So We're Going to Pay Off the Mortgage

Talking things over with a few friends last week helped us make a decision: we're going to pay off the mortgage. All at once, by using the remaining cash we have from selling our two rental properties, but mostly by selling investments we have in our taxable accounts.

I already know from our mortgage swoop posts that most people probably won't like this idea. I'll try my best to explain our rationale, which I really do think is sound. But I'm not trying to convince other people that this is what they should do. Instead, I want to explain where we're coming from, our thought process, and just want to be as transparent and honest as I'm comfortable with on the blog.

Transparency hasn't always been my approach. The last time we paid off a mortgage, with our first home back in 2013, I wrote about it and the post got a little publicity. A reporter from a major outlet interviewed me about it and then, the next day, I emailed her and asked if she would kill the story. 

Mrs. Done by Forty and I were convinced that someone would piece together the details, and our anonymity would be blown. What if our real names got out there? Would one of the right wing jagoffs I argue with online end up finding our home address? A lot of these dudes have guns. Some people happily threaten violence over Twitter. What if I pissed off the wrong dude?

Thankfully, the reporter was willing to stop the story. That scare nonetheless started a trend of being less and less open on the blog. I took down the post outlining our mortgage payoff. Weeks later, I'd deleted all our net worth and monthly 'budget porn' posts. I stopped revealing as much about our financial lives, and any thought of meeting other bloggers at conferences like FinCon or at meetups was out of the question.

Recently we've started realizing that our anxiety might not be entirely justified. No one really cares about our situation, as far as I can tell. And with other bloggers inspiring us to be more transparent, to be more honest about our situations, we're more comfortable sharing some of the details.

So yeah, about that mortgage payoff.

Here's the basics of our current situation:

• $262,000 owed on the mortgage
• 3.75% on a 30 year fixed, only about two years in
• If we threw everything we could at the mortgage, including dividends from taxable accounts (while still maxing out our tax-advantaged accounts, because, taxes) we could put $40k additionally towards principal each year, but wouldn't be mortgage free until a little over five years. 

But because I want to be done by forty, here's our current plan, to be executed in July.

1. Take our available cash and earmark that for the mortgage payoff. (We'd been dollar cost averaging these funds from two somewhat recent investment property sales.)
2. Sell the most advantageous lots in our taxable accounts to minimize taxable gains. This means selling any lot with a loss first, then sell those with the smallest gains, looking for the lowest % long term gains (net, after offsetting losses, are taxed at 15%), trying to avoid any lots with short term gains (net, after offsetting losses, are taxed at our marginal tax rate of 22%).
3. On the plus side, we'll have another $1,300 to invest each month without the P&I portion of the mortgage. If we spend at our same levels but invest that extra money, with our new, no-mortgage budget for two years, we'll only need about a 3% return each year to hit our goal of being financially independent by the last day I'm forty. Seems possible.

Okay, that's a lot of numbers. Way too many numbers for a Monday morning. Let's look at some cute golden retriever puppies to get our minds right.

Whew! Tiny goldens to the rescue.

Now that we're centered again, we can dig into the plan a bit more.

Since we are selling investments out of our taxable accounts (roughly $200,000 worth) this will generate some capital gains taxes.

Wait, where are you going? Please, don't leave. I'll keep it short. Here, here are more puppies.

Bottom line: we'll pay somewhere around $1,400 in capital gains taxes to execute this plan.

On the plus side, we'll avoid over $10,000 in interest each year without the mortgage. (This naturally would reduce as we move through the amortization schedule, but this is the amount we paid last year.)

I can already hear the personal finance blogger refrain though: what about the opportunity costs? Think of the gains I'll be missing out on.

And I'm usually the one telling other people to think about opportunity costs and to minimize taxes.

But we are very close to financial independence. We think a different strategy may be warranted.

We're planning on hitting financial independence, and likely leaving full time work, in roughly two years. At this point in the game, we're much more concerned with limiting losses than we are with maximizing gains. Seeing how our goal is a paid off home and a nest egg sustaining our spending, it's really a question of how we get there in the most prudent way. And we figure taking some money off the table to pay off the mortgage, and then building back up those funds, is a more conservative path forward.

The way we see it, there are three things that can happen over the next two years.

Scenario 1: the market is lower two years from now than it is today
In this scenario, we probably feel smart for taking some money out of the market before the correction. It's market timing, for sure. While we'll still have plenty invested, we will have limited our losses by taking some money out of play. Additionally, with the extra cash flow from having no mortgage payment, we'll be buying more stocks on sale, while the markets are down, than we would otherwise. And we'd certainly be buying more than if we'd been doing a traditional mortgage payoff, with all our available cash going towards principal payments.

This is probably the 'we got lucky and ended up doing a good thing' scenario, if it comes to pass.

Scenario 2: the market stays more or less flat over the next two years

This isn't the worst outcome, because even though we'd like to see some positive returns, we're at least getting a 3.75% by paying off the debt. That is technically a little better a return that we'd see in a flat market, even if we consider the 2% dividends we'd have received had we kept those funds invested.

Not a great scenario either way, but we'd probably still be ever so slightly better off paying down the mortgage.

Scenario 3: the market is higher two years from now than it is today

This is definitely the bad scenario for us, as we'd suffer opportunity costs for taking money out of the market. It's also probably the most likely scenario: most years, the stock market goes up.

Our Simpleton's Portfolio (sometimes called the No-Brainer Portfolio) has provided a median "real" return of 6.5% historically: a nominal return of 8.5% if we assume 2% inflation. So taking $260,000 out of our portfolio to avoid only a 3.75% interest rate would suffer some real opportunity costs: missing out on an additional 4.75% of returns: so over $12,000 in opportunity costs in an average year.

Still, in this scenario where we suffer these opportunity costs, the remainder of our nest egg we have invested is still going up. We're still seeing gains that are sufficient to make our goal of retiring by forty. In this bad scenario, while we could have reached our goal a few months earlier, we still reach financial independence in the timeframe we set for ourselves.

If that's the bad scenario, sign me up.

The bottom line is that we're trying to achieve a specific goal: not maximize our hypothetical gains. Because risk and reward go hand in hand. 

Avoiding opportunity costs is not my primary goal at this point in the process. Rather, I want to mitigate our risks. I want to minimize potential losses at this stage in our financial independence journey: if there's going to be a market correction, we want to ease its impact.

The way I see it, we're in the fourth quarter. We're up by four, there are just two minutes left in the game, and we have the ball on the fifty. My goal isn't to score another touchdown and run up the score. It's to protect the ball, make sure the team doesn't do anything stupid, run out the clock, and win the damn game.

I really couldn't care less if someone on the sidelines criticizes us for only winning by four, pointing out that we could have won by eleven. All I want is the "W".

As always, thanks for reading.

Disclaimers and FAQ

• Just like everything on this blog, nothing in this post should be read as advice. I'm no professional, and you should consult with one if you're thinking about doing anything like this.
• Why not just keep this very low interest mortgage all the way into your retirement, and use it as a potential arbitrage play? The short answer is that mortgages are bad for early retirees because they increase sequence of return risks. But read Big ERN's post for a full explanation.
• Have you considered just continuing to invest, hopefully getting better than 3.75% returns, and then paying off the mortgage all at once? That was our first plan: the original mortgage swoop. Most of the time, this would get us to our goal a few months faster since usually the market returns are better than 3.75%. But if we get unlucky there's a correction in the next couple years, we'd suffer more losses. So we're trying to manage that risk rather than maximize our gains.
• Why not just pay extra to principal with your extra cash each month? The timeline is just a bit too long: it would take us over five years with that plan, even if we threw everything we could at the mortgage...and I'd like to be done with full time work in about two. So we'd rather sell some investments rather than just relying on our paycheck income.

*Photo is from Debs at Flickr Creative Commons.