I'm a big fan of debt-free living. Probably too big of a fan, actually. I know of at least one financial error I've made because of a general abhorrence of debt (can anyone say HPSP?) At this point in our lives we only have two debts. One is on an investment property (our last house.) I owe $91K at 5.3% (3.3% after tax) on that property. We refinanced into a 20 year loan when we moved out and we've been paying on that for a little over 4 years. We pay $300 a month extra on it, so we're probably 8 years away from paying it off if we held on to it. We probably won't have it paid off before we sell it. [Update prior to publication: It's now on the market.] Obviously, upon selling it, that debt will be gone. After transaction costs, we'll probably get $20-30K out of it and will need to decide at that point whether to put it toward our current mortgage or invest it.
We are 29 months into a 2.75% 15 year mortgage fixed mortgage on our residence. At this point, our loan to value is about 50% on the property. The payment is very affordable on our income, but it bothers me to have it. I would be making extra payments on it to get rid of it sooner if it wasn't so darn cheap. I mean, our marginal tax rate is 38% this year and the interest is completely deductible to us. So our after-tax rate is 1.7%. Given current inflation of ~ 2% right now, the mortgage is better than free on a mathematical basis. But it still bothers me for a few reasons, not all of which are completely logical.
Why I Want To Be Debt Free
First, I feel like I need to make hay while the sun shines. I still can't believe I get paid what I do to practice medicine. There are many pressures on physician incomes, and it would not surprise me to see my income decrease dramatically at some point during the remaining time on this mortgage.
Second, there is a very real risk of job loss for employee physicians. I'm not an employee, but with regard to job loss, my job isn't much more secure than an employee's would be. Like most hospital-based specialists, our group would essentially disband if we lost our contract with the hospital. Those contracts renew every couple of years but at this point in our lives, we'd rather not move if that contract were lost. We like where we live-the schools are great, we have family and friends here, and we love the area. But if our group were to lose its contract, it would be unlikely that I could easily find another full-time job in this area. However, if our expenses were low enough it would be relatively easy to pick up some prn (as-needed) work in this area, perhaps fly somewhere else to do a bit of locums for a few days a month, and combine it with the income from WCI to maintain our standard of living. Having a paid-off home gives us much more freedom to survive a serious job catastrophe.
Third, I don't plan on ever working more shifts or more night shifts than I'm working now. In fact, I'd like to cut back a bit already-both fewer shifts and definitely fewer of the overnight ones. After-tax, my mortgage payment represents about 2 shifts a month. If I paid the mortgage off, that's two shifts I wouldn't have to work without changing my “after-mortgage income” at all.
Fourth, we're starting to spend a lot more money on stuff we want (but don't necessairly need)-expensive vacations, optional house upgrades, fancier toys etc. Buying stuff we don't need while we still owe money on our house is an awful lot like buying stuff on credit.
Finally, as Dave Ramsey likes to say, a paid-off mortgage is a status symbol. I value it a lot more than driving an expensive car. I make a ton of money, why shouldn't I have a paid-off house? Mathematically am I giving something up by not keeping a low interest mortgage for decades? Probably, but it's nice to be in a position to not need to take that risk.
Finding a Balance
So I've been thinking a lot lately about how to balance my desire to be debt-free with the mathematical stupidity of paying off a mortgage with a negative real interest rate early. I think I've decided on a solution.
The Plan to Pay off the Mortgage
My current P&I payment is $2,445 per month. In order to pay the mortgage off in 5 years, I would need to increase that payment by $3,140 per month. If I instead invest extra money in a side account, I will still owe $202K of my current $313K balance after 60 months. So I need that side account to be equal to $200K. I'm going to have to invest quite a bit of money to get to that in just 5 years. This, of course, is all in addition to our other financial goals- retirement and college for the kids.
Step # 1 Invest a lot of money on the side each year
How much I need to invest really depends on what kind of a return I can get on the account. If all I can get is 1.7%, then it will require $3,140 per month, or about $38K per year. However, if I can manage 8% on it after-tax and expenses, and I front-load it a bit, it would be only $31,500. Even so, that's still a big chunk of money.
Step # 2 Add in windfalls
I could further lower the planned amount if I'm willing to add in any windfalls and “found money” I get in the next 5 years such as the equity we get out of our rental property when we sell it. There will probably also be other windfalls, including months when my pay is particularly high or when WCI does well.
Step # 3 Take significant risk
Obviously, in order to get 8% after taxes and expenses, I'm going to have to take on significant risk. I could probably get that kind of return out of Peer to Peer Loans, but those don't meet my requirement of being instantly liquid in order to pay off the mortgage. I could probably also get that out of a real estate investment, but that also suffers from a liquidity issue. I'm almost surely not going to get that return out of any kind of a mainstream fixed income investment. So that leaves equities.
Taking equity risk for a goal that is only five years out isn't the typical financial advice you hear out there. However, just as I do with my children's 529s, I also look at not only the likelihood of losing money, but also the consequences. What is the really bad thing that could happen if I use equities to fund this side account? The really bad thing would be that I've almost got my $200K and we hit a big bear market and that $200K is cut in half. What's the big deal? I can clearly afford the mortgage payments. Waiting a year or two (or ten) for the market to recover certainly wouldn't be a catastrophe, especially since I'm not even sure I would rather have the mortgage paid off than the side account. Sure, I'm investing “on margin” but there won't be any margin calls. As long as I can service the debt, I can just wait it out.
I suppose I could take even more risk by getting a home equity loan and investing the proceeds. However, not only does that increase my debt (what I'm trying to get rid of) but I also probably couldn't get anywhere near the terms I've got on my mortgage debt. Besides, I can't legally deduct the interest on more than $100K of that anyway, further increasing the effective interest rate.
Step # 4 Flush out the capital gains using my charitable contributions
8% after expenses and taxes is no easy goal in a taxable account. Not only will I need to use equities, but I may even need to use relatively risky equities, like emerging markets stocks, microcaps, or small value stocks. It is relatively easy to keep expenses low using ETFs and mutual funds from companies like Vanguard, but keeping taxes low in a taxable account can be tricky. However, I've got an advantage and I plan to use it.
I make sizable charitable donations each year. This provides me the opportunity to flush the capital gains right out of my portfolio. Let's say I put $25K into this account in year 1. It increases in value over the next year to $30K. If I were to sell that, I would owe capital gains taxes (18.8% LTCG rate for me) on that $5K, or about $1000. However, if I transfer those shares to charity, and then take the $30K in cash that I would otherwise use for a charitable contribution and buy more shares with it, then those gains are flushed right out. I've essentially reset my basis to $30K. Although I'll still have to pay annual taxes on any distributions, this will dramatically lower any taxes due. Even better, unlikely with tax loss harvesting, there are no wash-sale rules.
Step # 5 Tax loss harvesting
I can further increase the tax-efficiency of this account by tax-loss harvesting. Since I'll be using relatively risky equities, I will likely see quite a bit of volatility over the next 5 years. By exchanging shares with a loss for a highly correlated fund or ETF, I can book that loss and deduct $3K a year against my regular income (at 38%, that lowers my tax bill by $1,140 per year.) If I can book even more than $3K in losses per year, I can use those against the distributions, or even save them up for future years. Between donating appreciated shares and tax loss harvesting, it's even possible that the net effect of taxes on this account is positive. Tax loss harvesting isn't that useful for most people, because you're just delaying taxes to when the replacement investment is eventually sold for a gain. However, if you have a way to flush those gains out of the portfolio, tax-loss harvesting is a much better deal.
Getting out of debt isn't all about math, it's also about behavior. While 5 years isn't forever, it is still a long time to stay motivated to work toward a goal. So it would be a good idea to have a carrot hanging out there to provide the motivation. So here's my carrot- when my side fund equals the mortgage debt I'm going to drop the three overnight shifts I work each month. Trust me when I say I'm highly motivated to quit staying up all night 3 times a month. And I'm going to use your assistance, dear readers, in staying accountable by periodically posting about how I'm doing toward this goal. Perhaps others with low-interest mortgage or student loan debt and an interest in being debt-free might like to play along. Before you decide to do so, however, please give proper consideration to the three issues below.
Avoiding Being House-Poor
Paying off a mortgage early brings up the issue of having too much of your net worth tied up in your home. I saw a good rule of thumb recently that you should have twice as much in retirement savings as in home equity, and I think that's pretty reasonable. Paying off my mortgage today would probably drop me below that amount, but 5 years from now I should be well above that ratio.
What About Asset Protection?
There is also the issue of asset protection. In some states, your home equity is well-protected by homestead laws and “tenants by the entirety” titling. Unfortunately, Utah is not one of those states. My retirement accounts are well-protected here, but I'm already maxing those out. Any additional home equity I get will be no more protected from my creditors than a taxable account, so there's really no advantage one way or the other for me from an asset protection perspective. This might not be the case for you.
What Does Your Spouse Say About This Plan?
I decided to ask my wife what she thought about this crazy scheme. Here's what she said:
“You listen to Dave Ramsey too much. You just want to call in and scream that you're debt free.”
That is not true, but she thinks my concern that our income could dramatically drop and put us into financial difficulty due to the mortgage payment is an awfully small risk, especially given the side income from WCI, my disability insurance, and our sizable emergency fund. (She's right, of course.) But she reluctantly said,
“Okay, you can save up this side fund, but not if it delays doing some of the house improvements we've agreed upon. It doesn't seem that paying off a loan that is less than inflation should be our highest priority and you have to be willing to make other sacrifices if you really want to do it.”
Then she suggested that if we didn't buy this fancy new boat I've been eyeing [update: and recently purchased] that we would have two years worth of extra housing payments right there. Ouch. Nevertheless, we're keeping the goal. It should be an interesting study in personal finance (which is both personal, and finance) to see how we do toward it.
My First Report
So here's my first report on The Great Mortgage Pay-off Scheme:
- Month 2/60
- Outstanding Principal: $313,465.18
- Value of side account: $0
- Basis of side account: $0
- Positive or Negative taxes generated from account: $0
We're obviously not making much progress so far, but I'm confident we'll catch up!
What do you think? Do you plan to pay off your mortgage early? Why or why not? Do you have a low-interest debt dilemma? What do you plan to do about it? Would you like to play along and post your progress? Comment below!
I paid off an (initially) 30 year 5.375% mortgage 19 years early. Refinanced it 3 times along the way down to 3.125%. No, it might not make complete financial sense, but it does adhere to the Boglehead principle of *keep it simple*. Simplifying one’s financial accounts is simplifying life! It’s one less thing to worry about; I know that my kids have a place to live even if I croaked today. Also, I was spurred to pay off my mortgage quickly by a quote in your book, I believe.
Quote by President J. Reuben Clark
Interest never sleeps nor sickens nor dies; it never goes to the hospital; it works on Sundays and holidays; it never takes a vacation; it never visits nor travels; it takes no pleasure; it is never laid off work nor discharged from employment; it never works on reduced hours; it never has short crops nor droughts; it never pays taxes; it buys no food; it wears no clothes; it is unhoused and without home and so has no repairs, no replacements, no shingling, plumbing, painting, or whitewashing; it has neither wife, children, father, mother, nor kinfolk to watch over and care for; it has no expense of living; it has neither weddings nor births nor deaths; it has no love, no sympathy; it is as hard and soulless as a granite cliff. Once in debt, interest is your companion every minute of the day and night; you cannot shun it or slip away from it; you cannot dismiss it; it yields neither to entreaties, demands, or orders; and whenever you get in its way or cross its course or fail to meet its demands, it crushes you.
What about keeping the 15 year fixed as an inflation hedge? investment just needs to beat 2% tax adjusted interest. If rates and inflation go up the fixed mortgage is a major plus.
What do you think about keeping the mortgage San inflation hedge?
Sure, a fixed mortgage is a great inflation hedge. Keep in mind that in 5 years I’ll only have 6 years or so left on that 15 year mortgage. Not exactly a super long term hedge.
We just finished paying off our mortgage two weeks ago. We were in a similar situation just over 18 months ago and for similar reasons as you I wanted to get the mortgage paid off sooner than later. We had a $335,000 balance on a 3.375%/15 year fixed. We had plenty in liquid assets to pay it off but I didn’t want to dip into liquidating some of our portfolio. At the time, we were investing approximately 35% of my gross salary for retirement. We decided to cut that back to 15% in investing and put the rest and any other excess (tax returns, bonuses, etc) to the mortgage until the mortgage was paid off. Now we can go back to saving 35% for retirement with the peace of mind of not having any debt. Probably could it have done it faster but similar to you, we have charitable donations close to 15% of my salary. We also employ the strategies of donating our appreciated securities and tax loss harvesting. The reason I chose this strategy was I didn’t want to let the stock market dictate when the house was paid off. As you know, you can’t predict the direction of the stock market so we cut back our retirement contributions but still invested 15% so we could enjoy some returns of the stock market if it went up. This strategy gave us more of a guarantee of when we would be debt free. With the recent run in the stock market, the odds are the returns are going to lower in the upcoming years and maybe be in the red. We have not regretted becoming debt-free. You can’t put a price on that peace of mind. I love my job and plan to work 15+ years but I love that I can walk away if I want. We still are doing well on the retirement end with a ratio of close to 5:1 of retirement assets to home equity. We have more flexibility to even be more generous with our charitable contributions. We also are blessed to have a good balance between work, play, and spending time as a family. Thanks for all you do. Enjoy your blog and enjoyed your book.
My biggest question to this is how much sooner will you pay off the mortgage by choosing this strategy, assuming you do in fact achieve 8% returns. How much longer would it take you to pay the mortgage off if you directed the same cash to the mortgage instead of investing it? My guess is only a few months over a 5 year period. I struggle with this question because I am in a similar situation as you. I want my house paid off, but if I invest the money and earn something like 8%, I will only be able to pay the mortgage off something like 4 months sooner. I am not sure the risk is worth 4 months. Yes, I am definitely able to take the risk, but if paying my mortgage off in 5+ years (instead of 5) is a sure thing, why take the risk? For an extra 4 months, I have definitely paid off the house so why play the investing game when I do not have to. I know I would be kicking myself if a big bear market hit at the beginning of year 4.
It’s not just the shorter time period you get for the additional risk. It’s also the option of not paying it off and just continuing to invest.
I understand your point and you make some valid points, but the title of this article is a scheme to pay off my mortgage early. So if your goal is to pay off your mortgage, why not just pay it off? If the mortgage will be paid off in 5 years with only a few months different between the two options, why continue to take risk. You made a post not too long ago about how you could retire in a few years. What is the purpose of continuing to be so aggressive? This sounds to me like you are choosing to invest because you like investing, not because it is the best way to pay off your mortgage. Or you want to live a nicer lifestyle than you admit to. Both are obviously fine, but your argument for investing with your financial situation does not make good sense. Doesn’t William Bernstein have a quote something like “After you have won the game, why keep playing?”
As George Foreman says, “It isn’t when I want to retire, but on what income.”
I have this same debate with myself/my wife constantly. I am very interested to see they updates on your report for this post. Please keep us updated!
THanks,
IMHO, if you have the debate constantly, it’s wasting too much of your time. Just pay the darn thing off and be done with it! Why borrow if you don’t have to. I stopped getting car loans and pay cash for cars for the same reason. Just think of it as a really big car.
This is an interesting idea. However, by your same logic you could liquidate enough of your current investments to pay off your mortgage TODAY, then funnel future earnings back into investments. Having a paid-for house feels really nice, and it eliminates the risk of market changes that are not mathematically factored into your calculations.
Except current investments are in tax-protected accounts.
Unfortunately My “lowly” FP pay doesn’t allow for me to pay off to much extra. At my current pace I will pay off my 30 year mortgage just before the start of the 29th year. I hope to increase that so I can pay off my mortgage about 7-8 years early. I doubt I will ever refinance given my 3.5% rate but who knows if I could get a 2.5% at 10 years to drop my 20 remaining to 15 I probably would.
How do I figure out my after tax rate?
My Mortgage is around 1575. Ins – 100. Taxes run about 650 a month. Total payment is about 2400 ($75 or so in excess)
It’s based on your current loan rate and your maginal tax rate (both your state and federal rate; for example federal 33% and state 5% = 38%).
So:
After-Tax Mortgage Rate = (Mortgage Rate) * (1 – Marginal Tax Rate)
= 5% * (1-38%) = 3.1%
An even easier way
https://www.bankrate.com/calculators/mortgages/loan-tax-deduction-calculator.aspx
I’m in this same boat right now and go back and forth, although I’m less than 5 years out on it. Mathematically it makes sense to wait, but being that it’s less than 5 years, which seems to be the minimum everyone recommends if you are investing, I’m torn.
I was thinking about taking the extra money I would use and just put it into my asset allocation, but instead of paying into my bonds, use that money to pay down the morgage. For example, if I have 50K extra to pay down the mortgage and I save 100K for retirement, (80% stocks 20% bonds), instead of paying 50k on the mortgage, 20k into bonds and 80K into stocks I would add the 50K to the total pot. Thus I would have 150K to invest, and 120K would go into stocks and then the remaining 30K, instead of bonds, could be put towards the mortgage. Mathematically the return should be similar.
Although, because I tend to think about these things for a while, I’ll probably just end up staying the course and finishing to mortgage normally in the next few years. Either way, it’s a nice problem to have.
Most of the Financial literature would suggest that over a given time period, not pre-paying the mortgage and investing is the better way to go. If paying off this debt makes you warm and fuzzy…go for it. I think some of us are channeling our parent’s values about mortgages.
Invest the difference in a Total Stock Market fund…if the investment goes up; then pay-off the mortgage, likely at cap gains rate. If the investment doesn’t go up, don’t pay it off. Generally over 30 year time frame the Market has a strong upward bias.
You have to get compound interest working on your side.
I very much doubt that the Whitecoatinvestor would be out of a job for very long.
Good read but more interested about the boat! We’re looking at an x-30. Can’t justify the cost of new. Considering buying a 2-3 year old and adding the Gen II surf tabs. Our current Mastercraft is 20 years old and runs great. Hopefully I’ll hang on to a new-used one that long. Curious, what did you buy?
Axis T23, got most of the options. Make sure they’re willing to add the surf tabs. You really don’t want to try selling a boat without a surf system going forward from here. Everyone wants one.
I couldn’t justify a new Mastercraft/Malibu/Nautique, but could with the Axis.
I have been thinking of the same dilemma. What if:
buy MUNI BONDS….duration of 22-25 years…..yielding 4.5% (totally tax free)…..
my mortgage/effective tax rate is 2.75%
4.5(minus)2.75=1.75%….will pay for some of the real estate taxes/insurance
totally safe …
We did this exact same thing, and just paid off our mortgage in May. It really is a good feeling.
The greatest aspect of it, to me, is the optionality it provides. In 5 years (or less, if the market is kind), you can pay off the mortgage, or not. Or if some other emergency or business opportunity comes up along the way, you can use the money for that.
I actually had enough saved up to pay off our mortgage in 2007, so I took some profits from some stocks and set the cash aside. Just about then, the economy started to slide, and I sat on the cash. I decided to keep the mortgage a bit longer, and put the money back into the market. It was probably just luck, but needless to say, that was a very good decision!
By this year, that money had more than tripled, so I finally pulled out enough to pay off the mortgage.
“You listen to Dave Ramsey too much…” Hahaha! Love this!
My husband and I have a home mortgage, mortgages against multiple rental properties, 2 car loans and 1 student loan between us. And we aren’t paying extra on any of them. As bankers we are probably a bit too comfortable with leverage – the opposite extreme.
We are currently refinancing into a 30 year mortgage at 3.75%, and the weighted average of our rental mortgages is under 4%. We have more than enough cash to pay off the consumer debt, but those loans are all right at 2%.
Sometimes I get the itch to put extra money toward the debts; we have just enough cash on hand to wipe out the consumer loans (incl student loan) in full. But then I just think back to the days not so long ago when my money market was paying me 4% and consider how I’ll feel when that day comes again.
A few factors for us that sway our decision: 1) we’re both young (30s) and the debts will be paid off well before retirement even without extra payments being made; 2) we plan to rent out our home if/when we move and it would cash flow with the current mortgage; 3) our jobs are both very stable and income is likely to increase if anything; and 4) our budget has plenty of wiggle room even with those payments (and even with maxing out 401ks, backdoor Roths, HSA and hubby’s ESPP).
Plus – and this is a lame excuse – but I kind of like the forced savings of the amortizations on the loans. Several are 15 year notes, and the cars are of course much shorter. Our net worth increases by over $50K a year just from loan balance reductions. If cash starts to build up we will probably use it to buy more rentals (or start a business) rather than repay current mortgages. At some point leverage reduction will become more of the goal, but currently we are still in the accumulation phase.
WCI: any updates on your plan?
Well, I was going to jumpstart it when my investment property sold this Spring, but it still hasn’t sold. So not much of an update.
I don’t understand how you are getting a mortgage interest deduction on your investment property. I thought the mortgage interest deduction phased out as your income rises (maybe $300K for married couples filing jointly) and based the comments on your blog I think you are making enough income that you wouldn’t be eligible for the mortgage interest deduction. But maybe I’m missing something I should be taking advantge of.
# 1 – Mortgage interest is always deductible on an investment property as a business expense. But I think you meant to say my personal property.
# 2 – All itemized deductions, including mortgage interest on your personal residence, do start phasing out at an AGI of $309,900 (MFJ). However, the phaseout is pretty gradual. It takes hundreds of thousands of dollars of additional income before you hit the maximum (at which point you still get 20% of your deduction.) You basically lose 3% of the amount of AGI over the threshold. So if you make $610K, you would lose 3% of $300K, or $9K in deductions. That would cost you another $4K or so in taxes.
15 years at 2.75% is extraordinary. Rates were under 3 percent for a year in 2012-13 and for a short while in 2016. You timed that mortgage really well! A few questions:
1) Was there something you used to identify that the rate going to be a “low?”
2) How did the new standard deduction affect your “effective interest rate” of 1.7%? We’re not going to have much advantage from that deduction anymore because my wife and my house has only 12K in interest a year, on the other hand, the standard deduction is now twice what it was, so it’s not like I’m feeling that bad about it. 3) How are you doing on this payoff plan? Is it even relevant now that WCI has exploded in value and income?
1. No.
2. It didn’t. I already paid the mortgage off.
Sounds like you missed the follow-up post. Here you go:
https://www.whitecoatinvestor.com/were-debt-free/
I did indeed. Thanks as always.