Most investors make the mistake of focusing solely on the left-hand side of the balance sheet, their assets. They tend to ignore the right-hand side. This chapter briefly addresses the issues related to the liability side of the balance sheet. We begin with the home mortgage, as it is the largest debt obligation for most individuals.
Most people use a mortgage to finance the purchase of a home. Mortgages raise some important questions. How should the mortgage be treated in terms of determining your asset allocation? For investors with sufficient assets to have alternatives to using a large mortgage the questions are: Do I use my investment assets to keep the mortgage to a minimum or to pay down an existing mortgage, or do I borrow the maximum? As is often the case in investing, there is no right answer, just one right for each individual. Let's review the important issues that should be considered.
A mortgage (or any other form of debt) should be considered as negative exposure to fixed-income assets and treated as such in the asset-allocation picture. For example, if you are holding a $200,000 mortgage and have $200,000 of fixed income assets, your fixed-income allocation is zero, not $200,000.
It is unlikely an investor can beat the risk-free rate of return on a mortgage if the fixed-income asset is held in a taxable account (unless interest rates have risen significantly since the debt was incurred). If fixed income assets can be held in tax-advantaged accounts, depending on the investments chosen and assumed tax rate, borrowing might be advantageous.
If a home is financed with a fixed-rate mortgage, the fixed rate provides inflation protection. A fixed-rate mortgage also has a feature enabling the borrower to prepay the loan if interest rates decline, usually without prepayment penalties: refinancing at a lower current rate. This provides protection against deflation and, for those with reinvestment risk, falling interest rates. If a home is financed with an adjustable-rate mortgage, the risk picture is considerably different, the rate moving up or down as interest rates change. Note that adjustable-rate mortgages do have annual and lifetime caps on the maximum amount the rates can adjust (up or down).
Having little or no mortgage provides a high comfort level for investors. This is the "sleep well" issue. With little or no debt, investors are likely to be more comfortable accepting the risks inherent in equity investing and more likely to stay disciplined during the inevitable bear markets.
With little or no debt, investors may feel more comfortable taking the greater risks inherent in value and small-cap stocks, allowing for higher expected returns within the equity allocation.
From an investment portfolio standpoint, the principal reason to hold a mortgage is if the investor has a high need to take risk and estimates a large equity premium. The relatively low after-tax cost of the mortgage compared with the possibility of large relative returns from tax-efficient equity investing can make the mortgage an attractive alternative. As an example, assume a mortgage rate of 6 percent. The after-tax cost for a high-bracket individual is probably under 4 percent. On the other hand, an investor might expect his equity portfolio to return 10 percent and do so in a highly tax-efficient manner. That large differential can be tempting, but it means the assumption of all of the risks of equity investing.
The right answer ultimately comes down to the investor's marginal utility of wealth. The greater the marginal utility of wealth, the more equity one should hold (and thus have as big a mortgage as possible) and vice versa. Run the math before drawing any conclusion, including a Monte Carlo simulation as to asset allocation (see Chapter 16).
Many individuals are faced with the choice between either prepaying the mortgage or increasing their investments in tax-advantaged retirement accounts. The study, "Responsible Fools? The Trade-off Between Mortgage Prepayments and Tax-Deferred Retirement Savings," examines whether individuals were making financially optimal choices.[9]
The benefit of increasing the contribution to a tax-advantaged account is that the investment grows either on a tax-free basis (Roth account) or on a tax-deferred basis (IRA, 401(k), profit sharing). This allows for a tax arbitrage: mortgage interest is tax deductible if one itemizes, while earnings inside the retirement savings account are either tax deferred or tax free. That benefit more than offsets the slightly higher rate on the mortgage than can be earned by investing in a mortgage-backed security (MBS) of similar maturity. The advantage is enhanced by increasing the investment into a 401(k) plan if the individual also gains a matching contribution from the employer.
The authors concluded that almost 50 percent of individuals would be better off increasing contributions to retirement savings accounts rather than prepaying their mortgage. The individuals most likely to benefit are those in high tax brackets. The decision to increase retirement savings would yield incremental savings of between 11 cents on the dollar (if the investment is made in Treasury instruments); 17 if the investment is made in higher yielding MBS. The cumulative cost of inefficient decisions approaches $2 billion a year.
These benefits are basically riskless, a tax arbitrage. So, why do individuals forgo them? The authors hypothesized that a high aversion to debt—the desire to be debt free—can drive the "investment" choice toward paying down the mortgage instead of increasing retirement savings.
Three other points are worth noting. First, those with mortgages with a loan-to-value (LTV) of more than 80 percent should consider paying down the mortgage to that level, eliminating the cost of mortgage insurance. Second, the liquidity risk should be considered: Withdrawals from tax-advantaged accounts prior to the end of the early withdrawal period (prior to age 59½) face a 10-percent penalty. Of course, as you approach 59½ the risk of having to make an early withdrawal decreases. Third, if the money that would be invested in the tax-deferred accounts will be invested in low-yielding fixed income, it may make sense to pay down a mortgage. The mortgage rate might be so much higher than the fixed income yield that it swamps any tax arbitrage opportunities. As always, check current mortgage rates to see whether you can refinance at a lower interest rate.
Credit-card debt is generally the most expensive form of debt, and interest is not tax deductible. A good rule of thumb is that the first "investment" an individual should make is to pay it down, prior to any equity investing. Unless the debt is expected to be outstanding for a very short time, equities held in taxable accounts should be sold to pay off credit-card debt.
Nonsubsidized car loans and student loans are similar to credit-card debt, so the same rule of thumb generally applies. There may be cases where the loans are made at below-market rates, such as with car loans (when the price is discounted through the financing instead of lowering the price) or student loans. If the investor can earn a higher rate of return by investing in high-grade fixed-income securities, it doesn't make sense to pay down the debt early.
In most cases, we believe that individuals should not use margin to buy equities. With the cost of the margin being higher than the risk-free rate, equity investors using margin earn less than the market's required return on the margined asset. Part of the incremental risk is the risk of margin calls that might not be able to be met. Using margin for investing purposes is an inefficient use of one's capital, the rewards not commensurate with the risk. Only an investor with a very high marginal utility of wealth and a very high tolerance for risk should use margin to increase the equity allocation beyond 100 percent. As we discuss in Appendix A, there is a more prudent way to increase the expected return of the portfolio: Increase the exposure to the riskier asset classes of small-cap and value stocks. Higher expected returns fully compensate the investor for the incremental risk.