Prepaying mortgage for cash component?

[staythecourse]

Hi all,

New to the forum, but a big fan of Harry Browne and his beliefs. 

I have most of the features of the permanent portfolio.  Mine is not as good as Mr. Browne's, but one I can "stay the course" with so I am content on that basis.

I do have a question for you all (sorry if it has been discussed already).

For the cash component can one just prepay their mortgage?  I just started a 30 yr. jumbo at 5.375% a few months ago.  I was thinking that 5.375% (after tax/deductions of 3.33% for me) would be hard to rival with a gauranteed fixed return in cash on an aftertax basis in the 40% (fed+ state) tax bracket.

From the Browne devotees is this something Mr. Browne has discussed before his passing or something you think would fit into his idea of the cash component?

Thanks.

[MediumTex]

One of the purposes of completely liquid cash in the PP is to provide dry powder with which to purchase lagging PP assets when it comes time to rebalance.

Since home equity is utterly illiquid (e.g., you can't sell your driveway to top off your LT bond holdings), it is best to leave your home and home mortgage outside the PP.

[moda0306]

I tried justifying using my house as my "inflation hedge" piece and paying down my mortgage as the "LT Bond" piece of the portfolio extremely early on in my understanding of how it works, and after a while you realize that your home and mortgage should really be viewed outside your "portfolio."

That's not to say these two things aren't extremely important in your personal finances, but they really don't behave in the way you need them to to make the PP work.

Regardless, if you're paying PMI, you're probably paying too much for the cost of borrowing, and you should look into paying your mortgage down to 80% LTV.

[staythecourse]

One of the purposes of completely liquid cash in the PP is to provide dry powder with which to purchase lagging PP assets when it comes time to rebalance.

Since home equity is utterly illiquid (e.g., you can't sell your driveway to top off your LT bond holdings), it is best to leave your home and home mortgage outside the PP.

Thanks for the response.  Should have mentioned that I make a pretty good living so I never rebalance the classic way, but rebalance every month with a good amount of new money from my paycheck.  So the classic rebalancing will never be an issue for me.

Any other diadvantages?  Thanks in advance.

[staythecourse]

I tried justifying using my house as my "inflation hedge" piece and paying down my mortgage as the "LT Bond" piece of the portfolio extremely early on in my understanding of how it works, and after a while you realize that your home and mortgage should really be viewed outside your "portfolio."

That's not to say these two things aren't extremely important in your personal finances, but they really don't behave in the way you need them to to make the PP work.

Regardless, if you're paying PMI, you're probably paying too much for the cost of borrowing, and you should look into paying your mortgage down to 80% LTV.

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 .

[MediumTex]

I tried justifying using my house as my "inflation hedge" piece and paying down my mortgage as the "LT Bond" piece of the portfolio extremely early on in my understanding of how it works, and after a while you realize that your home and mortgage should really be viewed outside your "portfolio."

That's not to say these two things aren't extremely important in your personal finances, but they really don't behave in the way you need them to to make the PP work.

Regardless, if you're paying PMI, you're probably paying too much for the cost of borrowing, and you should look into paying your mortgage down to 80% LTV.

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 .

I'm not following what you mean when you say you want to use your house for the cash piece.

Let's say you have $300,000 to invest in a PP and you have an $85,000 mortgage on a house that is worth $110,000.  How would you set up a PP in this situation using the house as part of the PP's cash holdings?

What would happen to such a PP if the value of the house fell to $75,000? 

[staythecourse]

I'm not following what you mean when you say you want to use your house for the cash piece.

Let's say you have $300,000 to invest in a PP and you have an $85,000 mortgage on a house that is worth $110,000.  How would you set up a PP in this situation using the house as part of the PP's cash holdings?

What would happen to such a PP if the value of the house fell to $75,000? 


[/quote]

Not sure what you are not understanding.  I have to make a mortgage payment at an interest rate of 5.375%.  I wanted to know people's feelings on just prepaying that loan for a guaranteed fixed return each month with new money for the cash component instead of putting the same amount of new money into T-bills, for example, which have considerably less return than the prepayment interest.  You know that whole idea of a debt is a negative bond/ cash idea.

I figure the mortgage payment is should classify as cash to Mr. Browne, no?  It is fixed, gauranteed, no volatility.  How is that any different than T-bills?

Thanks.

[moda0306]

It may not be liquid if you don't 1) have a line of credit set up, or 2) your house has fallen significantly in value.

Cash is supposed to stay liquid for when you need it, and you can't always count on easy money from your home.

[staythecourse]

It may not be liquid if you don't 1) have a line of credit set up, or 2) your house has fallen significantly in value.

Cash is supposed to stay liquid for when you need it, and you can't always count on easy money from your home.

Great point about liquidity.  I may be fooling myself, but think that is not as big of an issue for us.  My wife and I are both physicians with very stable jobs.  No debts outside of this mortgage.  Plenty of insurances.  I was planning on leaving 20k in pure cash for whatever reason may come up outside the amount I was going to prepay.

Any other disadvantages?  Thanks. 

[KevinW]

The PP tends to attract people who are financially conservative and would never assume that wage income is perfectly stable.  My $.02, medicine is already highly regulated and is currently a burning political issue.  If you're a fan of Browne's beliefs, you can probably appreciate that that poses some risks.  If you see things differently that's fine, but if I were in your shoes I wouldn't be so quick to dismiss that risk.

As MediumTex pointed out, there's the risk that your house could end up underwater, at which point your cash allocation would be negative, which doesn't really compute.

Another risk that was mentioned implicitly is that one of the three volatile assets could swing down so quickly that your regular contributions aren't big enough to keep the portfolio balanced.  In that case you would need something liquid like cash.  This becomes more likely as your portfolio grows.

Browne believed strongly that real estate is either a retail consumption item or a small business, and in either case should be segregated from "investments."  IMO he was absolutely right.

[MediumTex]

I would keep the house and mortgage separate from the PP.

The PP is a package designed around the concept of all-season safety.  The approach you propose has risks around both falling housing prices and illiquidity when it may be needed the most.

You and your wife have the benefit of a very nice stream of income right now.  I would put as much into a PP-type allocation as possible and just sleep that much better knowing that the fruits of my labor were safe.

I would probably also try to pay off the house as soon as I could.  Debt of any kind just bothers me.  Debt makes me feel like I am entering into a bargain where the "me" of today is taking an advance on labor yet to be performed by some "me" of the future.  If the future doesn't unfold according to my plans, my current actions may significantly reduce the freedom that the future me will be able to enjoy.

This respect for the many configurations of "you" that is unfolding over time goes the other way as well.  Some of the most satisfying feelings I think a person can have is to look back on actions he or she has taken in the past that have led to positive outcomes over very long periods.  For you, I imagine you would say thanks to the earlier iteration of the person you are today who was willing to go through the hardship of becoming a physician.  For me, I'm glad I had the energy and support to get through law school when I was younger; I'm not sure I would be willing to go through it all again today.

[moda0306]

Staythecourse,

MediumTex could convince a man to move to Antarctica to sell lemonade the way he can phrase things.  I hope you know what you've gotten into by stumbling upon this forum.

MT, I mean that with respect.

[staythecourse]

Thanks for all the responses.

I haven't found anyone who could significantly sway me yet in life unless I found a logical reason, so I wouldn't worry about that 

Couple of points:

1.  If my house did fall in the water or blew up that is what I have home owner's insurance and umbrella coverage for so I am not buying that.

2.  I agree with MT that prepaying the mortgage should be a high goal.  That is what I was trying to do with this thread the most efficient way possible.  For ex:  If I have $4000 to invest in a normal PP that would be $1000/ asset class (including cash).  Now if I wanted to pay my mortgage quicker the standard way would be:  Paying an extra $1000 of that $4000 each month leaving me with $3000 for the PP.  That leaves $750 for each asset class, including for the cash component.  Basically overallocating to cash ($1000+ 750).

Wouldn't it be a better idea to be able to invest $1000 dollars to each asset class by getting a fixed, gauranteed rate of return in prepaying my mortgage as the cash component vs. only investing $750 dollars to each asset class because I had to "separately" pay off my mortgage?

3.  I don't see how the assumption of the cash being used to buy other underperforming assets hold?  It's not like cash is always going to be above the rebalancing band to be able to "take some of the table" to use to buy other assets?

4.  Other than liquidity, I haven't heard any other good reason having a mortgage payment each month is not like a negative T-bill.

[moda0306]

MT meant underwater on your mortgage, not literally underwater.

Personally, if you were to do a 3x 33% LT bonds/gold/stocks and simultaneously pay down your home loan, you'd be far and away ahead of most Americans (not that you aren't already!)... though I would keep about 3 months in living expenses in a savings account JIC.

Further, be aware we could have a year like 1981, where the other 3 assets drop 11% combined, and the only saving grace was your ST bonds/cash.  It's just good to backtest what you want to do so you can say to yourself, "I know what may happen, and I can stomach it."

[staythecourse]

MT meant underwater on your mortgage, not literally underwater.

Personally, if you were to do a 3x 33% LT bonds/gold/stocks and simultaneously pay down your home loan, you'd be far and away ahead of most Americans (not that you aren't already!)... though I would keep about 3 months in living expenses in a savings account JIC.

Further, be aware we could have a year like 1981, where the other 3 assets drop 11% combined, and the only saving grace was your ST bonds/cash.  It's just good to backtest what you want to do so you can say to yourself, "I know what may happen, and I can stomach it."

Doh!!! Underwater not underwater. 

Good point about preparing that the portfolio will work like a 33/33/33 vs. 25/25/25/25

Thanks.

[MediumTex]

Personally, if you were to do a 3x 33% LT bonds/gold/stocks and simultaneously pay down your home loan, you'd be far and away ahead of most Americans (not that you aren't already!)... though I would keep about 3 months in living expenses in a savings account JIC.

I was thinking the same thing about perhaps going with a 3x33% PP (which is a bit riskier than the 4x25% approach) and putting some pre-determined amount of cash into paying down the mortgage each month.

Bear in mind that as simple as the PP looks, it is highly engineered and functions in subtle ways.  Tinkering with the approach rarely results in improved outcomes IMHO. 

[moda0306]

MT,

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

[KevinW]

3.  I don't see how the assumption of the cash being used to buy other underperforming assets hold?  It's not like cash is always going to be above the rebalancing band to be able to "take some of the table" to use to buy other assets?

Cash can end up above the 15/25 bands if it stays stable while other assets depreciate.

Suppose for example that you have a $1.2 million 33x3 portfolio going into a 1929-magnitude crash where stocks lose 90% of their value.  You now have
stock: 400k -> 40k = 5%
bonds: 400k -> 400k = 48%
gold: 400k -> 400k = 48%
To bring this back into balance you'd need to buy $360k stocks, which I wager wouldn't be possible using monthly savings alone.

If instead you had the $1.2M allocated 25x4, you would now have
stock: 300k -> 30k = 3%
bonds: 300k -> 300k = 32%
gold: 300k -> 300k = 32%
cash: 300k -> 300k = 32%
You could bring stocks back into balance with bonds and gold buy spending $270k cash if you so desired.

(Actually you're supposed to sell the bonds and gold down to 25% too.  But the example illustrates why you might want cash as "dry powder.")

[moda0306]

KevinW,

Did the stock market really drop 90% during the depression?

and...

I think we could expect some extremely strong actions out of LT treasuries and maybe even somewhat gold... doubt they'd simply stay where they are.

[KevinW]

From Wikipedia:

"The market embarked on a steady slide in April 1931 that did not end until 1932 when the Dow closed at an all-time low of 41.22 on July 8, concluding a shattering 89% decline from the peak."
[ http://en.wikipedia.org/wiki/Wall_Street_Crash_of_1929 ]

And yes, a stock correction of that magnitude would probably cause a lot of motion in bonds and/or gold.  But I was just trying to concoct a simple example that shows how cash can become unbalanced, and how it may be impossible to keep a portfolio balanced with new contributions alone.

[staythecourse]

I believe stocks did drop 80 some percent overall, not in one year.  

This example makes no sense though.  You took some liberal assumptions.

1.  Only stocks fall.
2.  No other changes in the other 3 asset classes
3.  How do you know if this was to happen cash (in american currency) will not fall as well and need to be rebalanced up.
4.  Why is cash the only one that needs to be sold to rebalance in your example and not gold or LTGB?

Sorry can't buy a hypothetical just to prove your point.

The idea of liquidity to easily spend in a situation like that does make sense though, but really only if you had it under your mattress and not in a brokerage account.

I do see MT POV that doing my idea would in fact change the performance to a more 33/33/33 which is not what I want.

Thanks.

[moda0306]

Scary stuff, Kev.

Even if one were to be confident that stocks would outperform over the next 40 years, and that they can stomach the 10, 20, 30, 40% (89%???) losses along the way, throwing gold and LT bonds into your portfolio can actually IMPROVE your returns, while smoothing them as well.

[moda0306]

Stay,

I had a really hard time with cash too... still do sometimes.  It's like you're the federal reserve's whipping boy.

Basically, you can sell the other ones, but you'll have to at a loss sometimes... and keep in mind, this is a fundamentally conservative portfolio that also happens to perform well.  When you remove cash, you don't improve your CAGR that much in the history of the PP (1% about)... but you do have to suffer large losses in years like 1981 (11.5% calendar year loss).

To some people, it's not worth it.  To some, they'd rather have the sound sleep.

Also, the VP (variable portfolio) opportunities are there for you as well.  The PP is supposed to be looked at as the money you can't afford to lose, so there's always more opportunities with other $$ you have.

Funny thing is, as completely disaster proof as the PP is compared to most standard portfolios, its returns are incredibly impressive.

[KevinW]

Sorry can't buy a hypothetical just to prove your point.

I took your claim to be "for any combination of asset returns, cash will never exceed 25% and I can maintain portfolio balance using new contributions."

That predicate is falsified if there exists at least one combination of asset returns that invalidates either clause.  Any combination for which the non-cash assets together shrink enough to bring cash up past 35% invalidates the first clause.  Any combination which requires a cash infusion larger than one month's salary invalidates the second (and this becomes more likely as the portfolio grows relative to income).  My example is one such scenario, but if you don't like the figures I picked, it's easy enough to make up another set of figures.

Scary stuff, Kev.

Yeah!  This historical fact, combined with all the "Great Recession" talk in the last couple years, were the nails in the coffin for my interest in stock-heavy portfolios.

[moda0306]

Yeah!  This historical fact, combined with all the "Great Recession" talk in the last couple years, were the nails in the coffin for my interest in stock-heavy portfolios.

Don't forget about 1966-1982 or 2000-2009.  Flat stock market during those periods.  That's 2 periods that make up half of the last 50 years.  For curiosity's sake, I wonder what LT treasuries did during the depression... I was impressed with gold holding its own in 2008 when commodities were crashing like crazy.