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 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. 🙂
- 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.
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!
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.