Monday, March 25, 2019

The New and Improved Bond Mortgage Swoop

The New and Improved Bond Mortgage Swoop
Last week, we dreamed up the idea of our mortgage swoop, where we'd pay off our mortgage all at once as soon as our financial independence fund got to $1M plus our mortgage balance. The feedback from readers was a little...mixed. With few in outright support of the swoop, I think the general consensus was that even if the plan isn't optimal by the numbers, it is at least simple, straightforward, and good in the sense that being without a mortgage in early retirement can be a pretty good thing on its own.

Then I tweeted out to Big ERN as well as Joe & OG from Stacking Benjamins, just to get the take from some people who know more about analyzing financial options than I do. Instead of just giving his opinion on the swoop, Big ERN threw out an entirely different idea, too.
It just so happens that we do have bonds. We use Bernstein's Simpleton's Portfolio, which calls for 25% of our investments to be held in short term US bonds. The kind of very safe, very boring bonds that yield something like 2%: less than our 3.75% mortgage rate.

For the three of you who aren't already bored to tears hearing about a mortgage payoff plan last week, let's examine a new an exciting one: the Bond Mortgage Swoop.

The proposed plan has four steps.
  1. Sell about $205k of bonds and pair them with the cash we have on hand (mostly from recent property sales that was going to be dollar-cost-averaged into our FI funds)
  2. Pay off the $260k mortgage
  3. Do a cabbage patch
  4. Between now and our FI date, use our extra monthly cashflow to get our bond allocation up back to 25%
Step three is critical.
There are some good things about this plan:

One, we would not have to sell any of our stock mutual funds, only our bonds. Since we're leaving the stocks alone, the typical arguments about opportunity costs for paying off the 3.75% mortgage are somewhat mitigated since we're not selling stocks to pay down the mortgage but, rather, just the lower yielding bonds.

And as Big ERN notes, we'd technically be getting a better return with the guaranteed 3.75% return than with the certainly-not-guaranteed return of our bond fund, which is subject to things like interest rate and credit risk. Below is how our humble bond fund has fared in the past.

Source: Vanguard
Historically, the mortgage rate is higher than each of the bond fund's average annual returns.

So what's not to love? We get to be mortgage free later this month, we'd potentially get a better return with the debt repayment than the bonds have historically provided, and we get to keep all our stock funds right where they are. What could go wrong?

Well, there do seem to be at least a couple downsides to this bond mortgage swoop.

Problem one: All our bonds, like every last one, are in retirement accounts due to us trying to be tax efficient. That means getting them out is going to incur some taxes. Oh, the irony. To create a 'net' sale of bonds, we'll have to do some maneuvering: selling many, many lots of our stock funds that are in our taxable accounts and then, on the same day, buying those same amounts in our tax-advantaged accounts, our IRAs and in our 401k brokerage account, to offset them.

But since we are going to definitely have some capital losses to harvest, and we definitely want to avoid a wash sale, we can't buy the exact same or substantially similar investments.

I guess it's not all that complicated, but say we sell $50k of VFIAX, $50k of VSMAX, and $100k of VTIAX in our taxable account. Then we'd have to buy three funds that are similar but not too similar to them in our IRAs and 401k. The end result is that we'd have about $200k of bonds gone, while holding roughly similar stock positions.

But all that leads to the second problem.

Problem two: Selling investments in our taxable account, in order to really 'sell' our bonds, is going to create some capital gains, and thus some capital gains taxes.

How much in taxes? I had to do some exporting and build a spreadsheet to see how painful the tax bite is going to be.

I went into our taxable accounts, looked at the cost basis of all our historical purchases in our three stock funds, and sorted the lots which had the losses (short and long term) as well as small/reasonable gains, trying to find the most tax efficient lots to sell.

I'll spare you the gritty details (the final plan would involve us selling 166 individual lots in order to get the money we'd need) but here is the high level summary:

Only a grand in capital gains taxes? That's not so bad. I'm looking for the most attractive lots in our taxable account, but still, I was anticipating a higher figure. [I suppose this is a good time for a disclaimer that I'm not an accountant or financial professional, that you should consult one of those people if you're considering any moves like this. None of this is advice.]

Still, there's one more potential problem with the approach.

Problem three: We are drastically changing our asset allocation in order to pay off a mortgage.

One of the sneakier risks hiding in this plan is that if there's a big, scary market correction, we're probably going to be without our most effective tool to mitigate that: our annual rebalance. Each August we rebalance our four investments to go right back to their 25% target in the Simpleton's Portfolio.

If stocks take a nose dive, we're not going to have a big pile of bonds lying around, ready to buy a bunch of equities on sale in that rebalance.

We'd go from having about 25% of our portfolio in short term bonds all the way down to only 4% bonds. Even with our increased cashflow post-mortgage payoff, it will take a couple years of bond-heavy purchases to get our asset allocation back to our original target. If a stock correction happens during that time, there probably isn't going to be a whole lot of rebalancing happening, unless we want to just throw our asset allocation out the window entirely.

In our efforts to get rid of our mortgage, we'd be jettisoning the bonds that diversify our portfolio. As we always seem to do, we'd be trading one type of risk for another.

So anyway, there you have it. Two different whack-ass mortgage payoff strategies in back to back weeks. Do you like Big ERN's idea to use our bonds to be mortgage free right now?

Do you prefer mortgage swoop classic?

Or would you go another route altogether, like a traditional mortgage payoff or just keep the mortgage through financial independence, like Carl at 1500 Days?

As always, thanks for reading. I'll make a promise to both of my readers that we'll get back to our regularly scheduled programming of liberal guilt and half-baked progressive policy talk next week.

*Photo is from D H Wright at Flickr Creative Commons.


  1. I'm no master here, but the strategy seems complicated. Especially when you could just go the traditional mortgage payoff (using cashflow to pay it early).

    You would, also, be maneuvering out of bonds, to again build up your position to bonds after your mortgage payoff.

    How long would it take to payoff the mortgage early with after tax cash flow? 2, 3, 4 years?

    1. Hi there SFL. Agreed, this plan is very complicated.

      The timeline for paying off the mortgage with our extra cash flow alone would be over five years, about two years longer than our hypothetical FI date. I think that might be part of the reason we'd be willing to use our investments pay it off sooner (though as you note, we'd be replacing them in this scenario).

  2. I think that all the maneuvering is unnecessary. Yes the bond fund yields a lower rate that the mortgage balance now, but what about in
    10 years. The mortgage rate will be the same. Also you change your mind a lot, so I can see you getting to the end of the swoop and saying you know I think I'll just keep this big pile of money and pay the bank just a little bit of it every month.

    1. Tim, you are 100% right about the fact that we change our minds a lot, especially regarding the mortgage. That was one reason I was in favor of the original mortgage swoop. If we get to $1.26M and decide "Hey, let's just keep the money invested" then there's no problem because we haven't given it to the bank yet.

      The fact that we do pivot a lot on our thinking is one reason I'm not all that keen on the traditional mortgage payoff plan, which would take five years and has a good chance of us changing our minds mid-stream.

  3. If your children plan to go to college and you hope to get financial aid, you will regret giving up the retirement space (yes, home equity is also hidden from financial aid, but there are limits). I don't understand why swoop at all. There's nothing magical about having it paid off. Money has opportunity costs.

    The interest rate on a mortgage is different than the interest rate on, say, bonds, because the mortgage does not amortize. Early payments will be worth more than later payments. But that's not going to be worth paying a 10% penalty and losing tax advantage and having the money hidden from college financial aid calculations as retirement savings.

    1. Hi Nicole,

      Just wanted to clarify a few things. There are no penalties since we're not taking money out of any retirement accounts. There are also no tax advantage losses: we're not reducing the amount of money in any of our retirement accounts.

      Given that, I'm not sure there is going to be an impact on something like FAFSA calculations either, if the retirement accounts are being left alone.

      You're losing me a bit on the opportunity cost argument. What opportunity costs are we suffering if we keep money our money in bonds, rather than using those funds to pay the mortgage? I feel like I'm missing your point here.

      I obviously don't think there's anything magical about having the mortgage paid off. Indeed, opportunity costs are precisely why I think Big ERN is suggesting we sell the bonds in the first place: their return at 1, 3, 5, and 10 years are all far less than our mortgage rate. But maybe I'm missing something.

    2. What with me being unable to comment from my phone and then consistently failing the capcha code when I finally get to a computer and then my comment after skimming the post at said computer sounding stupid, I think the universe is telling me I should give up commenting on your blog.

      Ok, when you said incur taxes, you meant the capital gains tax from selling your taxes from taxable accounts. Because you have bonds in your tax-deferred accounts. It would make sense to have your low return investments out of the retirement accounts and your high return investments in them anyway. But no, if you're not actually taking money out of retirement accounts then taking your taxable money and putting it into your house at least two years before your first kid goes off to college is a good idea.

      The house and bonds are "safe" investments. The house is not as diversified as bonds because it is one house in one real estate market. Whether or not that's a problem depends on whether or not you ever need to move (and depending on circumstances, how one feels about bankruptcy).

      Again, I do want to reiterate that early payments to the mortgage are worth a lot more than later payments. They don't have a constant interest rate like bonds do because of how early payments are mostly interest and later payments are mostly principal. You can play with a mortgage payment calculator to see that. Maybe you've already done that and I'm just sounding dumb and condescending again. Monetarily it makes sense to prepay the mortage early on and then put money into bonds later if you want that safe investment. When we were doing this, I had calculations about how much interest I was saving off the next month's payment and how much interest it was saving over the life of the loan should I stop prepaying the next month. The GRS amortization calculator spreadsheet is very nice for this exercise.

      Now to fail finding cars and buses and traffic lights.

    3. Sorry that you're having trouble commenting on the blog, Nicole. I unfortunately don't know much re: troubleshooting that bit, as I know less about coding and technology than your average seventh grader.

      To address some of your points:

      "It would make sense to have your low return investments out of the retirement accounts and your high return investments in them anyway."

      Vanguard & the bogleheads advise to do the opposite, for what it's worth: because bonds throw off dividends and stock funds primarily have capital gains, they recommend putting all available bonds in your taxable accounts. I think this is particularly good while you're working & in a high tax bracket; we may indeed shift closer to your line of thinking in early retirement when our income (& income tax rates) are low.

      "Again, I do want to reiterate that early payments to the mortgage are worth a lot more than later payments."

      Yep! I was surprised to see you pan this swoop plan as well, because, well, it's one big payment, and as early as possible. It gives the biggest bang for our buck.

      "Monetarily it makes sense to prepay the mortage early on and then put money into bonds later if you want that safe investment."

      Yes, essentially this IS the bond mortgage swoop plan. But I suspect I'm doing a poor job explaining it in the post, which is par for the course around here. ;)

    4. "It would make sense to have your low return investments out of the retirement accounts and your high return investments in them anyway."

      "they recommend putting all available bonds in your taxable accounts"

      Isn't that actually the same thing? I would say Bonds are low return investments (she said OUT of the retirement accounts i.e. the taxable accounts).

      Anyway, I didn't comment on the last post as others had pretty much said it all, but FWIW I like this ERN plan better.

      Also I don't really see how a market correction would be too bad because you would just buy monthly into stocks and shares to keep your allocations up rather than having to rebalance. So you can rebalance as you go.

      For example in month 1 say the market crashes so you would be 2% under allocated in stocks, well instead of buying stocks and bonds with your cash flow that month, you would just plough it all into stocks. You may be very slightly out on any given month if there is a ridiculous crash, but I don't think it would take that long to get your allocations back to what you want them to be over say 2-3 months.

      This is assuming that you are happy for your house equity that you just paid off to count as part of your 25% bond allocation, which I think it makes sense that you do that because you are happy to swap one for the other which is implicit due to the nature of the plan in the first place.


    5. Whoops! I meant to type that the bogleheads/Vanguard recommend putting bonds IN retirement accounts (the dividends they throw off are taxed at worse rates than capital gains).

      We're considering both swoop plans but was honestly hoping to have a more general consensus on the two ideas, and which was better. Lots to think about to be honest but we're going to keep pondering it over.

      Thanks for commenting, friend!

  4. You should do what you want. Paying off the mortgage or investing are both good calls. You can't go wrong with either decision.
    We're going to keep our mortgage. It's not a big deal to us anymore. It's simpler than trying to maneuver to pay it off.

    1. Carl at 1500 Days suggested the same thing, and you guys are actually living this early retirement life, while I'm still just planning for it.

      I'm guessing you already read Big ERN's post on mortgages in ER. For what it's worth, it's this exact post that has us spooked and making us want the mortgage gone before ER:

  5. I hadn't weighed in on the earlier post because I had no useful opinion and I honestly still don't. I like seeing all the permutations of what you COULD be doing but I tend to strongly err on the side of more simplicity than complication when possible because I know that the more details I juggle, the more likely it is I'll miss a step.

    I was smiling a bit at Nicole&Maggie's "there's no magic in a paid off mortgage" because I feel like my response to that is very much - but YOUR grass is greener!!


    I would very much like to eliminate the debt for the sake of eliminating the debt and I want that nearly to the point of not caring about opportunity cost but at this point in our journey I don't think we personally can afford to ignore opportunity cost either. We aren't close enough to an FI number to just not mind if something is a little more or less than we expect, every penny counts.

    So we will personally keep investing aggressively and figure out what to do with the mortgage when we get closer to the finish line. I might even adjust our annual goal for the mortgage this year, thinking about this further with the anticipation of wanting more cash on hand to face whatever recession happens in the next year or two.

    So basically I have been no help to you here :)

    1. Love that whole comment, Revanche. Even if it technically is not helping me. ;)

      I similarly really like looking at all the possible options. Having paid off a mortgage before with the 'traditional' path of just making regular payments to principle, I'm not really in love with the risk inherent of a job loss/disability event/other big bad thing happening in the middle of the five to six year payoff. I'd rather do it all at once and quick (swoop later, or swoop now with the bonds).

      But as you noted, it's anything but simple. The post doesn't even begin to address how tricky it will be to sell those 166 individual lots (and, whoops, since these stocks change in value every day, I'd have to recalculate on the day of just to get the right estimates of taxes & sales prices).

      Anyway, I'm definitely back on the 'no mortgage in early retirement' train but no idea if that means doing it now, over a few years, or waiting until we're retired...

  6. I'd be wary of depleting that much of your diversification, but I'm also a worrier. I say just make some extra payments now and/or make one big payment once you hit FI + mortgage. Especially if it means NOT selling off 166 individual lots!

    1. Hi Abigail! That is also our worry with this plan. That as soon as we do it, the correction comes and we're without our bonds, so we can't take advantage of the dip in a rebalance.

      The swoop later certainly has some attractiveness to it in that regard. We can keep our AA intact throughout.

  7. Use the bonds to pay off the mortgage and then use the exhilaration from paying off the mortgage AND the panic of the loss of your bonds to replace them asap. I like using emotion as a motivator. I paid off my mortgages because it was thrilling and motivating regardless of whether is was the most financially beneficial because I found that lifestyle inflation was getting in the way of my investment plan.

    1. Oooh, I like that, Daizy. Behavioral economics for the win, I think.

      With all the talk of math, you're the first one to really focus in on how our behavior might improve simply because of the payoff.

  8. Well, the great thing about this is that it is personal finance. Sounds like you want the mortgage paid off more than you want the taxable accounts and the like. I think that is personally fine. However, why are you doing the simpleton portfolio? I mean I get it trying to smooth out your returns, but why now when you aren't FI yet. Why not wait and then do the portfolio?

    1. Hi Jason!

      We're doing the Simpleton's Portfolio now in particular because we're so close to our FI date: the sequence of returns also has an outsized impact on our success rates in the few years immediately prior to retirement, too.

      In fact, if we really want to be done by forty there's probably an argument to go even heavier into bonds now.

  9. You might consider retiring your mortgage but opening a HELOC. The HELOC will have a higher interest rate, but you only draw down if you need it. The problem with paying off your mortgage is that if you need the cash, you won't qualify based on equity but based on income.

    1. That's a neat idea and one we might just steal. Thanks, Caroline!

  10. This comment has been removed by a blog administrator.

  11. Your mortgage is leveraged against your entire portfolio, not just the bond portion. You pay off your mortgage in proportion to your portfolio, i.e. pay it off with 75% stocks/25% bonds to retain the same asset allocation.

  12. At 3.75% I would not pay off the mortgage any quicker than the regularly scheduled payments. The mortgage doesn't "know" that it's only supposed to be leveraging your bond portion of your portfolio. It's leveraged against your entire Asset Allocation. Therefore your arbitrage is measured not against the interest you collect on your bond investments, but rather, your earnings or expected earnings on your entire portfolio. If you feel your portfolio is too "risky" as it is, the solution is not to eliminate the mortgage; rather, it's to reallocate some of your stocks into more bonds. If you want to be at 75/25, and counting the mortgage as a negative bond, you have to sell enough stock, and buy enough bonds, so that after you subtract the negative bond component represented by the mortgage, you're at 75/25. So if you have $1,000,000 stocks, 0 bonds, and a $250,000 mortgage ($250,000 negative bond), you actually have to sell $437.5k worth of the stock and buy $437.5 worth of bonds (although I would stick with intermediate term bonds except for maybe about two years worth of expenses in short term, but you don't really need to even do that. Your choice.) So anyway this leaves you with $562.5 stock, $437.5 bond, and $250 negative bond. 437.5- 250 = 187.5 which is your net bond allocation. Your total equity is 1,000,000 - 250,000 = 750k. Your AA is 562.5/750 = 75%/25% net stock/bond allocation.

  13. You end up with: $562.5 stock; $437.5 bonds; $250k mortgage (negative bond--actually it's a negative "mortgage backed security" which isn't exactly the same thing as a bond). Your overall AA is 75%. Which is quite aggressive enough. What you're doing by leveraging your entire portfolio with the mortgage is straight out of standard portfolio theory: figure out your preferred risk level and then borrow money (if you can get it at a favorable rate) and leverage the portfolio to increase returns, INSTEAD OF increasing returns by using zero leverage but increasing your equity allocation. The problem with having an effective equity allocation of 100% (or more) is it exposes you to an unacceptable amount of concentrated "tail risk" from a bad equities market crash. By using leverage at a favorable rate (and 3.75 is a VERY favorable rate!), yes it's true you are substituting leverage risk, it's a different kind of risk, so you are diversifying your sources of risk to increase return, which is precisely what you should be trying to do. Your risks from having the mortgage are very different then the risks from having a higher net allocation to equity, which concentrates your risk in a single area which you can't really control. There are many benefits to having a mortgage at a favorable rate such as 1) built in put option to refinance if rates drop lower--although unlikely, in the event of a horrible stock market crash and bad recession, like ten years ago, your stocks will crater--but at that time, interest rates might also go way way down too as the Fed tries to stimulate (as it did last time interest rates went way down). So because you have diversified your sources of risk, you can actually conceivably take advantage of a recession/bad stock crash by refinancing to a lower interest rate. Also, in many states--and I don't know where you're from---there are a lot of consumer benefits with a mortgage. You can have mortgage forbearance, work out a deal with the bank, sell the house if you had to, or even do a short sale. Or you could just continue paying the monthly nut and as long as you are able to do that, you can survive till the stock market recovers. That will be much easier to do if you've got the mortgage AND the extra $250,000 in safe bonds sitting around because you DIDN'T pay off that mortgage.

  14. If you look at Vanguard's page a 75/25 portfolio returns an average about 8-9%/year. By keeping the mortgage, you're paying 3.75% /year interest and in exchange (at least over let's say 10-20 years) you should average around at least 8% a year returns so that's a very positive arbitrage situation. Even if if it's a couple of percent less average return you still win long term.

  15. Another way of looking at the mortgage pay off is that you're in effect "buying" a $250,000 mortgage-backed security from a single debtor, on a single property. In this case, you're buying it from yourself. That's a very undiversified way to invest your money. Think about it for a second. Wouldn't it be rather foolish to invest $250,000 in a single debtor's mortgage on a single property, if that's a substantial portion of your total investible assets? Fundamentally it doesn't really make any difference that you're buying the mortgage from yourself. If instead you take that $250,000 and invest it in say an intermediate term bond fund, you should over time make about the same interest rate, if not more, and even if you make less, you are much better diversified, because a bond fund/index fund has thousands of different bonds, not just a single huge mortgage backed security from one person, on one property. Besides, as I pointed out in one of my prior comments, you're actually leveraging the entire portfolio when you use the mortgage, not just the bond portion.

  16. Critical to the analysis of increasing return by using a favorable mortage rate to leverage your portfolio, rather than no leverage and an overly heavy stock allocation, is understanding that your Sharpe Ratio doesn't change (at least not in theory) depending upon how much leverage you apply to the portfolio. Sharpe Ratio measures your risk adjusted return, or return per unit of risk taken. Using cheap leverage such as your low interest rate long term fixed mortgage (which unlike brokerage margin is uncallable) doesn't change your Sharpe Ratio. You do add the expense of the leverage however which somewhat diminishes portfolio efficiency.

  17. There are a number of related benefits from maintaining the mortgage and a higher bond allocation. Obviously if there is a financial crisis, market crash, etc., that's the time when a lot of people also lose their jobs. Having an extra 250k available will give you much better liquidity at exactly the time when you need it most. You won't be able to refinance your house to pull money out of it during the next market crash if part of that involves being unemployed for a while (as happened to a number of people in the 2008 debacle). And of course--if you're a rebalancer, and let's say your job is safe and sound in the next bad recession/crash, you have the optionality of "buying low" with some of those liquid bond funds that you didn't prematurely pay off your mortgage with.