I may appear, at times, to be a bit schizophrenic. Allow me to explain….
First, I was excited to become 100% Debt Free in April 2016.
Then, just 18 months later, in Oct 2017 I was happy to Take On Debt as part of our relocation from Good Great.
Today, just 4 months later, I’m excited to become 100% Debt Free. Again.Today, I'm excited to be 100% DEBT FREE (for the second time in 20 months, and that's today's story). Click To Tweet
We just sold $170k from our Muni Bond portfolio and will be using the proceeds to pay off our cabin mortgage. In a few weeks, we’ll be 100% Debt Free! Why the change of heart?
Today, I’ll explain our thinking.
Why We Just Sold All Our Muni Bonds (And Became 100% Debt Free)
You read that right. We just changed our minds, again, and sold $170k of muni bonds (where we’d been holding the equity from our Good Cabin sale since Oct 2017), and applied the $ to pay off our Great Cabin mortgage. After having been debt free, then assuming debt on purpose, we’re once again at the point of being 100% debt free.
The question I would suspect these schizophrenic actions raise among you, the reader, is:Why, in this short span of 20 months, did he have 3 changes of heart on mortgage debt? Click To Tweet
Like I said, my actions may appear to be a bit schizophrenic.
I assure you my actions make sense. (to me, at least…)
I hope you can learn from my actions and the thought process used as I adapted our strategy based on the changing environment in which we live. Today, I’ll address those changes, and how they’ve affected our decisions. Think about decisions you’re facing in your world of personal finance today, and apply the lessons as they make sense in your own process.
First, a quick rundown of our first two decisions, and then I’ll get into what’s changed that caused us to shift our thinking yet again. Summarized below are both of our previous decisions, along with a bit of background on what was going on at the time.
1) Why I Was Happy When We Became Debt Free
April 2016 Summary: On April 12, 2016, I wrote the biggest check of my life, and paid off our cabin’s mortgage. We took a picture of it, wrote a post about it, and became 100% Debt Free (yes, a check. I did it on purpose. It was a big occasion….). We completed our planned downsizing move and used the equity in our “big city house” to pay off our mountain cabin home in its entirety. We had executed our plan. We were debt free!
2) Why I Was Happy When We Went Back Into Debt
October 2017 Summary: 18 months later, things changed, and we changed our plan accordingly. We decided to move from Good To Great, and did a second downsizing move in less than 2 years (from a “good” cabin to a “great” cabin). After we sold our “Good” cabin we had a new decision to make during the purchase of the “Great” cabin. Do we roll over the home equity from the “Good” cabin and payoff our “Great” cabin, or do we assume a mortgage and invest the equity?
As I wrote about at the time, we decided to take on the mortgage and invest the equity. The main driver behind that decision was to create a low-cost option as we finalized my pension decision, and gave us flexibility as we finalized our retirement cash flow plans. Using this option, we were able to delay a final decision on whether or not we should tie up our liquidity with a payoff the Great cabin. The option to payoff the mortgage was available at any time.
We invested the home equity from the sale of our “Good” cabin into Vanguard Muni Bond fund (VWITX) in late October 2017:
That flexibility we gained by investing in Muni’s paid off, as you’ll see in #3 Below:
3) Why I’m Now Happy Selling Our Muni Bonds To Become 100% Debt Free
January 2018 Summary: Markets change. New Tax Laws Get passed. Put the macro forces together, and the math that previously favored investing the equity in Muni Bonds to retain flexibility on our cash liquidity now favors a different decision.The New Tax Law and Changing Bond Markets caused us to change our mortgage strategy for the 3rd time. Click To Tweet
With the flexibility we achieved by #2 above, we were able to more fully evaluate our decision, which was helpful given the significance of the Tax Law change in January 2018. In the past 4 months, we’ve finalized my pension start date/amount, and have calculated the liquidity/income we’ll need to pull from our investments. We’ve also developed a strategy to take advantage of the New Tax Law Loophole, and have estimated the impact of our Before-Tax to Roth conversions on our taxes and investment withdrawal requirements over the next 3 years.We Know The Gap In Our Retirement Spending Plan, and how much money we'll have to pull from Investments to fund it. Click To Tweet
Knowing the gap helped us to identify how much liquidity we need for our Bucket Strategy. Turns out, we don’t need the extra liquidity we had available by holding the home equity in Muni’s. From a liquidity perspective, we could afford to pay off the mortgage and knew we wouldn’t get into a cash crunch as we transitioned into retirement.
We Made Our Final Decision.
This week, we decided to pay off the mortgage.
Bottom Line: The situation changed, and we changed our strategy as a result.
How The New Tax Law Led Us To Sell Our Muni’s
I’ve been thinking a lot about the next tax law (including the Retirement Tax Loophole). My thinking has directly led to this third iteration in my schizophrenic decision-making process, where we’ve decided we’re now better off cashing out the Muni Bonds, which were being used as a safe place to store the home equity from our previous home sale.
We’re now going to use the money to pay off our Great Cabin mortgage and become 100% Debt Free.
Earlier today, I executed the following trade to sell $170,000 from our Muni Bond fund at Vanguard:
In my humble (but deeply considered) opinion, the new tax law is going to have a negative impact on Muni Bonds, as well as a negative impact on the economics of carrying a home mortgage. Both of these impacts result in us being advantaged by selling the munis and paying off the mortgage.
I’ll summarize my thinking of the specific changes and their impact in the bullets below:
New Lower Income Tax Rates: With the new lower income tax rates, tax-free muni income becomes less attractive on after-tax, “apples to apples” comparisons to other investment options. The “tax-free” yield is analyzed using the marginal tax rate to determine the break-even point vs. taxable bonds, for example. Lower tax rates mean munis are LESS attractive than other alternatives. I suspect there will be some selling pressure on munis, further reducing their potential for attractive returns.
The Loss Of The Mortgage Interest Deduction: With the increase in the standard deduction to $24k (Married, Filing Jointly), we’ll be losing our mortgage interest deduction, given that our itemized deductions will total less than $24k. Therefore, the interest rate payoff on our mortgage becomes MORE attractive on an “after-tax” basis, since it’s no longer subsidized by the tax write-off. It’s just math….
Interest Rate Risk On Bonds: With an average bond maturity of 6 years in our muni bond fund, we would suffer a 6% loss in principle for every 1% increase in interest rates. We’ve seen a bit of decline in this fund’s principal since we invested in Oct, and further interest rate increases look likely. Bottom line: the interest rate environment increases our risk of loss in the Muni Bond Fund. Meanwhile, there’s 0% risk in paying off the mortgage early, and we lock in the 3.5% “return” which was our mortgage interest rate. 3.5% risk-free return looks reasonably attractive, given the alternatives in this “Everything Has A Crazy High Valuation” investment market.
My Income Will Go Down Post-Retirement: With a lower post-retirement income, my marginal tax rate will be lower than it is today (unless I decide to rollover $200k/yr of before-tax IRA money!). Even if I do large rollovers, the new lower tax rates result in an after-tax arbitrage that favors paying off the mortgage when compared to keeping the money in Muni-Bonds (the mortgage isn’t deductible, and the muni-bonds aren’t as attractive in a low tax scenario).
Our Mindset: After surviving the One More Year Syndrome, we’re in a good place from a financial perspective, and we can be more conservative with our investments. With a Withdrawal Rate of only 3.0%, we don’t need to take on excessive risk. As I commented in this article about risk from Financial Samurai, I believe you should only take on the risk you need to achieve your required investment returns, which in our case is “low”. We’re able to tolerate the lower return that comes with less risk, and we want to avoid any major losses early in retirement. So, we’re tucking our horns in for a while, and the 3.5% fixed rate (with no risk) we “earn” by paying off the mortgage is more than sufficient for us. With markets overvalued and concerns about Sequence Of Return Risk, we’re going into a defensive position for the first few years of retirement. 3.5% risk-free? I’ll take it.
Besides, looking at a 3.5% nominal return (1.0 – 1.5% real return) looks reasonable compared to this forecast for the returns over the next 10 years by Asset Class just published by Research Affiliates:
10 Year Expected Returns By Asset Class
What If We’re Wrong?
The good news about this decision is that there’s limited downside. Some folks, like my friend Nords are taking every bit of mortgage they can get in this low mortgage environment, feeling they can make higher returns by investing the money elsewhere. If Nords is right and I’m wrong, what do I lose? Not much, in reality. Perhaps a few percentage points of return on $170k. Not enough to change my retirement, and I’ll sleep well at night.
I like to sleep.
And….in case you’re curious, I’m sleeping well with this decision.
As macro forces evolve, it’s important to adjust your personal finance strategy accordingly. Sometimes it makes sense to carry a mortgage, and sometimes it makes sense to pay it off.
Take time to think about the impact that macroeconomic changes could have on your retirement situation. For example, with the new tax law being a significant factor, have you thought about how it may change your approach in certain areas? Are you going to leverage The Tax Loophole to reduce your future Required Minimum Distributions? Another potential “impact area”: If you’re thinking about relocating for retirement the new tax law would make it more important to find a state with low state and property taxes since deductions for state & local taxes are now capped at $10k.
Look at the process we used as we decided between paying off our mortgage vs. investing the home equity. It wasn’t an easy question to answer, as demonstrated by the 3 changes in strategy we’ve had in the past two years. Use our situation as a Case Study, and see if you can apply the process that we used in a decision that you need to make. Feel free to throw a question into the comments, we’ll look at your situation together.
Risks are changing. As interest rates appear to be ending a major “down” cycle and starting to turn “up”, the risk of owning bonds increases as their 30 year Bull Run looks to be reaching its final mile. As stocks reach valuations well above “normal”, the risk of a “reversion to the mean” increases the odds of a market correction in the next few years.
Risk is increasing, at precisely the wrong time for those approaching (or in) retirement.
Position yourself accordingly.
In our case, it meant paying off the mortgage. What does it mean for you?
I look forward, as always, to your comments. Am I schizophrenic, or does my logic make sense? Would you pay off the mortgage, or continue to carry the mortgage and hold the equity in an investment? If so, which asset would you hold, and why? Can you apply the process we used to a situation you’re facing? Let’s discuss it in the comments. (BTW, the comments has been FANTASTIC in my past few months. Thanks to all of you who interact.)
If you’ve never commented before, Live Life At The Edge, and leave a comment today.
Let’s discuss the issues, and together We Can Achieve A Great Retirement.