Stocking Up

Jonathan Clements

IT’S ANECDOTAL evidence, so take it with a grain of salt. Still, I’m once again hearing a dangerous argument—that you should always carry the largest mortgage possible, so you have extra money to stash in stocks.

During the roaring bull market of the late 1990s, and during the booming market for stocks and real estate in 2005 and 2006, readers regularly wrote to me, making the same argument. The strategy isn’t without logic—and it isn’t necessarily a sign that stocks are about to crash. Nonetheless, I consider it wrongheaded, for three reasons:

1. You’re making a leveraged bet on stocks. To be sure, it isn’t like buying stocks in a margin account, where you could get a margin call if stocks fall far enough, possibly compelling you to sell shares at fire-sale prices. Still, the mortgage-to-buy-stocks strategy makes your finances far more perilous.

Imagine two choices. With option A, you have $100,000 in stocks and a mortgage-free $100,000 home. With option B, you have $180,000 in stocks, plus a $100,000 house saddled with an $80,000 mortgage. In both cases, your initial net worth would be $200,000. But if stocks fell 50%, your net worth would drop to $150,000 with option A—and plunge to $110,000 with option B.

I readily concede option B will likely generate greater wealth over the long haul, provided you diversify broadly, keep investment costs low and stay the course. But how many folks really would stay the course? Even if you don’t panic and sell when your stocks are down 50%, you might be forced to sell—because you lose your job during the accompanying recession and need to cash in stocks to pay the mortgage.

2. Paying down a mortgage offers a guaranteed return—one that will likely outperform high-quality bonds. Today, you can get a 30-year fixed rate mortgage at 4.1%, which seems like cheap money. Who wouldn’t want the largest mortgage possible? Problem is, paying 4.1% to others doesn’t seem so cheap when you can only earn 2.4% by buying 10-year Treasury notes or just 2.8% with intermediate-term corporate bonds.

Yes, your mortgage interest should be tax-deductible. But Treasury bond interest is taxable at the federal level, and corporate bond interest is taxable at both the federal and state level, so the tax argument is pretty much a wash.

What if you bought your bonds in a tax-deductible or Roth retirement account? Your tax-adjusted return might be higher than your gain from mortgage prepayments. But remember, you’re limited in how much you can invest in tax-deductible and Roth accounts each year. If you’re an aggressive investor, you will likely want to use those tax-favored dollars to buy your highest-returning investment, which should be stocks.

A digression: It’s been argued that, if you buy stocks in a traditional retirement account, you convert gains—which would have been taxed at the lower long-term capital gains rate—into retirement account withdrawals that will be taxed at the higher ordinary income tax rate. But there’s another—and, I believe, more accurate—way to think about the tax issue: No matter what you buy, your gain should be effectively tax-free. With a Roth, that tax-free growth comes as part of the package. But with a tax-deductible retirement account, you can also end up with tax-free growth, because the initial tax deduction pays for the final tax bill. I explain the math in HumbleDollar’s online money guide.

The bottom line: Maintaining the largest mortgage possible might make sense if you have nerves of steel and you’re fully committed to a leveraged 100% stock portfolio. But if you have any inkling to hold bonds along with your stocks, you’ll likely find a better combo is paying down your mortgage with taxable account savings, while using your tax-favored accounts to buy stocks. Eventually, with the approach of retirement and the need for a more conservative portfolio, you may want to hold some bonds in your retirement accounts. But until then, your top priority with your conservative dollars should probably be paying down debt, including mortgage debt.

3. Buying a home locks in housing costs—and paying off the mortgage dramatically reduces them. Housing is the single biggest expense for most American families. Indeed, lenders will typically allow you to take on mortgage payments, including homeowner’s insurance and property taxes, equal to as much as 28% of pretax income.

But once you’ve bought a house, that percentage should shrink over time, if only because your income is driven higher by inflation. Arguably, that’s the big advantage of homeownership. While renters often see their monthly payments climb as quickly as their paychecks, the housing costs incurred by owners should slowly decline as a percentage of their income—and, once the mortgage is paid off, those costs will fall sharply.

That’s a magical moment. Suddenly, your fixed living costs are so low that it becomes much easier to pay the kids’ college bills and save for retirement—and you might even discover you can quit the workforce entirely. Indeed, for many folks, making that final mortgage payment is the signal that retirement is finally affordable.

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