He says that he maintains as much housing debt as possible, in order to take advantage of the mortgage interest deduction.
My advice to him is to sell his stock portfolio, pay off his housing debt, and take long positions in stock index futures.*
*In practice, the prospect of incurring capital gains taxes might make this a bad move.
Here is my thinking.
1. If you maintain housing debt that you could pay off, you have to put the money to work somehow. The question is whether you can earn more on your money than the after-tax interest rate. If you invest in risk-free securities, the answer is obviously “no.” Borrowing at 3 percent to invest in a money-market fund is a losing proposition, tax deduction or no tax deduction.
2. There might be some bond that you can buy that earns more than the after-tax mortgage interest rate, but that bond is going to have some risk attached to it. And you will have to pay taxes on the interest from that bond.
3. That leaves stocks. If you maintain housing debt in order to own stocks, then you are saying that you are happy to have a leveraged position in stocks, because you think that the expected return on stocks is higher than your borrowing rate. In Pikettyian terms, you believe that g is greater than r.
Fine. But if that is true, then I am pretty sure that the most efficient way to take your position would be by holding a position in stock index futures, rather than by taking out a mortgage loan to invest in stocks.
If you don’t like paying taxes, I understand that. As much as I disparage non-profits, I give large amounts to non-profits because I prefer that to paying taxes. But from a purely financial perspective, I think that maintaining mortgage debt that you could afford to pay off strikes me as a losing proposition. You unnecessarily enrich the mortgage lender at your expense.
Would this advice still hold if his stock portfolio is in tax-advantaged and often illiquid accounts? Suppose a hypothetical 36 year old named Roy (okay, maybe that’s hyperthetical?) has a family whose only stocks/mutual funds/index funds are in a 403b, a Roth IRA, a traditional IRA, and a 529; which if any of these should be sold to pay off mortgage debt faster?
It would still apply, because the mortgage debt should be viewed as a bond with a negative interest rate. It’s still not better than you can get with safe investments tax-free.
Everything in this post is pretty obvious, except this point:
“…I am pretty sure that the most efficient way to take your position would be by holding a position in stock index futures, rather than by taking out a mortgage loan to invest in stocks.”
Care to explain your reasoning here?
A mortgage loan costs something. Your after-tax cost is less than the pre-tax cost, but it is still a cost. With your futures position, at most you have to put up margin, but that is not an expense.
What’s missing from this assessment is liquidity risk (i.e. the risk of a margin call), if i buy $100k in notional equity index futures and the position moves against me i will have to post additional margin, if i buy cash equities with the proceeds of a home mortgage/line of credit, i won’t face a margin call during the the time of my loan…there is some value to this…
If you lose your job and the best job that you can find is far away from your current one, or you need to move for any other reason– that’s a margin call. The risk is nonzero.
Yes you can end up being a landlord, which is what many other people did. Or you can default on the loan. But at the first level of abstraction, without considering details, needing to move suddenly is a margin call.
I generally agree. I’m close to pulling the trigger to pay off the last 10 years or so of our 15-year mortgage which is at 2.75. Seems kind of crazy to want to get rid of debt with interest that low, but I can’t match it risk-free anywhere else.
It’s hard to resist paying it off, and it’s equally hard to explain why.
Financial advisors generally say you should take your time paying down your mortgage, at least if you are a decade or more away from retirement, because it’s very easy and fairly reliable to invest it in the stock market. This is especially true if you are talking about a decision between a tax-deferred retirement account versus paying down your mortgage.
However, nobody makes the logical leap of saying you should try and keep your mortgage debt as high as possible, even taking out equity loans if you have foolishly paid off the house in the past.
I would hazard that there’s something more reliable about a paid-off property than it seems like on the surface. There’s something really great about that lein going away and about having “your own house” in the most literal sense. Saying it’s psyschological is an incomplete response; *why* do people feel so much safer with the mortgage being paid off?
“However, nobody makes the logical leap of saying you should try and keep your mortgage debt as high as possible, even taking out equity loans if you have foolishly paid off the house in the past.”
As in other things, “nobody” can mean “well, nobody except for Bryan Caplan and maybe Robin Hanson. ;)”
There’s *some* value in liquidity, and then some people want to keep the right to walk away from the house, I suppose.
Mr. Caplan must believe that open borders will increase the value of his housing holdings.
Depending on what state you live in there is also the option of “sending back the keys” without recourse in the event of a financial calamity. I could also envision some form of broad mortgage forgiveness in the event of a deep, lasting recession. These options may have a lot of value.
No, it isn’t equivalent to a leveraged position in stocks. A mortgage is a borrowing against future income, not future stock gains. It converts a portion of a quasi stable income flow into an equity position which only makes sense with that income. Without that income, borrowing no longer makes sense.
A mortgage is *also* in many cases a borrowing against future home appreciation, or at least future non-depreciation.
As a retiree I have a considerable amount of fixed income that is not inflation adjusted. My 3% mortgage matches fixed income with fixed expenditures. For that matter the remainder of my assets are tied up in tax-sheltered accounts.
I realize that I am incurring costs to get the tax benefits and the inflation hedge. If my assets were in the millions and not in the hundreds of thousands, I might have more options.
How is it an inflation hedge, either, if your fixed income is not inflation adjusted? Paying off the mortgage now would decrease your fixed income; if you expect your fixed income to fail to grow with inflation, there is no loss to paying it off now. The only thing that matters is whether your fixed income assets yield more than the mortgage interest rate, after adjusting for relevant tax treatment. The tax-sheltering of the retirement assets and deduction of the mortgage interest only matter for adjusting the yield (together with any restrictions on withdrawals to pay off the mortgage.)
There is a non-finacial reason to keep a property mortgaged. That is to inhibit government confiscation through civil forfeiture. Granted, this may be a better strategy for commercial rather than residential property. However, property owned free and clear, that can be confiscated for substantial profit for law enforcement is alluring to government. A mortgage removes the cash for your use, while reducing the profit motive for law enforcement. This assumes you are innocent owners of the property and not engaged in illegal activity.
https://www.ij.org/massachusetts-civil-forfeiture
A large pot of cash sitting on the side of the road is often to enticing. Best to not leave it laying around.
Oh and I do realize this is a cost, not a benefit, that arises due to increasingly insecure property rights in American society.
Just wondering out loud here, but what would be the impact if an eminent domain “takings” tried to pay a market price that was less than the mortgage on the property, thus rendering the “homeowner” homeless?
The problem that I see with Bryan’s thinking is that bank loan require overhead and the bank does not know what a great risk you are. You are close to zero risk so without overhead you should get a rate close to the t-bill rate but because of risk and overhead you do not. Also if you pay off your mortgage you can opt out of insurance or at least reduce it so that you can save the insurance company’s overhead.
My broker offers a 1.64% margin lending rate. That’s got to be lower than Caplan’s mortgage interest less mortgage deduction. It doesn’t make a whole lot of sense to compare mortgage rates and stock returns. If you want a levered investment in stocks, just take out a simple as pie margin loan. The problem with futures is that you are buying a call *and selling a put.* Don’t sell puts on leverage, the risk of ruin is too great. The goal is maximizing geometric returns, not average.
I think you are overlooking the non-monetary income of owning a house (I think it is sometimes called imputed rent). A paid-off house (and other such assets) is a good way to receive a form of tax-free income.
If you think about it that way, the mortgage interest deduction looks like a wash. So I think it is mostly a good deal either way.
What if the stock market goes down? What date is on those futures?
Your scenario makes one key assumption that doesn’t apply in my case. I don’t have a portfolio I can liquidate that would satisfy my mortgage. But I can choose to build one over 20 years, or I can choose to prepay my 3.5% mortgage. I choose not to prepay. Here’s why I’m with Bryan. (Also, I have no idea where to by an index futures contract longer than 12 months.)
1. The average return from stocks (the Dow) in any 20 year period is 10% and the minimum is 5%, except for one outlier year: 1928, which was something like 2%. I like those odds against a fixed 3.5% return.
2. Inflation, while low at the moment, may increase over the next 20-30 years. This might affect stock values a lot or a little; I certainly can’t predict. But it definitely will reduce the real cost of my mortgage payments. The kind of value stocks I like that already pay dividends on the order of 3.5% should hold up pretty well under inflation.
3. It’s possible today to yield more than 3% just in dividends in a diversified low-cost fund. The plan nearly pays for itself as you go, even if stocks go down.
4. I’d rather have a mortgage and a large liquid portfolio in 20 years, than no mortgage and all my equity in my house.
The mortgage interest deduction only makes this plan slightly more attractive. I’d do it even without the deduction. The fact that qualified dividends and long-term gains are taxed at reduced rates also helps a little.
In short, I think recent historically low interest rates have created this opportunity, and I don’t think it’s excessively risky to take advantage of it. If I had a 5% mortgage I wouldn’t be doing this in today’s market.
Having mortgage debt can be a disciplining device as most people have financial self-control problems; not unlike firm leverage as a disciplining device for spendthrift CEOs.