Safe withdrawal rate when you have a mortgage?

[jason]

There seems to be somewhat of a consensus that 4% is the maximum SWR for the PP.  I have a mortgage, so how does that work into the SWR calculation?  If I was renting, I would think my rent payments would count 100% towards the withdrawal rate.  But since I am building equity in my home every time I make a mortgage payment, how should I account for that?  Should I count the interest portion of my mortgage payments, along with taxes and insurance, as pure expenses, while not counting principal paydown as an expense?  Principal paydown seems to be like moving assets from your left pocket (cash) to your right pocket (equity in real estate).  How are others handling this in regards to SWR?
Thanks!
Jason

[Pointedstick]

Home equity is irrelevant to a retirement calculation because you can't access the value that the home equity represents without selling your house and upending your life. Mortgage payments should be considered expenses, which will therefore require you to sock away $25 per dollar of your mortgage payment (4% SWR = every dollar of annual spending requires $25 in investments) if you retire before the mortgage is finished.

Personally I would pay off the mortgage before retiring, and endeavor to pay it off ASAP regardless of the situation, especially if it is large and you have a high income.

[dragoncar]

I personally don't count the principal as expense because to me it help model the fact that:

1) eventually the Mortgage goes away-- you do not pay interest in perpetuity.
2) the mortgage does not increase with inflation.  The typical 4% rule assumes you increase spending by CPI every year, but your mortgage interest actually goes down over time

It's not perfect, but I have done exact models using firecalc and it's an OK approximation.  I do encourage you to do the same-- you have to model your mortgage as a fixed annual expense that disappears in X years.  The biggest issue with the back testers is they don't work well for gold so you might want to try the CARG+volatility approach for the PP

This also assumes fixed rate mortgage

[KevinW]

My retirement plan is to both own a home outright, and also to have a PP that is large enough to comfortably cover all remaining living expenses. I view these as separate projects, and am trying to time things so that they are both complete at about the same time. So my mortgage situation and portfolio situation are not intertwined at all.

[Fred]

I'm going to be retiring with a mortgage too. After re-financing, the payment is less than I could rent for unless I live in a dump so I don't intend to pay it off unless I have some really great years of ROI with money to spare.

I'm anywhere from 0 days to about 23 months away from retiring, depending, but I don't even think about SWR any more. I plug the figures into my own and Fidelity's retirement planner and if it shows that my wife will have the same amount of money we have now when she dies (she's 17 years younger than me), then I figure I'm good to go. (And BTW I'm good to go according to the figures and thus the 0 days idea).

Over on the Bogleheads Forum Taylor Lattimore made a post about SWR and he said when he retired back in the late 70's, I believe, they never even heard of SWR. He said if your investments have a good year then you spend a little more and if they have a bad year you spend a little less and just play it by ear as you go along. Made sense to me.

[Libertarian666]

I'm going to be retiring with a mortgage too. After re-financing, the payment is less than I could rent for unless I live in a dump so I don't intend to pay it off unless I have some really great years of ROI with money to spare.

I'm anywhere from 0 days to about 23 months away from retiring, depending, but I don't even think about SWR any more. I plug the figures into my own and Fidelity's retirement planner and if it shows that my wife will have the same amount of money we have now when she dies (she's 17 years younger than me), then I figure I'm good to go. (And BTW I'm good to go according to the figures and thus the 0 days idea).

Over on the Bogleheads Forum Taylor Lattimore made a post about SWR and he said when he retired back in the late 70's, I believe, they never even heard of SWR. He said if your investments have a good year then you spend a little more and if they have a bad year you spend a little less and just play it by ear as you go along. Made sense to me.

Right. The notion that people will spend a fixed % of their original portfolio value, adjusted for inflation, no matter what happens in the markets, is ridiculous. Humans don't behave that way.

[Tyler]

I'll leave this here for conversation purposes:
[img width=500]http://i66.tinypic.com/30xczzr.jpg[/img]

Safe withdrawal rates differ based on your timeframe and also your asset allocation.  The PP supported a 5% safe withdrawal rate for a long-term retiree since 1972, and at 4% it still maintained its inflation-adjusted principal at the end of the single worst retirement period over that timeframe.  Even if you discount those numbers a bit just to be safe, I agree that someone planning on a 4% withdrawal rate is in good shape.  Looking at the numbers, an older retiree with a shorter time horizon or a smart and flexible person who rationally adjusts their burn rate when necessary might even be just fine a little higher than that on average.

+1 to everything Pointedstick said.  Your house should not count as an investment asset for SWR purposes, and your full payment should count as an expense.  It's true that it will eventually disappear, which does complicate things a little.  You just have to work it out to see what you're comfortable with.

EDIT: The following paragraph can help put things into perspective, but it is also overly conservative and in retrospect may not be the best example.  See my later post below.
One thing that convinced me to pay off my mortgage at retirement was that I calculated how much of my investments were really just working to pay the safe withdrawal rate for my mortgage payment.  If your mortgage is $2k a month (ignore property taxes, as they'll still be there even after it's paid off), then at a 4% SWR it requires $600k [(2*12)/0.04] to support that for 30 years (you can use the chart above to alter that for shorter periods).  I compared that number to the value of the house and decided to just pay it off with a portion of that amount and let the rest of the money work for other things. 

Even beyond that, my personal philosophy is that when you already have more than enough money to never work again, you can afford to stop optimizing for every dime of possible leveraged returns.  As Bill Bernstein says, "when you've won the game, stop playing!"   

Of course, YMMV -- some people really like having a mortgage and have perfectly good reasoning behind it.  Different people have different approaches to this, for sure.

[Libertarian666]

I'll leave this here for conversation purposes:
[img width=500]http://i66.tinypic.com/30xczzr.jpg[/img]

Safe withdrawal rates differ based on your timeframe and also your asset allocation.  The PP supported a 5% safe withdrawal rate for a long-term retiree since 1972, and at 4% it still maintained its inflation-adjusted principal at the end of the single worst retirement period over that timeframe.  Even if you discount those numbers a bit just to be safe, I agree that someone planning on a 4% withdrawal rate is in good shape.  Looking at the numbers, an older retiree with a shorter time horizon or a smart and flexible person who rationally adjusts their burn rate when necessary might even be just fine a little higher than that on average.

+1 to everything Pointedstick said.  Your house should not count as an investment asset for SWR purposes, and your full payment should count as an expense.  It's true that it will eventually disappear, which does complicate things a little.  You just have to work it out to see what you're comfortable with.

One thing that convinced me to pay off my mortgage at retirement was that I calculated how much of my investments were really just working to pay the safe withdrawal rate for my mortgage payment.  If your mortgage is $2k a month (ignore property taxes, as they'll still be there even after it's paid off), then at a 4% SWR it requires $600k [(2*12)/0.04] to support that for 30 years (you can use the chart above to alter that for shorter periods).  I compared that number to the value of the house and decided to just pay it off with a portion of that amount and let the rest of the money work for other things. 

Even beyond that, my personal philosophy is that when you already have more than enough money to never work again, you can afford to stop optimizing for every dime of possible leveraged returns.  As Bill Bernstein says, "when you've won the game, stop playing!"   

Of course, YMMV -- some people really like having a mortgage and have perfectly good reasoning behind it.  Different people have different approaches to this, for sure.

I have a 2.625% non-recourse mortgage with ~13 years remaining.

I see no reason to pay it off early, as it gives me inflation protection.

[Tyler]

I have a 2.625% non-recourse mortgage with ~13 years remaining.

I see no reason to pay it off early, as it gives me inflation protection.

Fair enough.  That's a actually a good point -- my previous calculation crossing SWRs with mortgages is overly conservative because mortgages are oblivious to inflation.  It's just been a while since I've had a mortgage, and clearly I'm out of practice discussing them.   

Personally, I still like being debt free even over a low-rate mortgage for the other reason I described.  But everyone is different.

[jason]

Home equity is irrelevant to a retirement calculation because you can't access the value that the home equity represents without selling your house and upending your life. Mortgage payments should be considered expenses, which will therefore require you to sock away $25 per dollar of your mortgage payment (4% SWR = every dollar of annual spending requires $25 in investments) if you retire before the mortgage is finished.

Personally I would pay off the mortgage before retiring, and endeavor to pay it off ASAP regardless of the situation, especially if it is large and you have a high income.

It is not clicking with me to treat my mortgage payment no different than a rental payment or money I spend taking vacations.  If nothing else, the equity I'm building in my home should be added, on paper, to my VP, no?
I like having a mortgage because my 30 year fixed rate is really low at 4%.  With the tax deduction, my effective rate is even lower.  Real estate, on average, over many decades, appreciates at around 4% per year.  So, on average, paying for a house in-full is not a great investment, financially.  The PP has averaged returns of about 9% per year, so, while I can't predict the future, based on past performance, I figure I'm very likely better off keeping my money in the PP and having a low-interest mortgage.  Of course, if the PP does relatively badly, like it has done for the past 2 1/2 years, then I'd be better off just paying in-full for the house.  But, I'm betting on the PP, long term.

[Tyler]

The safe withdrawal rate is calculated from your liquid investments that you can sell 4% of every year to pay the bills.  You can't do that with your house, so it doesn't count.  Your home equity does count towards your net worth, but that's a different measure that is unrelated to SWRs.

Just looking at the average return vs the interest rate, a 30 year fixed rate mortgage makes a lot of sense these days for making more money over time provided you wait long enough.  I admit my opinion on mortgages is based on more than just the math for maximizing returns (which is nice but not the be-all-end-all when you already have plenty of money).  For example, I found my mortgage bank to be borderline deceptive at times (a form of counter-party risk), and I have a personal preference at this point in my life for prioritizing minimizing uncertainty over maximizing returns. 

And FWIW, one of the reasons markets don't stress me out is that -- without a mortgage -- my expenses are so darn low that even in a poor investment year covering them completely with a little part time work is really easy.  That flexibility is nice and makes my retirement finances very stress-free.  Everyone is different, though, and depending on your situation you may prefer more invested assets (with an offsetting mortgage) to provide the same peace of mind. 

[dragoncar]

For tons of discussion on this topic, you may want to start here:

http://forum.mrmoneymustache.com/invest ... #msg605854

[sophie]

I was figuring to calculate expenses for the mortgage separately.  That is, the 4% SWR applies only to non-mortgage expenses.  To this figure add the balance of the mortgage at retirement.

If your mortgage rate exceeds 4%, you should be able to just pay it off upon retirement.  If it's less than 4% (as in Libertarian666's case), you can decide to carry it, as the mortgage balance would theoretically generate more than enough $$ to carry the mortgage interest.

Personally, I favor the pay it off on retirement option, if my retirement income takes me down at least one tax bracket.

Hope that's useful.

[Dieter]

Just don't forget to factor in the money to pay taxes on the money used to pay the mortgage (sorry if discussed.)

Not an issue if from Roth, but elsewhere.... And any impact on Social Security.

[jason]

The safe withdrawal rate is calculated from your liquid investments that you can sell 4% of every year to pay the bills.  You can't do that with your house, so it doesn't count.  Your home equity does count towards your net worth, but that's a different measure that is unrelated to SWRs.

Just looking at the average return vs the interest rate, a 30 year fixed rate mortgage makes a lot of sense these days for making more money over time provided you wait long enough.  I admit my opinion on mortgages is based on more than just the math for maximizing returns (which is nice but not the be-all-end-all when you already have plenty of money).  For example, I found my mortgage bank to be borderline deceptive at times (a form of counter-party risk), and I have a personal preference at this point in my life for prioritizing minimizing uncertainty over maximizing returns. 

And FWIW, one of the reasons markets don't stress me out is that -- without a mortgage -- my expenses are so darn low that even in a poor investment year covering them completely with a little part time work is really easy.  That flexibility is nice and makes my retirement finances very stress-free.  Everyone is different, though, and depending on your situation you may prefer more invested assets (with an offsetting mortgage) to provide the same peace of mind.

I'm not sure I completely agree with the idea that equity in real estate adds nothing to your SWR. While you can't sell a piece of your home every year, a home is a fairly liquid asset. If I live in a 500k house today that I have 400k equity in, I can downsize to a 200k house and pocket the difference. That has to have some value in terms of SWR. I guess it comes down to how willing one is to sell/downsize. I think it's like owning art or investing in a private equity fund. It has value, but it falls under the VP. I guess the big question is what the SWR is for one's VP, which is probably very hard to ascertain.

[Pointedstick]

I'm not sure I completely agree with the idea that equity in real estate adds nothing to your SWR. While you can't sell a piece of your home every year, a home is a fairly liquid asset. If I live in a 500k house today that I have 400k equity in, I can downsize to a 200k house and pocket the difference. That has to have some value in terms of SWR. I guess it comes down to how willing one is to sell/downsize. I think it's like owning art or investing in a private equity fund. It has value, but it falls under the VP. I guess the big question is what the SWR is for one's VP, which is probably very hard to ascertain.

That's certainly less liquid than hitting sell on your brokerage account's online interface. It's less liquid even than going down to the coin shop to sell some gold. I guess the question is "how illiquid is illiquid?" I personally see a house as a very illiquid asset. Selling a house and moving is a big undertaking with extremely substantial time and transaction costs. It involves potentially separating yourself from location-based relationships and conveniences. It may entail buying new furniture and probably the new house has a bunch of little things you want to change or correct that you won't know about until you're there. In addition, if you are moving between houses in the same real estate market, downsizing represents moving into a smaller house, a worse house, or a worse neighborhood. In a lot of urban markets, a 500k house is about the minimum for a livable neighborhood, and going down to 200k means you're in close proximity to a ghetto, a bunch of crack houses, or other problems. And there may not be a lot of room to downsize if you're already living modestly.

In my own housing market, there's not much room to do this at all. I bought my house--a fixer-upper--for a little less than 100k. Right now it's worth maybe 130k, I dunno. That's probably wishful thinking. If I wanted to transform my sweat equity into cash, I'd have to find a livable place for 100k or less, and based on my experience doing this last time, it's not an option. A livable 70k to 100k house in this market puts you either 15 miles away from anything or in the part of Albuquerque that's nicknamed "The Warzone." No thanks.

[lordmetroid]

If you got a house worth anything you can simply sell, pocket the who profit and move into a rental apartment. Maybe a one room flat. That is a huge downsizing and now your portfolio is worth several 100K more in a relative small amount of time.

The yield that the profit will generate might be larger than the relative small rent you have to pay for your single room.

[Libertarian666]

If you got a house worth anything you can simply sell, pocket the who profit and move into a rental apartment. Maybe a one room flat. That is a huge downsizing and now your portfolio is worth several 100K more in a relative small amount of time.

The yield that the profit will generate might be larger than the relative small rent you have to pay for your single room.

Warning: don't try this if you are married. Divorce is very expensive.

[Pointedstick]

Yeah that's only a practical option if you're single without kids. But if that's your situation, then living like that can indeed be a good financial move, and it'll give you a lot of flexibility, too.

[Tyler]

Yeah that's only a practical option if you're single without kids. But if that's your situation, then living like that can indeed be a good financial move, and it'll give you a lot of flexibility, too.

Yep.

Safe withdrawal rates are simply back-tested measures of sustainability for passive investments that you are depending on to pay the bills.  They're just one piece of the retirement puzzle, and are not all-inclusive of every item of financial value that you have access to.  They don't account for things you own that aren't liquid enough to pay your water bill every month (like home equity, cars, land, etc), they don't account for things you actively manage (like downsizing your house, day trading a VP, or managing a bunch of rentals), and they don't directly* account for non-investment income sources (like social security, annuities, or part time work). 

(*) Other income reduces your dependency on your investment income, but does not actually affect the calculated SWR for your investments.

That certainly doesn't make those other things worthless, and there are many ways to improve your retirement picture beyond simply massaging the SWR for your investments.  A bit of smart money management will beat purely passive SWRs every time. 

[BearBones]

I do not think that a mortgage should be compared to the average back tested performance of your entire investment portfolio.

Paying off a mortgage is equivalent to a guaranteed and safe investment return of that rate (post tax equivalent). As close as we can get to a guaranteed and safe return is from short term treasuries. So, especially in the current economic environment, I'd rather be using cash to pay off a mortgage rather than park it in the second most guaranteed/safe investment that is paying well less than 1%.

[Libertarian666]

I do not think that a mortgage should be compared to the average back tested performance of your entire investment portfolio.

Paying off a mortgage is equivalent to a guaranteed and safe investment return of that rate (post tax equivalent). As close as we can get to a guaranteed and safe return is from short term treasuries. So, especially in the current economic environment, I'd rather be using cash to pay off a mortgage rather than park it in the second most guaranteed/safe investment that is paying well less than 1%.

There's nothing wrong with that, but in my case I get almost free inflation protection by owing more on my mortgage than my holding of USD.