I have spent the last year challenging my beliefs, asking myself where they came from, are they still valid and what is my purpose/motivation behind just about everything I do. I've found that the more "common sense" something is, the greater the chance that it's bullshit OR really needs evaluation before being applied to each individual/situation.
Case in point, pre-paying on a mortgage. Here is our situation and my current point of view, please tell me if I'm not seeing this problem correctly.
We took a 186,000 30 year down to 109,363 in eight years via pre-payment.
NOTE: the military pays me 2K a month in housing stipend, I almost felt obligated to put the entire 2k towards the 1,300 monthly payment.
We refinanced three years ago when I couldn't stand to pay the 5.25 in a 3% environment any longer.
That left us with:
15 year note
I have a stable military retirement on the way, it pays more than our monthly bills including mortgage.
This ignores tax advantages etc.... and I failed to calculate the value of investing the ENTIRE mortgage amount in post-mortgage payment years... maybe I need to do that....
Standing by for face punches, what did I miss in this process, what am I not looking at? What am I looking at from the wrong angle?
I'd keep the mortgage.
Everyone with a COLA pension can reasonably expect to make money from a 30-year mortgage. You're using an inflation-adjusted annuity (with a rising stream of nominal income) to make a fixed payment of an obligation that's being eroded by inflation.
A military pension makes this even easier because the inflation-adjusted annuity is coming from the world's best source. In 15 years of military retirement, my pension has risen by over 30%... despite three separate years of 0% COLAs.
To boost the portfolio's success rate even further, money which could have paid off the mortgage can now stay invested in a high-equity portfolio. However the market volatility is not for the faint of heart.
Back in 2004 my spouse and I signed up for a 30-year mortgage fixed at 5.5%. We'd been having the usual "Pay off the mortgage or invest?" debate at Early-Retirement.org, so I ran FIRECalc on the success rate and decided to track the result:http://www.early-retirement.org/forums/f28/covering-a-mortgage-without-losing-your-ass-ets-15237.html
These numbers are for the iShares small-cap value ETF (ticker IJS). They assume that the dividend distributions are taxed at 15% and the remainder is invested at the next day's share price. My spreadsheet does not consider the additional tax deduction for paying mortgage interest, because after the first 10 years the interest goes below the standard deduction. That ETF also has a heftier expense ratio (0.25%), so an equivalent ETF today may have a much smaller drag on returns.
Note that we "won" the early years but suffered a nasty recession during the first decade. (In early 2009 the APY actually turned negative for a couple months.) I suspect the Great Recession is a pretty good example of sequence-of-returns risk, and perhaps from now on the long-term APY is going to hold above 7%.
In other words, borrowing at 5.5% and investing in equities for the long term gave us an after-tax risk premium of over 1.5%.
Last month we decided to refinance our rental-property mortgage (4.625%). The broker suggested that instead we should pay off its loan by taking out a bigger 30-year mortgage on our home. The result is that we're borrowing a new 30-year mortgage at 3.25% and using it to pay off the mortgages on our rental property (4.625%) and our home (3.625%). The refinance drops our monthly payments by over $400 and will pay back the closing costs in less than two years.
Note that since I now have a VA disability rating, we opted for a VA loan where we can waive the 1.25% funding fee. The payback would be longer if I'd had to pay that fee.
Borrowing money at 3.25% and investing it? Navy Federal Credit Union is already offering 7-year CDs at 3%. Now one of my new life goals is outliving the mortgage-- we'll make our final payment when I'm 86 years old.
Again, this works great with a military pension because it has a COLA. More importantly, that federal pension should be reliably paid for at least the next 30 years. Those with a corporate COLA pension, or a pension with no COLA at all, will find that mortgage arbitrage is more risky.
If you're using the 4% SWR with no annuity income whatsoever (except Social Security) then your FIRECalc success rate may be less than 75%... even in a high-equity portfolio. More importantly, I suspect that the emotions of behavioral financial psychology will be very difficult to handle.
Mortgage arbitrage also makes the most sense for an asset allocation that has an average historical return which is higher than the mortgage interest rate. If you're holding a large amount of your investment portfolio in bonds or cash then you're just wasting money on the assets which return less than the mortgage.