Prepaying mortgage for cash component?

[Lone Wolf]

Staythecourse, it seems like the simplest arrangement is to go with a standard 4x25 Permanent Portfolio.  That's a strong, no-fuss, no-muss performer.

As you mentioned, you do have the option of going with a 3x33 but that's a very different beast from the PP.  It may do very well but this arrangement certainly "breaks the package", so to speak.  I'd just let the Permanent Portfolio do what it does best, but that's just me.

All of this points me toward going with a straight 4x25 Permanent Portfolio for the money you can't afford to lose and then deciding how much you would like to put into your mortgage each month.  My recommendation would be to look at how far you are from getting a Conforming Loan rather than the Jumbo that you have now.  Then you can pick a target date to investigate refinancing into a Conforming loan.  You'll see much better rates with the Conforming loan, which will save you a lot of money.  You can calculate how much you would need to put into your mortgage each month to reach your "target date".

With rates this low, sooner could be better.  Rates may stay super low as they are now or they could rise.  None of us knows which it will be.

Scenario 1 is that interest rates stay extremely low.  If they do, you can refinance into a Conforming loan and save yourself a lot of money (we recently got into a 3.75% rate, although this is a 15-year.)

Scenario 2 is that interest rates rise (perhaps even rise a lot) before you can make this transition.  If this happens, you may not have the opportunity to refinance in a way that helps you very much.  That part is a pity but it will mean that the cash portion of your PP will begin to do better and better.  If you find yourself heading into a rising rates "headwind" that would make refinancing a lost cause, you could even scale back the rate at which you pay the mortgage and simply increase your PP contributions.  If rates are rising due to inflation the principal of your loan will be getting chewed up by that inflation and scaling back your rate of payment a bit will make sense.

So I'd go with a 4x25 for your PP and then set up a target for getting to a conforming loan... perhaps even a 15-year if that makes sense for you.  If rates stay low you could save yourself a real bundle.

Good luck!

[MediumTex]

MT,

Could you expand on what you mean by "highly engineered and functions in subtle ways."

Compared to most conventional approaches to investing, the PP acknowledges a much broader range of possible scenarios that can affect an investor's portfolio and provides simple protection from most of them.

The PP is subtle in that it provides this protection in a simple-looking package.

The fact that HB described the PP in such simple terms really masked the depth of his understanding of what one needs to do in order to invest safely in an uncertain world.

[6 Iron]

I would side with those that opt for maintaining a 4x 25 PP, if only because the future is unknowable. For myself, with extra cash I look at how gold is doing; if it is lagging, I put extra cash there; if it is doing well, I aggressively pay down my mortgage. That said, the majority of my PP is in tax advantaged accounts, allowing me this binary decision.

[cowboyhat]

Staythecourse

I think of myself as entangled two large financial instruments. One is a PP, the other is my house.

My PP is liquid to the extent that the funds are outside my 401k/IRA accounts, and the value of my PP in real terms is stable to slightly appreciating due to the types of assets inside, their lack of correlation, the fact that I periodically re-balance them, and the lack of leverage in the portfolio. If something bad happens in my life that can be fixed with a big chunk of money, then my PP is waiting to help me. Otherwise I'll spend it in retirement or pass portions to my children.

My house is not liquid, is leveraged, incurs heavy ongoing maintenance costs, and I believe has recently decreased in in value in real terms. In most possible financial futures my house a terrible deal as an investment, but I need to live somewhere, I couldn't rent anything as comfortable, and no one harasses me about the dog or my wife's taste in paint colors. One really nice thing about my house is than in about 10 years I'll be able to live in it for the cost of taxes, insurance, and maintenance, which means I will be much less dependent on the mercy of my employer than I am now.

I also currently make more money than I need for my expenses. I put 1/2 of this extra money into my PP and 1/2 toward paying down my mortgage.

[staythecourse]

Thanks all for the insights and opinions.

I find the H.B. conservative views most responsible and appealing, but treating the mortgage on a  house (maybe the single highest debt in most lives outside of having kids) outside of your total investments I find odd.  My point, is it is great to invest in the PP for a conservative 2-3% real return/ year, but in reality most are not getting that return.  In reality, due to high levrage to buy a house the debt and consequent interest paid in mortgage (often 100% of the original loan amount) is enough to significantly lower that consistent return.

It is like being happy having a strong looking bucket to carry water to put out a fire knowing there is a leak at the bottom.  In the end, you will have enough water to put out the fire, but have lost a good portion of that water along the way.

Does that make sense?

[Wonk]

STC,

Couple questions for you:

1. Do you have enough liquid assets to pay off your entire mortgage balance today if you decided to?

2. If you are employing a 4 x 25 PP, what trigger do you  employ for rebalancing?  Annual or bands?

Your answers will guide my response.

Thanks.

[staythecourse]

STC,

Couple questions for you:

1. Do you have enough liquid assets to pay off your entire mortgage balance today if you decided to?

2. If you are employing a 4 x 25 PP, what trigger do you  employ for rebalancing?  Annual or bands?

Your answers will guide my response.

Thanks.

1.  Don't have the liquid assets to pay it off right now.  That is why I was more interested in prepaying as I go.
2.  I rebalance every month with new money to keep my quasi-PP portfolio to the desired %'es.

Thanks.

[Wonk]

Have you given thought to liquidating 90% of your investment portfolio and using the proceeds to pay off as large a chunk of your mortgage as possible?  If you haven't already, does that sounds like a favorable idea?  Why or why not?

[staythecourse]

Have you given thought to liquidating 90% of your investment portfolio and using the proceeds to pay off as large a chunk of your mortgage as possible?  If you haven't already, does that sounds like a favorable idea?  Why or why not?

My portfolio has a return much higher than my 3.33% after tax value of my mortgage payment.  I would be losing money on that deal.  So if I liquidated my portfolio, not even discussing tax implications, I would be giving up a higher return then I would be from my negative bond in mortgage.

BUT...

Since I do have a cash allocation in my portfolio giving me less than 2% what is wrong with using the my monthly additions to my cash component for the higher risk free, gauranteed return of 3.33% from my mortgage?

Doesn't seem to make any sense to allocated 25% to cash making less than 2% instead of paying more to mortgage costing me 3.33%. 

That is why I don't see why you can't use the prepayment cash as the allocation to the cash component of the PP.  Most people with other asset allocation would not consider this because they as I stated above would be giving up higher returning fixed income for cash my taking on duration or credit risk. 

The PP is great because you always have a static 25% in cash.  Why does it matter if that cash is in prepayment of mortgage or in T-bills?  The liquidity feature not withstanding.

[moda0306]

The liquidity piece is the big risk.  It may seem liquid now, but if housing, as a result of contracting credit (a deflationary trend that can be difficult to stop once it's got some momentum), were to drop another 30%, then your cash portion would be totally wiped out in that you really can't use all that paying down that you did.

That said, you're 95% of the way there... I don't see a HUGE risk of you doing that, just be aware if deflation takes hold, and credit starts to contract, it could be really difficult to get a LOC at a good rate to rebalance your portfolio.

Keep in mind that we're awash in credit right now, at a rate much higher than 1929, so asset prices could plunge if people truly start to question, to their core, the sustainability of the lifestyles we live.

What is your LTV (Loan-to-value)?

[KevinW]

Why does it matter if that cash is in prepayment of mortgage or in T-bills?  The liquidity feature not withstanding.

You're right that the only thing cash has going for it is liquidity, BUT that liquidity is a huge deal and integral to the whole PP design.

You said you can only be convinced by logic, so I've been trying to do you "solid" and appeal to logic on this issue, apparently not very successfully. 

As a thought experiment consider this similar statement: Stocks are volatile but cash is nice and steady.  Why not just hold cash?  The higher-rate-of-return feature not withstanding.

That one little feature dangling on the end there is important!

The cash allocation is integral to making the rebalancing mechanism work while controlling taxes and transaction costs.

There are certain rare market conditions, as seen in 1929 and 1981, where cash is the only asset that provides protection.  These conditions occur rarely and humans have a tendency to treat unlikely events as impossible.

There's always the risk of needing to tap the portfolio for an unexpected expense, and the cash allocation provides a way of doing that with minimal disruption.  Stated another way, the cash allocation allows the "emergency fund" to be integrated with "retirement savings."

For what it's worth, we have automated transfers into retirement accounts holding 4x25 PPs, and throw our leftover cash and found money toward paying down low-interest debt.  This works out to moderate compromise as others have suggested.  I just think it's important to maintain the PP's structure as designed, because as Tex said it works subtly and tinkering is a slippery slope.

[Wonk]

My portfolio has a return much higher than my 3.33% after tax value of my mortgage payment.  I would be losing money on that deal.  So if I liquidated my portfolio, not even discussing tax implications, I would be giving up a higher return then I would be from my negative bond in mortgage.

BUT...

Since I do have a cash allocation in my portfolio giving me less than 2% what is wrong with using the my monthly additions to my cash component for the higher risk free, gauranteed return of 3.33% from my mortgage?

Doesn't seem to make any sense to allocated 25% to cash making less than 2% instead of paying more to mortgage costing me 3.33%. 

That is why I don't see why you can't use the prepayment cash as the allocation to the cash component of the PP.  Most people with other asset allocation would not consider this because they as I stated above would be giving up higher returning fixed income for cash my taking on duration or credit risk. 

The PP is great because you always have a static 25% in cash.  Why does it matter if that cash is in prepayment of mortgage or in T-bills?  The liquidity feature not withstanding.

Ok, there are a few things in play that you might want to factor in:

1. Rebalancing.  I don't know how close your portfolio is to the 4 x 25 or even 3 x 33 at the moment.  I'd give serious thought to how I would rebalance my portfolio in the event of a tight money recession like in 1981.  Would you continuously be purchasing gold, stocks and LT bonds all the way down every month as per your current rebalancing strategy?  Would you take out a LOC to rebalance?  There isn't a right answer here.  Just figure out how you would handle such a situation and if you feel comfortable with the worst case scenario.

2. Liquidity.  As others have mentioned, I wouldn't discount the liquidity piece.  You can get a 5 year CD from Ally for 2.39% with a 2 month interest penalty for early withdrawl.  Is the 90bps from your mortgage worth it for you to rely on obtaining favorable rates on a LOC in the event you need it?

3. Asset risk.  I might be in the minority on this one, but I don't like the idea of paying off a mortgage if you have great terms.  Personally, I think over the long term, higher returns are to be found investing that capital in an allocation like the PP.  Additionally, I just don't like the idea of a majority of my net worth being tied to one asset that I can't liquidate in less than a day or relocate easily.  We live in a world where crazy stuff happens and housing assets are affected.  Natural disasters of all varieties along with nutty folks who just want to spread NBC toxins over our neighborhoods:

http://www.vancouversun.com/news/Qaida+ ... story.html

I like the option of simply walking away from my house if a bad enough disaster strikes.  Just food for thought.

[staythecourse]

That said, you're 95% of the way there... I don't see a HUGE risk of you doing that, just be aware if deflation takes hold, and credit starts to contract, it could be really difficult to get a LOC at a good rate to rebalance your portfolio.

I thought in a deflationary period fixed debt is bad as opposed to an inflationary period.  Because each dollar saved is worth more when spent on other goods that have become cheaper?

So paying down your debt should be a good thing in a period of deflation.

I am not doing this to have more equity in my house, just to pay down a significant debt that would otherwise in real terms lower my overall investment returns.

For ex:  One way to calculate ROR is:  (Final value-contributions)- Initial value/ Inital value.

Now real terms (money actually available to buy stuff) that is not really true it is more like:

[(Final value-contributions)- Initial value/ Initial value]- Amount spent on debt (House, credit card, auto, etc.)

So you may get a PP result of 10%, but that is not the overall money you have to buy stuff as you have not taken out the money from debts. 

[moda0306]

You are right about debt being bad during deflation... we're not telling you not to pay down your house... simply that there are certain risks with calling that your cash piece of your portfolio.

If the economy collapses and you have 25% in cash, you can rebalance with that or use it to pay bills since you're unemployed.  If it collapses and you have been paying down your mortgage, you LTV ratio could get down to where you can't get that back.  Imagine the cash-holding you as a guy next door... the economy collapses, and he is $150,000 underwater, and you're about even, but he can go buy food and pay his utilities and maybe just dump the house on the bank while nobody will loan to you, two or all three of your PP assets are down, and all that equity is doing you no good.

It really does come down to liquidity... but when you start running certain scenarios through your head, you can see how liquiditi is about 1,000x more important in some scenarios than it is when everything is moving along swimmingly.

[MediumTex]

In a deflationary spiral of falling asset prices and contracting credit I would not rely on the availability of a HELOC in order to rebalance my PP.

As we found in 2008, there are market conditions in which credit isn't available at any rate.

Even now, over two years later, the market for second mortgages is a shadow of its former self.

[Plumbline]

Stay - welcome to the club.

Personaly I would pay off the debt ASAP. At minimum re-fi to a 15 year.  Your personal residence is not a performing asset.  Build up emergency fund and then knock out the house debt.  According to your comments, cash flow is full and steady; you have an incredible opportunity to be debt free in a few years.  I would rather be debt free with a smaller PP than have a larger PP w/ debt. We are so proned to be lulled into presumption upon the future; 30 year mortgage?  This is maddeness and only kicks the can down the road - extending and pretending.  No one knows the future, especially 30 years into the future.

[cabronjames]

random idea/advice.  Disclaimer: I am not a PP nor personal financial planning guru.

Why not yourself & your spouse max out 401k & Roth IRA each year, 100% in PP assets, whether HBPP 4X25, or cash-less 3X33 stock/LT bond/gold.  IIRC from reading a Vanguard doc on Roth IRA conversion, there is a loophole in which those above the regular income limits for Roth IRA, can fund $5K in a Traditional IRA each year, & then convert it to Roth IRA.  With a HBPP 4X25, you could extend the tax-exempt space in a quasi-tax exempt manner, for the CASH portion, by purchasing up to $10K per year yourself & spouse in I-Bonds Savings Bonds from the US Treasury.

After this, with any extra money saved, use it towards prepaying the mortgage.

Given your description of a 2 high pay, low unemployment, career family, with this approach you could probably pay off the house in <= 5years.

Actually, I would appreciate if MT/other gurus opined on this approach for my own edification.

[cabronjames]

I am appreciate the comments, but am not trying to substitute my house as an investment or in place of any other component of the permanent portfolio.  Just wondering if it could act as my cash component since my mortgage rate is higher than I would make on any cash alternative currently?  The prepayment does act as cash, I figure, in that it is a fixed return, no volatility, gauranteed, and risk free. Opinions appreciated.  Thanks in advance .

Another angle to look at it

ST bonds or other CASH equivalents - you are the lender, it's an asset
house mortgage - you are the borrower, it's a liability

The context of PP assumes that for the 2 bond components, CASH & LT BOND, you are the lender, you have an asset.  It's probably not appropriate to consider liabilities like a home mortgage as part of the PP "asset allocation pie"

[Storm]

Why not yourself & your spouse max out 401k & Roth IRA each year, 100% in PP assets, whether HBPP 4X25, or cash-less 3X33 stock/LT bond/gold.  IIRC from reading a Vanguard doc on Roth IRA conversion, there is a loophole in which those above the regular income limits for Roth IRA, can fund $5K in a Traditional IRA each year, & then convert it to Roth IRA.

I have not heard about this, but would be very interested.  I am above income limits for a Roth IRA, so I did a traditional IRA last year.  I decided it wasn't worth it.  Although the money can accumulate tax free in the IRA, I had to pay tax before I put it in there, and I have to pay tax again when I withdraw it in retirement.  This seems like double-taxation to me, and it's difficult for my brain to figure out whether the years of untaxed growth make up for the double taxation.  If I could convert it to a Roth IRA (after all, I've already paid taxes on it before even contributing to it), that would be ideal.

  With a HBPP 4X25, you could extend the tax-exempt space in a quasi-tax exempt manner, for the CASH portion, by purchasing up to $10K per year yourself & spouse in I-Bonds Savings Bonds from the US Treasury.

I already do this.  It's a great way to extend your tax-deferred portion each year.

[moda0306]

Storm,

Actually, if you contribute to a traditional IRA, that is a reduction to your taxable income on your 1040.  Therefore, you're in effect NOT paying tax when on the money you earn that you end up putting into the traditional IRA.  You are not getting double taxed.

Maybe I'm misunderstanding, but I'm not sure why you're thinking that an IRA results in double taxation...

[MediumTex]

Storm,

Actually, if you contribute to a traditional IRA, that is a reduction to your taxable income on your 1040.  Therefore, you're in effect NOT paying tax when on the money you earn that you end up putting into the traditional IRA.  You are not getting double taxed.

Maybe I'm misunderstanding, but I'm not sure why you're thinking that an IRA results in double taxation...

I think he may be talking about an after-tax traditional IRA.  A high wage earner would want to do this to get tax free accumulation on any investment gains in such an IRA account.  At distribution time, you would not be taxed again on your initial after-tax contribution (only its earnings).

[Storm]

I think he may be talking about an after-tax traditional IRA.  A high wage earner would want to do this to get tax free accumulation on any investment gains in such an IRA account.  At distribution time, you would not be taxed again on your initial after-tax contribution (only its earnings).

You're right there.  I am above the income limits, so any money I put into a traditional IRA is already taxed.  I wasn't aware that at distribution time, you only pay income tax on the earnings, and not the principal investment.  This makes sense, and avoids the double-taxation.  Another consideration here is that at retirement, you pay normal income tax on distributions, where if you use a taxable account now, you only pay capital gains tax at a hopefully lower rate.

In the end, it might be more important to let your money grow tax free, rather than having annual taxes eating away at your hard-won earnings.  I feel we have strayed way off topic though, but I appreciate your input, MT, as always.

[moda0306]

This is a big reason that, especially for high tax rate indivuduals, taxable interest bearing securities should be used in your tax-deferred accounts.  I think due to how much high capital gain rates clog up the market, they tend not to stay around very long before a republican gets in office, lowers them, and releases a bunch of "trapped" capital.

So definitely, if you can, try to weight your tax-deferred accounts towards holding your interest-bearing securities.

[Storm]

So definitely, if you can, try to weight your tax-deferred accounts towards holding your interest-bearing securities.

I have already done this, Moda.  My tax-deferred accounts consist almost entirely of LT treasuries and a little cash.  The rest of the stocks, gold, and cash are in taxable accounts.

[moda0306]

How do you rebalance if things get really out of wack?

Do you have a preferred FMV ratio of the price of your tax-deferred account assets and your taxable account assets?  If so, does it bother you that you don't have a functioning PP in both taxable and non-taxable accounts?

Just curious.