A counter argument to the investment option is, “what if you don’t get 8% return in your investment account?” To respond, let’s further suppose that Joe & Susie invest their money in a US balanced portfolio (60/40 stock/bond mix)[1], and that their total investment expenses decrease their rate of return by 1% from the historical market results. Using the historical returns data, we find that the probability of exceeding 8% return (after expenses) is 69.15%. However, the portfolio must only return an average annual return of 1.45% to to come out ahead. The probability of the portfolio getting 1.45% average annual return or greater over the time horizon is 99.45%. 

The idea of pulling money out of investment accounts to pay off the remaining mortgage brings us to the next common question. Using all Joe & Susie’s information from above,

•   Remaining mortgage balance of $192,672
•   Remaining time to pay the mortgage off is 114 months
•   Combined marginal tax rate of 36.4%
•   Monthly mortgage payments are $2,052.23

we can easily calculate the opportunity cost and probability of outcomes. The first option is simple, take money out of the Roth IRAs (a tax-free event since they are both now age 60.5), and pay off the mortgage ($192,672). 

The second option is to make all the remaining mortgage payments on schedule using money from the Roth IRAs. By doing this, option 1 and option 2 are identical from a personal cash flow perspective (i.e. Joe & Susie won’t spend from their normal income to pay the mortgage). They also continue to get a tax write off for mortgage interest paid. Including tax benefits and additional gain on the remaining investment, option 2 comes out $96,825 ahead of option 1.

The counter argument to option 2 is again, “what if you don’t get 8% return on your investment account?”. Once again, we turn to the statistical analysis of the historical return data[1]. Using the same data set as above, we find the probability of exceeding 8% return after expenses over a 10 year time horizon is 67.72%. The break-even rate in this case is 2.18%. The probability of getting at least 2.18% over 10 years is 98.62%.

Now that we’ve compared the two early payoff options, let’s address the final common question. This time we'll introduce a new couple with different circumstances. Dave & Amy are both 40 with two children, living in Oregon. Their combined taxable income is $550,000 per year, putting them in the marginal tax brackets of 35% for the feds, 9.9% for state, and 2.5% for local. Dave & Amy have combined savings of $2,000,000 and are buying a second home for weekend and summer vacation use. They are under contract to purchase a home in Washington state for $1,000,000. The question is: should they pay cash or finance 75% of it?

The cash option is straight forward. They pull $1,000,000 from investments and close on the house. The upside is no loan costs and no interest on a loan. The downside is the opportunity cost of the investment money not working for them anymore and tax benefits they will forego (interest as an itemized deduction).

The second option is to put 25% down and finance the remainder ($750,000). As of today (8/29/2021), loan rates on a second home in White Salmon, Washington are 2.75% for a 15-year fixed rate loan, or 3.00% for a 30-year fixed loan. In either case, Dave & Amy will be able to take the mortgage interest as an itemized deduction from their federal and state income taxes. To make the family cash flow identical to option 1, we will assume Dave & Amy pay the mortgage from their investment accounts rather than from their regular income. Assuming Dave & Amy’s investment performance is an average annual 8% return, financing their second home for 15 years comes out ahead by $1,047,617. Financing for 30 years comes out a staggering $5,505,400 ahead!

Finally, to determine how likely this outcome is we’ll look to statistics and historical return data. As with previous examples, we assume Dave & Amy invest in a globally diversified 60/40 portfolio with 1% total annual expenses[1]. The probability of getting an 8% average annualized return over a 15-year time horizon is 68.44% The breakeven rate of return is 0.79%. The probability of getting this average annual return or higher or a 15-year time frame is 99.64%. Looking at the same statistics for a 30-year time horizon, there is a 96.41% chance of achieving an 8% average annual return or higher over 30 years. The breakeven rate is 0.944% The probability of achieving a 0.944% average annual return or higher over 30 years is better than 99.99%.

As in previous examples, the same rebuttal can be presented to option 2, “what if you don’t get 8% return on your investment account?”. Once again, we turn to the statistical analysis of the historical return data[1]. Using the data set employed above, we find the probability of exceeding 8% return after expenses over a 10 year time horizon is 67.72%. The break-even rate in this case is 2.18%. The probability of getting at least 2.18% over 10 years is 98.62%.

Debt can be a powerful tool to create wealth. The above analyses are purely financial. There are numerous other factors to be considered in making a decision to carry debt, including individual risk tolerance and the psychological distress that debt may cause. Speak with your Skyline advisor to evaluate your situation and specific considerations.

[1] Assume portfolio is the DFA Balanced Strategy: Normal 60% Equity, 40% Fixed Income. Historical performance (1973-2020) is 10.8% average annual return with a standard deviation of 9.3%.