Mortgage or 401K?

Had a back and forth today on Twitter with Michael Kitces (I’m a huge fan!) regarding whether it makes sense to put money in a 401k if you have an existing mortgage.  I know.  So exciting! XD (I was actually objecting to the idea that you should pay mortgage before emergency fund, from the originally referenced tweet.  Apparently he only meant the 401k.  But I still disagree, somewhat).  His position is to pay off the mortgage first, because otherwise it is the same as taking out a HELOC to invest in stock market.  Which it kind of is.  Here is his post on the topic:

To understand the paradox, let’s look at a simplified example here. Imagine you have a client with a $500,000 house and a $400,000 mortgage with a 5% interest rate, who also has only $100,000 in investment accounts; the client’s net worth is $200,000 (with $100,000 of equity in the house, and $100,000 in investment accounts). In addition, the client has managed to generate $20,000 of free cash flow by the end of the year, and asks what to do with it: he could either use the $20,000 to pay down his mortgage, or to put into his investment account (or into his 401(k)). The standard advice from most planners would be pretty straightforward: keep the mortgage as long as possible, because it’s only a 5% interest rate, while stocks have a much higher long-term average return, and save the money into the investment account for long-term growth. Had the client used the money to pay down the mortgage, he would have finished with a $380,000 mortgage and a $100,000 investment account; instead, by saving the money for growth, the client has a $120,000 investment account (and still holds a $500,000 house with a $400,000 mortgage).

So what’s the problem? Imagine if the client instead had simply come to us and said “I have a $500,000 house with a $380,000 mortgage; should I take out a $20,000 home equity line of credit at 5% to invest in stocks in my $100,000 investment account?” Almost every planner I know would say “NO!” That’s a little too risky. Keeping your mortgage is one thing, but proactively taking out debt against your house to invest in the stock market is another thing. Even FINRA has an Investor Alert out against mortgaging your house to invest in securities unless you are really comfortable with “betting the ranch” on stocks (which most seem not to be, when framed this way).

The problem is, these are still the same thing!

Well, it’s kind of the same thing, but not exactly the same thing.  Borrowing more against a HELOC to invest is not the same as investing instead of paying down a mortgage.  The HELOC will have to be repaid, so payments will increase, or be extended.  You will have reduced your home equity, and skewed your asset allocation.  In addition, you have in the first scenario a client who is generating $20,000 cash per year extra.  In the second, not so.

So what’s the bottom line? If we wouldn’t tell our clients to borrow money to buy stocks in their investment account (I say stocks, because certainly we wouldn’t be buying bonds that yield less than the cost of the loan) in the first place, we probably shouldn’t be telling them to keep their mortgage and direct savings to the investment accounts, either. Yes, I realize in some cases that can lead clients to have a lot of equity in their house and not a lot in their investment accounts: but the reality is that that imbalance occurs not because they pay down their mortgage, but because they invested so much money into a real estate asset (the house) in the first place! In other words, if your clients are concerned about being “house rich” and investment-account poor, the key is not to keep the mortgage, and debt, and leverage, and risk… the key is to not put so much money concentrated into real estate assets in the first place!

As he noted here, you wouldn’t buy bonds returning less than 5% with money borrowed at 5%.  I would submit that the mortgage itself is a very bond-like financial instrument, even for the payer.  You could look at your home equity as having somewhat bond like behavior, and maybe you prefer to have some money invested in higher risk assets (with presumably higher returns).   If the client has a plan that includes sale of this (presumably high value) home at some  point in the future, and the home and the mortgage are part of the financial plan, then the advisor should be able to determine what really makes the most sense.  Even if the client does not ever want to sell the home, as long as the plan includes retiring the mortgage before the client, it might be a better plan to invest while paying down the mortgage.

Saying that it’s always best to pay down the mortgage first is like saying that you should invest all in bonds while you are young.

It’s also not helpful to tell the client to buy less house.  There are lots of reasons that this can happen other than “I want the biggest McMansion that my salary will allow.”  They may live in an area where they are faced with either paying a lot for a house or paying for private school for their kids.  In some cases, mortgage is held on a second or even third home.  I would encourage clients to pay down mortgages to the point where they are unlikely to go underwater (say, 50% of current market value).  At that point, it really does become a bond like asset.  That mortgage payment feels a lot more like paying rent, rather than risky leverage (because it is).  Why shouldn’t they invest in stocks while paying off a vacation home?

And I would have to look on a case by case basis to see what makes sense as far as amount to pay down mortgage vs. amount to invest.  Don’t forget that compound interest thing for the investments, not just the mortgage.

And of course, there are tax considerations, both with the mortgage and the 401k.

I didn’t do any math at all here, so maybe I’m about to get my butt kicked…


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