk, i.e., the very unpleasant tail risk of running out of money after 30 or 40 years due to poor portfolio returns in the first few years after retirement.

In my case i have pension income that more than covers the mortgage so I am not inclined to pay off a low rate mortgage early

That certainly helps. But not having a mortgage would also help with Sequence Risk, so some people would pay off the mortgage even in that situation.

This article is fascinating to me and I wish I could hire you to analyze our financial situation. The previous article on the reverse equity glidepath has been a guiding light for us, but this article threw all of that into disarray. I’m curious if you have comments on a very high-level summary and/or can recommend tools to do a better analysis?

Current investments: ~$2.1M, goal $2.3M

AA: 80/20, goal to be 60/40 at FIRE

Mortgage: ~$800k

We have enough in taxable investments to wipe out the mortgage but that would incur some capital gains taxes as well as leave us cash poor outside our retirement accounts. We intend to be FI in the next year or two, or at a minimum drop to part-time work for a little while to pad the stash.

I realize there are a ton of factors at play (MAGI for ACA subsidies, tax basis, AA, Roth vs trad vs taxable breakdown) so what advice do you have on how to analyze this whole complex situation?

Thanks!

I don’t offer for-pay advice (yet), but here’s my 2-cents:

It’s painful to see the large mortgage plus a 40% bond portion, which implies about a bond portfolio the same size: 0.4x$2.3m=$920k.

If there’s a way (say, through a large chunk of high cost basis stocks and/or bonds in taxable portfolio) I’d pay off the mortgage. How high is your interest rate? It would be painful to see a 4%+ mortgage rate when bond yields are so low.

Also, with a mortgage this large, how big is the house? Do you have enough resources to pay for property taxes, maintenance, etc. while in retirement?

Mortgage rate is 3.625%. We live in a HCOL area, so at 1100ft^2 for a family of 5, we are already on the inexpensive side for our area, as crazy as that may sound. We do have budgeted in for property taxes, insurance, and other expenses in retirement.

If it makes a difference, bonds are all in tax-advantaged accounts and the tax basis of the taxable account is fairly high (~10% is gains).

Well, 3.625% safe return… One could make the point that it’s wise to pay down the mortgage then, if you’re risk averse. Your (esteimated) $4,000 mandatory motnhly mortgage payment increases Sequence Risk .

But if you’re not that risk averse, probably keep everything as is and concentrate on Roth Conversions to fill up the lower tax brackets. first. Maybe in later years fill up the 0% capital gains tax bracket sell high-cost-basis equities in the taxbale account to pay off the mortgage…

If we paid off the mortgage then I see it would make sense to follow this article’s advice on asset allocation for a reverse equity glide path. If we keep the mortgage, what asset allocation would you follow in our shoes?

If we are going purely by gut/risk tolerance, I’d hate to wipe out such a big chunk of my taxable account. Then again, I may feel differently about that mortgage note once no longer working.

A third, intermediate option is to pay down some of the mortgage and have it recast. This is available to us if we pay in chunks of at least $50k.

With the mortgage you’d need some bonds to hedge the Sequence Risk.

I like the idea of paying down pieces of the mortgage and recasting the mortgage (i.e., keeping the same term but lowering the payments).

But I als see that it’s problematic to wipe out too much of the taxable account. It’s always best to keep at least a few years (5+) in the taxable account, certainly until you got a Roth Ladder going.

I finally found some time to do some more analysis using cFIREsim. I modeled everything from keeping the full mortgage to recasting the mortgage by paying off chunks in $200k increments, all the way to paying the entire thing off tomorrow. I used both a reverse equity glide path asset allocation and a fixed 75/25 allocation.

I found that my success rate is highest keeping the full mortgage amount using reverse equity glide path, and decreases somewhat linearly the lower the mortgage is. The same phenomenon is seen with a fixed asset allocation, though overall success rates are lower than with reverse equity glide path.

So what I am trying to understand is why I am getting the opposite conclusions than you did in your analysis? Is it the limitations of cFIREsim (US-centric data)? Is there something else I am missing here? I’m a little surprised at these results after reading everything you have done here.

I can only vouch for my own Google Sheet, so I can’t tell you for sure where cFIREsim differs. I can imagine that if you enter a nominal mortgage payment in cFIREsim at today’s rate of 4% then, sure, during the 1970s you would have done better with the mortgage due to the high inflation. But in today’s environment, your mortgage will be deflated only at 1.5-2% p.a.

That’s why I prefer the mortgage modelling as described in Part 21 of my series. Work exclusively with real returns and assume the mortgage payments shrink by 2% p.a. to account for today’s inflation. Again: if you apply historically high inflation rates (10%+ in the 1970s) it’s a no-brainer to keep the mortgage! This may explain the difference!

Disagree that the correct metric to measure the mortgage interest rate arbitrage against is only the bond component of the portfolio. Instead, you use the return of the total portfolio, not just the bond portion. So if your 50/50 equities/bonds portfolio averages a 5% return and your mortgage interest rate is 4%, you’re earning a plus 1% (over time, on average, of course–but then the mortgage is either 15 or 30 years, so that’s the correct time period to measure over). The mortgage doesn’t “know” that it’s only supposed to be used as leverage against the bond component of the portfolio. Nor does the portfolio “know” that only the bond portion is being leveraged. In fact, this error in ERN’s post is very common, but shows a fundamental misunderstanding of the basic theories of portfolio construction–i.e. the capital markets line. You construct your asset allocation stocks/bonds in accordance with your preferred risk level (Sharpe Ratio), ideally, the “tangency portfolio.” You then lever up or down (i.e. borrow to invest more in the portfolio at the preferred AA, or alternatively, hold cash). No one can borrow at the risk free rate, but if you can get a low enough interest rate, it can make a lot of sense. Remember: When you take out a mortgage (or do any other form of borrowing), you are levering the entire portfolio, not just the bond portion.

Disagree. Believe me, I do undestand portfolio construction quite a bit better than you. Actually, you are the one misunderstanding the issues here.

You seem to be under the false pretense that there’s a contractual constaint that you HAVE to keep the asset allocation at 50/50. But I don’t. I can pay off the mortgage and use the bond portfolio for that and I get a positive carry from that. Plain and simple.

Further, if you maintain your net asset allocation at the same level, and assuming you have a reasonably low mortgage interest rate, having a mortgage doesn’t increase Sequence of Returns Risk. ERN’s post is conflating tax issues (having to withdraw from an IRA to pay the mortgage for example) as well as neglecting to account for the fact that leveraging the portfolio with a mortgage, but insisting on buying more equities rather than bonds with the additional funds (due to the above misunderstanding about portfolio construction theory and the capital market line), means you’ve increased your equity risk level. It is the increased level of equity risk that creates the additional risk, which is not Sequence of Returns Risk. So let’s say you have a $1,000,000 portfolio with a 50/50 stock/bond allocation. You also have a $500,000 house with a $250,000 mortgage on it. Treating the mortgage as a negative bond (in actuality it’s more of a negative mortgage-backed security, which isn’t quite the same thing), your net AA is 500 stocks & 250 bonds, or 500/750 = 66.66666…%, rather than the 50% without the mortgage. Going into retirement, if you pay off the mortgage from your 500k in bonds, you end up with 500 stocks & 250 bonds, and no mortgage. But your AA is exactly the same: 66.66666…%. So you haven’t reduced your Sequence of Returns Risk at all. Your 66.6666% portfolio is subject to the exact same SRR as any other similarly risky portfolio. Now let’s say instead of paying off the mortgage–let’s say you have a 4% mortgage and your average expected return across your entire investment portfolio is 6%–not a very long reach–and you want to take advantage of that arbitrage, so you keep the mortgage into retirement. You don’t have to withdraw any additional funds from your IRA to make the monthly mortgage payments since you have an “extra” $250 k in fixed income (because you didn’t use it to pay off the mortgage early). If you didn’t have it in after tax accounts in the first place, you would have had to have withdrawn it from IRAs to pay off the mortgage early, anyway. The “extra” $250k is what you use to make the mortgage payments in retirement. The mortgage isn’t just leveraging that “extra” $250k–it’s leveraging your entire portfolio. That’s the conceptual error (or one of several) that ERN and many others seem to repeatedly make in this kind of analysis. Another mistake often made seems to be that when people have the choice between either making extra payments on the mortgage or buying more investments, they don’t seem to realize (as ERN doesn’t seem to realize) that you can’t simply use those additional funds to buy 100% equities without increasing your portfolio’s risk level. THAT’s what causes the increase in Sequence of Returns Risk. When making the choice between paying the mortgage down quicker with extra funds, or investing more in the portfolio, you have to use the extra funds to invest in your portfolio in stocks and bonds in the same proportions in order to maintain the same risk level. If you buy all stocks with the extra money you will increase your risk level. What is not “good” for most people to go into retirement with, is a 100% (or higher, if they retain a mortgage and have an all-equities portfolio) equities asset allocation. THAT’s what creates excessive SRR. If you have a relatively conservative portfolio going into retirement, let’s say 60/40 net of your mortgage, it’s perfectly fine to have a mortgage in retirement, and can be quite beneficial, if you have a good interest rate.

Look, you obviously misunderstand both my post and Sequence Risk in general.

I show with the simulations that Model 7+8 (again 80/20 portfolio if netted) DOES INCREASE Sequence Risk.

“Even a 40% stock allocation according to Vanguard returns an average of 7.8%/year so why would anyone not want to keep a 4% mortgage going into retirement in this scenario? ”

Because you still don’t understand Sequence Risk. The MEAN return may be higher, but Sequence Risk doesn’t care about the mean return. By definition.

Thanks for the insightful post. It’s a good reminder that in (early) retirement the goal isn’t so much maximization of returns but protecting against sequence of return risks. Running out of money is a much larger issue then ending up with too much money.

The one place where I think the model falls short is in the 20’s / 30’s. In other times, the 2% inflation assumption coupled with todays mortgage rate works well enough (since both the inflation and mortgage rate move together). But the deflation of the 20’s / 30’s would have made the situation a lot worse. Increasing your mortgage payment with 10% a year in real dollars would not be pretty.

Yes! Good point. Though I hope that we have a central bank today with enough resolve to not let double-digit deflation happen ever again. If push comes to shove they’ll drop money from helicopters (!) to create inflation. 🙂

There might be a mistake in #3 under section “Situation”. Shouldn’t that be $2000 (not $4000) vs. $1500? Still proves your point…just by a smaller margin.

Before:

Total spending: $5,000

Mortgage: $1,000

Discretionary: $4,000

After:

Total spending: $2,500 (-50%)

Mortgage: $1,000 (same)

Discretionary: $1,500 (-62.5%)

In Europe, you can get mortgages at flexible 12 month (or even 3 month) Eurobor + margin rate of 1% or less.

If your mortgaged value is just 10% of total portfolio, doesn’t the sequence risk get substantially lower while mean projection still keeps high?

Who knows, maybe that’s what’s in stock for us here soon, too.

Yeah, if I lived in Europe with mortgage rates like that and the mortgage principal is low enough relative to the net worth then, yes, I would certainly have a mortgage, too! 🙂

I do have another question though. How do I account for mortgage based apartments in my portfolio? Initially I did discount my bond weight by amount of mortgage and added my apartments into my “commodities & other hard assets” line, which contains all hard assets at their current realistic (less than 6 month sell time) sell value.

But I’m not sure if mortgage should just be as it’s own line with it’s own negative yield as my bond mix currently yields around 3.5% where as my mortgage yields just -0.75% (though I do get freebies from bank for the value of bond of 0.25% in addition, that can be used for insurance and banking fees)

Managing glide path on this isn’t as simple as just going from 60-100% in 10 years though, but it’s a nice exercise to do every few months.

Good question.

I’d keep the apartment separate. Calculate the net cash flow after mortgage and add that as a separate, supplemental cash flow. Keep the paper asset portfolio as is.

Any thoughts on doing a cash out refi after a stock market crash where the cape is similair to 2008/2009 lows would be a good idea.

Haha, that’s something on my mind as well. Might actually work because likely interest rates will be low. But you better hope there isn’t a banking crisis where bank get really tight with their cash. 🙂

It’s something I thought about too. On my to-do list!

Basically, you wait unti lthe market dropped enough, so the expected stock return is really high again and then get a loan. Hopefully for a really low rate because the Fed just lowered their interest rate.

Two caveats: You may not get the loan because banks crack down on lending standards. And this might backfire really badly in a Japanese-style long bear market where the market takes way too long to recover,

But generally, a good idea!

I’d love to see this analysis! I was also wondering how much sequence of returns risk could be mitigated if you used a securities-based line of credit (conservatively, of course, so you don’t run into margin issues)? What if you put the mortgage payments on the line of credit just in the years of a significant drop in the stock market and paid it back once things recover? At 1-2% interest, seems like it’d possibly increase your minimum safe withdrawal rate…

It’s on my radar! IB (Interactive Brokers) has a very low margin rate!

Indeed! Looking forward to it. Thank you for all you do for our community, we appreciate it!

Greetings ERN! While I’m not new to pursuing FIRE, I am fairly new to your website and therefore wanted to give you a hearty thank you! I’ve had ERN bookmarked for months now, but I’m finally getting around to reading through it. Wow. You are amazing and are providing such a kind service, and I cannot thank you enough.

This particular post about mortgages saddens me because as a 43yo military officer who has recently moved 5 times in the past 7 years (on 3 continents, with a wife and 5 kids!), we have no home equity and are currently renting in expensive Northern Virginia. I owned two homes during my 17-year military career and lost money on both when I sold (yes, I realize I could have chosen to be a landlord instead), so I became soured on having any more mortgages while in the military. I’ll retire in 5 years (with no plan to work again) with roughly a $71K/year pension (with COLA increases) and about $1.5-1.7M in an 80/20 stock/bond Boglehead-style Three-Fund Portfolio.

When we eventually choose our permanent retirement locale (Colorado or Montana maybe?), we’ll therefore have to start from scratch on our home–with no transferred equity. I’ve been wondering if we should simply choose to become permanent renters, versus putting down a roughly $100K cash down payment on a 15yo fixed-rate mortgage for a ~$500K home. Either we rent, or we simply have no choice but to begin a mortgage when I retire.

JL Collins has discussed the many benefits of renting, vs. buying. Link: https://jlcollinsnh.com/2013/05/29/why-your-house-is-a-terrible-investment/

I’m wondering if you have mathematically explored this and have an opinion one way or the other. It would be very helpful to get your perspective.

Thanks again!

ERN, I should have added that my pension does begin immediately upon retirement.

Renting is the right decision if you’re moving so frequently.

I’ve written about the benefits of home-ownership frequently. If you are confident that you’re staying in one place for a long enough time it’s best to own from a financial point of view.

Also, see this post:

https://earlyretirementnow.com/2019/10/16/how-to-lie-with-personal-finance-part-2-homeownership/

JLCollins is spreading (at least) lies #1 (confusing price returns and total returns) and #3 (ignoring pass-through cost for renters). So, I’d be cautious about following his advice.

Ern,

Carl at 1500 Days just posted an article where he referenced this article, and the question he posed was:

How do the results change if the starting conditions are $X, no mortgage vs. $X+Y, with mortgage.

His premise was that if you had a mortgage you would be likely to have saved more in investment accounts and therefore the starting dollar amount for the simulation would higher ($X+Y) vs. if you had used that money to pay off the mortgage.

Thanks,

Aubrey

The really easy way to think about it is lets say you have $1million that covers your non-mortgage expenses and have a $300k house. If you took out a conventional mortgage on 80% equity or $240k, at 3.5% for 30 years. Your payment would be $1111.48/month or $13,337.76/ year, so if you kept that $240k in investments, you’d have to withdraw from those investments at 5.6%/year which Big Ern has shown has a fairly high failure rate.

Thanks!

Actually, the math is slightly more complicated. It’s 5.6% p.a. initially, but then inflation will slowly erode this. So, the average payment over time is lower than 5.6%. But still high enough to create a headache from a Sequence Risk perspective. Especially because the payments are front-loaded, i.e., higher initially and lower eventually.

Good point, in addition the home equity in investments would create a tax drag. Even if your LTCG and dividends rate is 0 %, it would take up Roth conversion space and could limit your ability to qualify for some programs that are based on agi such as ACA or college scholarships.

Out of curiosity, I was able to withdraw strategy to work for someone with a 3.375% or less 30 year loan if they ignored the tax drag. The SWR uninflation adjusted would be 5.3% but using 50% bonds, 40% stocks, 10% gold but someone would have to refinance to a 30 year right before retiring as a 29 year loan wouldn’t work.

Seems like a lot of work and stress for not much extra gain and it would be tough to even get a 30 year loan at that low of rate with no closing costs. I think if you’re someone who really tries to optimize, just use 0% credit card balance no fee transfers and put them in high yield savings accounts or CDs and sleep easier at night than trying to carry a mortgage.

Carl must have misread my assumptions. These are exactly my assumptions. $1,000,000 portfolio and no mortgage vs. $1,200,000 portfolio and $200,000 mortgage.

Thank you so much for writing this article! I’ve been thinking about this topic lately, and this really helped solidify my thinking. How does the mortgage rate factor in here? I’m guessing if the rate is below your SWR you’d always want a mortgage, and the higher up it goes, the less attractive it becomes.

No. There is no clear cutoff. If your REALIZED portfolio return ends up above your mortgage rate you’re better off. And vice versa. But you don’t know your realized return ahead of time.

Although If you are on non-fixed rate, usually when market goes down, so does interest rates, so it helps you in this sense. In Europe, we used to be able to get 3 month Euribor fixed loans, but these days 12 month rate is standard.

The marginal + floating rates will never exceed fixed rates unless banks make serious pricing mistakes on fixed prime.

well, there’s no clear cutoff in the sense that it all just depends on where real returns end up compared to the mortgage rate. But what I meant to ask is what would be the breakpoints on interest rate where the decision might look different? For instance, you mentioned in an above comment that if you you had an interest rate of 1% you would keep a mortgage. If at 1% you’d keep the mortgage, and at 4% you wouldn’t, that indicates that there must be some number between the two where you’d switch.

Maybe some point, interest rates are low enough that buying out your mortgage hurts your longevity risk more than it helps your sequence risk.

Yeah, gotcha.

I would look at the cutoff 2 ways: mortgage vs. bonds and mortgage vs. stocks.

1: if the after-tax mortgage rate is lower than the after-tax bond yield, then keep the mortgage. Otherwise, use the bond portfolio to pay down the mortgage. Also make sure you compare apples2apples: yeah, your junk bond fund might have a higher yield but also more risk!

2: It’s more tricky with equities: a lot of folks compare their 3% mortgage with a 10+% equity expected return. Yeah, with a 7% spread I’d keep the mortgage. But keep in mind that with the CAPE at 30+ you’ll expect maybe only 3% real, 5% nominal returns over the next 10 years for stocks. With a 2.75% mortgage you have a spread of only 2.25%. Not worth the risk.

Quick rule of thumb: you’ll look for a 4-5% spread.

It might be worth noting that when interest rates go back up, house prices will inevitably fall. Those who opt for a 30yr mortgage with 20% down could easily find themselves underwater on their mortgage. Not what I would consider financial independence.

Well, house prices didn’t tank in 2018 when the 10y yield hit 3.2%. But higher rates will definitely an impediment to future asset price momentum. Completely agree.

In your elevated CAPE analysis why did you restrict it to “CAPE between 20 and 30”? Why not “CAPE >= 20”? Does “CAPE >=20”, which includes CAPE > 30, change the results?

I’ve evolved over the years.

Probably >20 is the better slice. For example, some of the worst cohorts in the 1960s only had CAPE in the 20s. Never got even close to 30 that time.

Can someone help me understand how having a mortgage is like having a short bond position?

It’s not identical to a short bond but it’s only “like a short bond”.

That’s because a mortgage has amortization (a corporate bond doesn’t) and a mortgage can be prepaid, while not all bonds have that option.

Think about if you have a $100k loan at 2% interest and bonds/savings at 2% interest. The interest you pay and collect are roughly cancel each other out. The bondholder is the lender whereas the mortgage holder is the borrower. You might even have a little slice of your own mortgage if you hold a bond fund that has mortgage backed securities in it. A bond can increase/decrease in present value as interest rates change, but if you hold a bond to maturity, you’ll receive the given interest rate when you bought it, absent any defaults.

I found this Your Mortgage and Your Bonds https://www.personalcapital.com/blog/investing-markets/your-mortgage-and-your-bonds/ article really helpful.

Here’s my probably too simplistic explanation: a buying a bond is essentially lending money and gaining the interest rate while taking out a mortgage is borrowing money and paying the interest rate. So taking out a mortgage is the opposite of buying a bond. Another way of saying “the opposite of buying a bond” would be “taking a short bond position”. At the risk of telling you thing you already know, I’m using the word short as described at https://www.investor.gov/introduction-investing/investing-basics/how-stock-markets-work/stock-purchases-and-sales-long-and

I’m sure this leaves out a bunch of important details, but I think that is the general idea.

Yeah, good reference! 🙂

Except if you are shorting a bond and interest rate raises, you make profit because value of the bond will go down.

Disagree. Your mortgage also became less of a burden because you’re discounting your future payments with a higher rate. True, your mortgage balance is still the same, but your true future liabilities went down.

ERN, it seems to me that you are not *always* correct with this explanation, even though it’s usually right.

If interest rates go up solely because of (and at the rate of) changes in in inflation, then you’re correct. But if interest rates go up for some other reason – say, to pick a random(!) possibility, because the fed stops buying bonds at a prodigious rate – then the discount rate of your future payments isn’t really the same, is it?

Or am I misunderstanding this answer, and you’re agreeing with me just in different words?

Either way, seems to me the option value of a mortgage is pretty high in the current environment, if you believe that Fed purchases of long bonds cannot continue forever. Yet your model doesn’t have any way to express / account for this option value.

The context of the question: Is a mortgage the same as a short bond?

It’s not. If interest rates go down you lose money with a short Treasury Future. But you can refinance the mortgage (=option value). In that sense (and also in a few other dimensions), a mortgage is not the same as a short bond.

But: Right now the option value of the mortgage seems low. You get the option value if the interest rate goes down further. In the current environment I see more room for higher rates: inflation rates are going to be high. I wouldn’t be surprised if the FOMC raises the policy rate sooner/faster than people expect.

But don’t get me wrong. If we have another recession soon and the Fed then tries to push the longer-term bond rates toward Japanese/German/Swiss levels, there would be room for 10-year bond and 30-year mortgage rates to go even lower than the pandemic lows.

Thanks for the prompt responses! And thanks, @HubCity, for breaking it down in simpler terms. I’ve never shorted something, so I didn’t have a feel for that, and I needed some time for it to conceptually sink in.

While I’m not capable of doing a model of my own, I’d like to suggest a few changes to your model, each of which I think is as or more reasonable.

First let me say that I wholeheartedly agree that if you have a mortgage and buy long bonds of similar duration, that doesn’t make any sense.

My proposed changes:

1) change timeframe to 1926 on, rather than 1871 (personally, I think you should change to ~1946 on, after the Fed realized it would never again have a contractionary money supply policy – using “helicopter money” if necessary)

2) change the model to use no bonds, but instead use 60% stocks, 5% cash, 35% gold (the numbers using no additional cash flows I found delivered the highest SWRs since 1950). If you wanted to throw in a couple variants like 70-15-15 for people who are “afraid” of high gold allocations, the more the better. But the key is it must be little to no long bonds

3) in addition to 2.75% 30 year fixed mortgages now available, I’ve seen a 2.5% 10 year interest only mortgage. I don’t know how much harder it would be to model that (you’d have to make assumptions about interest rates 10 years out, or simply “end” the simulation in that case at 10 years perhaps, and from there do similar modeling to what you did when doing that “do we always have to worry about SoRR” post.

4) you modeled 2% inflation. Seems to me in the current macro environment, modeling 3% first 10 years, 2% thereafter is at *least* as reasonable an assumption

Those changes are specific and seem easy to model. Harder to articulate is how to model the option value of the mortgage. Perhaps it’s not important to capture the benefit (of lower cost when rates go down), but for the SoR risk it seems to me the mortgage option has a big benefit in all the most likely cases of inflation and interest rates rising other than another Great Depression.

What do you say – will you accept the challenge?

These are all model assumptions that people can implement and study themselves. I posted the Google Sheet so folks can “hack” the sheet and come up with their own calculations, so I don’t have chase after every request people throw at me. 🙂

Hello ERN, my question is based on a hypothetical scenario. Assume $2M portfolio with an 80/20 allocation and no home equity. If a person retires, moves to their desired post-retirement location, and wants to purchase a home for $400K, I’ve learned from your articles that it would almost always be mathematically smarter to purchase the home outright–let’s assume via selling the $400K bonds–rather than having a mortgage and maintaining the bond allocation. But it seems to me this would immediately push the person into the Model 2 scenario above (100/0, no mortgage), which seems bad, right? If an unfortunate SORR hits when they just began their retirement, they’d have to live off their stocks, with no bonds to sell instead. So although I understand the math regarding not having both bonds and a mortgage, I’m not sure how the better solution (using bonds to pay off or eliminate a mortgage) actually helps prevent SORR.

As an aside, if someone were to do exactly what I’m describing above (buy a house outright via decreasing or eliminating their bond allocation to pay for the home), would the person then “re-establish” the asset allocation by simply rebalancing back to 80/20 with the previously 100% stock allocation that remained after the purchase of the home?

Thank you kindly for the help.

Well, the idea would be to have the paid-off house plus a 75/25 portfolio, not a 100/0 portfolio. Not sure why this would “push” anyone into a 100/0 portfolio. You’d simply sell both stocks and bonds to pay for the house.

In my personal case, I sold a condo in SF and had enough money to buy a house in WA with cash and put more money into my investments.

Great read! If I’m reading your scenarios for keeping a mortgage correctly, it sounds like having a large mortgage (1M+) and cannot pay it off before retirement with cash flow means you shouldn’t even try to pay it down early? Or is there a benefit to throwing extra cash at the mortgage even though it won’t be paid off before retirement, assuming I have my bond-tent setup?

Depends on the situation. The biggest burden is the tax trap, i.e. progressive capital gains taxes if you wanted to pay it off all in one year.

But I wouldn’t have a very relaxed retirement with a multi-million $ stock portfolio and a $1m+ mortgage! 🙂

Got it. My question was more towards paying down the mortgage over time, either through cashflow or selling until capital gains taxes get too high each year. It seems like that would be the worst of both worlds because I’d be putting extra money into the house while the mortgage payments would stay the same in the first 5-10 years of retirement (assuming it will take me years to pay it off this way), and simultaneously not increasing (or even decreasing) my portfolio. Although, I suppose paying down a portion of the mortgage early would allow me to recast the mortgage to lower the payments/SORR at the cost of paying more in interest. I guess I’ll try running the numbers!

> But I wouldn’t have a very relaxed retirement with a multi-million $ stock portfolio and a $1m+ mortgage! 🙂

That’s not quite my situation yet! I currently have a 500k mortgage, but getting married + having kids means moving to a larger home, and those don’t come cheap in SF! Maybe we just can’t afford the bay area.

Recasting the mortgage would be one option.

Another option: move to Camas, WA in early retirement like we did,. And enjoy lower home prices and a zero income tax! 😉

In a situation that resonates with this thread and wondering how to plan this all out. How can people with a ~$1m mortgage and $1m+ in pre-tax retirement accounts pay off the mortgage in the most tax efficient way possible while also maximizing ACA subsidies if they are lucky enough to be able to retire early?

Just think of the loss of ACA subsidies as another roughly 10-20% bracket on top of your retirement tax brackets and plan accordingly. If you’re in the 22% or 24% tax bracket now, it might make sense to mix in some more Roth funds. You’re going to need some post tax buckets anyway to fund your first 5 years of retirement anyway while you wait for your Roth conversions to season before you can pull them out early.

Some people who are right at the ACA cliff, find that its best to alternate pulling 1.5 years of expenses out then 0.5 years so they get big ACA subsidies every other year.

That’s a good one, too: Due to the non-convexity of the ACA cliff, it’s best to alternate 1.5/0.5 or maybe even 2.0/0.0.

That’s one of the examples where you might want to keep the mortgage. Otherwise you generate way too much taxable and ACA-relevant income.

Interesting reading this now that bond rates are much higher than the existing mortgages many people (including myself) have.

If you’re getting a mortgage today, you’ll pay 6% and your bond portfolio yields 3.5% for Treasuries.

If you refinanced your mortgage a long time ago and now have a 2.875%, it’s a different story…

That’s me! 2.75%, I guess I shouldn’t pay it off?

I also have the 2.75%. Somewhat increasing bond allocation at these levels as we get close to retirement.

Nice!

Nice timing! You’re my hero!

While I think ERN’s advice for not keeping a mortgage in retirement is best for most situations, in your case, I’d dump that money in treasuries or CD’s that are now yielding almost 4% and use that to gradually pay off the mortgage until its gone or rates go back under 3%.

Agree. Conditional on having the 2.75% mortgage, it might not be a bad idea to plow some of the additional money into bonds now that they yield ~4%. Positive carry!

I’ve been racking my brain on this one…Given capital gains rates, does it actually make more sense to aggressively pay down the mortgage if retiring early is the goal? I would be in a spot to use taxable funds, but my mortgage while 3% is going to be around $290k on my current target date.

The main reason to pay down the mortgage early is to avoid sequence of returns risk IF investing the money into other assets down not make sense from a risk/return perspective. If CAPE is high, that means future equity returns will be lower. But bond return rates are basically guaranteed (if you buy actual bonds). This post argues that given the current rates (4-5%+) and your 3% mortgage, it probably DOES make sense to put the money in bonds instead. ERN writes towards the end:

> Finally, I can see how at some point down the road interest rates could be much higher than today. If you retire in 5 years and still have 20 years left on your 3.25% fixed rate mortgage but bond interest rates are now 3.5 or 4%, then by all means, hold on to that mortgage. Now the mortgage vs. bond leverage works beautifully!

Of course, you need to calculate the spread post-taxes for your particular situation. If you itemize your mortgage interest, you need to take the benefit over the standard deduction into account. You also need to take taxes out of your bonds gains.

I’m looking at a 7-8 year retirement target, which to me adds a caveat to the quote you called out. Given how gridlocked housing is and monetary policy in general, I would be shocked if rates stayed here beyond a couple years. While I could lock in the 30 year treasury rate in retirement vehicles, making that a relevant amount seems unwise.

Happy if my assumption is off base, but I am assuming that would mean this has to be taxable to make payoff an option when rates switch. Meaning treasuries would give a .005-.008 spread depending on tax bracket. The main upside of the bond approach would be if job loss happened, I didn’t wind up with an almost paid off house and create an additional taxable event with selling stocks. I suppose liquidity wins, but definitely food for thought, even being SINK.

Very good response. Thanks for weighing in!

If you need to liquidate highly-appreciated assets you may have to hold on to the mortgage longer. And if you have a 3% mortgage you’d keep that either way for now.