"Mortgage is a negative bond" - please help me understand

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alex_686
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Re: "Mortgage is a negative bond" - please help me understand

Post by alex_686 »

Kenkat wrote: Thu Apr 22, 2021 4:19 pm
alex_686 wrote: Thu Apr 22, 2021 3:32 pm First, you want to compare apples to apples, and the example you are giving are not apples to apples. I, on purpose, simplified the model to just equity/bonds. And it works just fine if you assume everybody has the same size house off of the balance sheet. However, you want to include a renter verse a home owner. To do this right you would need to add in the home value. Some would treat this as bonds but it is probably better to treat it as its own asset class.

Second, ok, they do have different risk profiles. Let us assume that they are living in comparable homes. The renter has more productive and liquid assets. The renter probably has higher expenses. But they have the flexibility of downsizing. Person living in the house may have higher mandatory expenses deepening if they have a mortgage. But so what?
If you are saying that someone is 100% equities but that statement can mean totally different things depending on situation (as it’s not apples to apples), then I would agree with you. So the negative bond makes the home owner 100% equities. So what? This doesn’t really accurately quantify their risk. The house is a de-risking asset - to properly assess risk, you have to include it. You reference this above (I underlined it).
You are correct.

So if you check upthread you will see me repeatedly saying I am taking the house out of the model of simplify things. That may be a mistake. I have seen formal training books for advisors saying to get the information, file it, and never reference it again. That is, very important but not worth the extra complexity. Which, yes, is a contradiction - but so are many things in life.

If we put it on the balance sheet what do we put it on as? As I also mentioned way upthread, this is a complex and nuanced question which has stumped plenty of people.

Probably as a diversifying asset with a expected real return of zero. This is the historic long term after inflation return. And you consume all of the imputed rent.
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Re: "Mortgage is a negative bond" - please help me understand

Post by willthrill81 »

alex_686 wrote: Thu Apr 22, 2021 4:52 pm If we put it on the balance sheet what do we put it on as? As I also mentioned way upthread, this is a complex and nuanced question which has stumped plenty of people.

Probably as a diversifying asset with a expected real return of zero. This is the historic long term after inflation return. And you consume all of the imputed rent.
A home is an asset, so we would put it on the balance sheet as real estate.

I agree that the expected real return of a home is likely zero. But we cannot ignore the value of imputed rent, even though we consume it as it is 'produced'. This is abundantly clear if/when someone sells their mortgage-free home and begins renting somewhere. Yes, there are maintenance costs, property taxes, and insurance to pay for, but in the lion's share of instances, but those are usually dwarfed by renting an equivalent property. We would have to pay about $2k/month to rent our home if we didn't own it. That's tangible, measurable, financial value that we get from it every day.

I don't see a real problem among those who understand that not treating a mortgage is a negative bond is a logical contradiction but choose to do so for the purpose of simplification. It's those who say that a loan is qualitatively different depending on whether you're the lender or the borrower for whom I shake my head.
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Re: "Mortgage is a negative bond" - please help me understand

Post by vineviz »

willthrill81 wrote: Thu Apr 22, 2021 5:47 pm I agree that the expected real return of a home is likely zero. But we cannot ignore the value of imputed rent, even though we consume it as it is 'produced'. This is abundantly clear if/when someone sells their mortgage-free home and begins renting somewhere. Yes, there are maintenance costs, property taxes, and insurance to pay for, but in the lion's share of instances, but those are usually dwarfed by renting an equivalent property. We would have to pay about $2k/month to rent our home if we didn't own it. That's tangible, measurable, financial value that we get from it every day.
Right. Imputed rent is a form of income, and it is properly accounted for like other forms of income and expense (including rent and dividends).

In several countries (not the United States) this imputed rent is taxable income.
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Re: "Mortgage is a negative bond" - please help me understand

Post by rossington »

vineviz wrote: Thu Apr 22, 2021 7:05 pm
Right. Imputed rent is a form of income, and it is properly accounted for like other forms of income and expense (including rent and dividends).
No it is not. It is neither tangible nor intangible. It is simply a theory.
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Re: "Mortgage is a negative bond" - please help me understand

Post by sureshoe »

alex_686 wrote: Thu Apr 22, 2021 4:01 pm
sureshoe wrote: Thu Apr 22, 2021 1:53 pm So I've tried to muddle through all this for a "so what?" moment. Truthfully, it just seems like a lot of wonky debate. What is the actual applied piece?

Let's say I have $2M in investments. $1.6M in equities and $0.4M in bonds. (80/20 mix) So if we pretend this is the risk level I want, does it matter if I rent or have a big mortgage?

Suppose I have a $400/month rental vs. a $700k house w/ $400k mortgage. Is the theory that the mortgage somehow cancels out my $400k of bonds making me theoretically 100% equity invested and I should be doing more bonds to offset that?
Sort of yes. You are kind of muddling 2 questions together.

Why do you want a 80/20 mix? What about that asset mix is attractive to you? I personally think this is a bit backwards. You get all of your other ducks in a row and then turn the crank to figure out the AA.

Yes, if you have a 400k mortgage you are effectively at 100% equity - if we ignore the home's value.

For the renter verse home owner you are comparing apples verse oranges. You probably want to toss 300k towards the renter to make a equal compression with the home owner. Or maybe not. It depends on what risks you are considering. Obviously, renters and homeowners have different goals and are exposed to different risks.
Let's take this, because I think this is a the crux of the debate. In my opinion, a home is LIFESTYLE choice, not an investment. So maybe your perspective changes how you think about it in AA. The same is true for cars, furniture, etc. I do note cars/house in my net worth, but I don't use it for AA. For example, owning a $500k house, I wouldn't reduce my REIT exposure by $500k because of the house necessarily. Maybe I should. I think you can get very wonky in this and apply science where it's mostly art.

But back to your point. There is 1 house, I can buy it with a $2000/month $400k mortgage or rent it at $3000k/month, to me this is just a wash except 1 decision is less liquid than the other.

Meh. I feel like I'm arguing now and I'm not particularly interested =) =)
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Re: "Mortgage is a negative bond" - please help me understand

Post by vineviz »

sureshoe wrote: Fri Apr 23, 2021 7:46 am For example, owning a $500k house, I wouldn't reduce my REIT exposure by $500k because of the house necessarily. Maybe I should.
You should not. REITs and houses (or any real estate, actually) are not interchangeable assets.
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Re: "Mortgage is a negative bond" - please help me understand

Post by Kenkat »

alex_686 wrote: Thu Apr 22, 2021 4:52 pm
Kenkat wrote: Thu Apr 22, 2021 4:19 pm
alex_686 wrote: Thu Apr 22, 2021 3:32 pm First, you want to compare apples to apples, and the example you are giving are not apples to apples. I, on purpose, simplified the model to just equity/bonds. And it works just fine if you assume everybody has the same size house off of the balance sheet. However, you want to include a renter verse a home owner. To do this right you would need to add in the home value. Some would treat this as bonds but it is probably better to treat it as its own asset class.

Second, ok, they do have different risk profiles. Let us assume that they are living in comparable homes. The renter has more productive and liquid assets. The renter probably has higher expenses. But they have the flexibility of downsizing. Person living in the house may have higher mandatory expenses deepening if they have a mortgage. But so what?
If you are saying that someone is 100% equities but that statement can mean totally different things depending on situation (as it’s not apples to apples), then I would agree with you. So the negative bond makes the home owner 100% equities. So what? This doesn’t really accurately quantify their risk. The house is a de-risking asset - to properly assess risk, you have to include it. You reference this above (I underlined it).
You are correct.

So if you check upthread you will see me repeatedly saying I am taking the house out of the model of simplify things. That may be a mistake. I have seen formal training books for advisors saying to get the information, file it, and never reference it again. That is, very important but not worth the extra complexity. Which, yes, is a contradiction - but so are many things in life.

If we put it on the balance sheet what do we put it on as? As I also mentioned way upthread, this is a complex and nuanced question which has stumped plenty of people.

Probably as a diversifying asset with a expected real return of zero. This is the historic long term after inflation return. And you consume all of the imputed rent.
Thanks for the good discussion; agree with your comments above.
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Re: "Mortgage is a negative bond" - please help me understand

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rossington wrote: Fri Apr 23, 2021 4:23 am
vineviz wrote: Thu Apr 22, 2021 7:05 pm
Right. Imputed rent is a form of income, and it is properly accounted for like other forms of income and expense (including rent and dividends).
No it is not. It is neither tangible nor intangible. It is simply a theory.
So me living in my house without paying rent is 'simply a theory'? :oops:
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Re: "Mortgage is a negative bond" - please help me understand

Post by willthrill81 »

sureshoe wrote: Fri Apr 23, 2021 7:46 amIn my opinion, a home is LIFESTYLE choice, not an investment.
By the strict definition of 'investment', a house certainly qualifies. It is an asset purchased to produce something. Now in the case of a personal residence, the housing that the house provides is immediately consumed by you. The fact that it doesn't directly produce cash leads many to falsely conclude that that disqualifies it as an investment. It's just that we consume what the house provides. Imputed rent is very real, which is why, as vineviz pointed out, it is taxed in some places.

It's true that housing is an expense. But it's false to conclude that a house is purely an expense and not an investment. Our lifestyle choice is what type of housing we choose to live in. A home that provides our desired housing is an investment. It's no different from determining how much we want to spend in retirement and then determining what assets (or income streams) we need in order to cover those spending needs.

Now whether a home is a good investment is whole other matter entirely and very situation specific. Many Americans have been sold the lie that their home is the best investment they can make, so they should spend as much on a home as possible, but this is backwards thinking. For most, the first question regarding housing is to determine what type of housing you want/need. Once you've determined that, you can then figure out what the most effective financial means of achieving your desired housing is. Buying a home that is more expensive than needed means that one is buying an asset that is producing more than you need; it's a financial waste unless you can convert the unneeded portion of the housing to an income stream (e.g., through renting out a portion of the home).
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Re: "Mortgage is a negative bond" - please help me understand

Post by alex_686 »

sureshoe wrote: Fri Apr 23, 2021 7:46 am Let's take this, because I think this is a the crux of the debate. In my opinion, a home is LIFESTYLE choice, not an investment. So maybe your perspective changes how you think about it in AA. The same is true for cars, furniture, etc. I do note cars/house in my net worth, but I don't use it for AA. For example, owning a $500k house, I wouldn't reduce my REIT exposure by $500k because of the house necessarily. Maybe I should. I think you can get very wonky in this and apply science where it's mostly art.

But back to your point. There is 1 house, I can buy it with a $2000/month $400k mortgage or rent it at $3000k/month, to me this is just a wash except 1 decision is less liquid than the other.

Meh. I feel like I'm arguing now and I'm not particularly interested =) =)
Ehh. Like I said, it is a complex argument. You should model your finances as whatever makes sense. But let me lay out my argument one more time, tailored to your concerns. You want your mortgage as a negative bond, and your house as a diversifying asset with a expected market return of 0%

Mortgage: Should be on your balance sheet and treated like a negative bond. It acts like a negative bond. It acts independently of your house. It tends to be a huge liability and has real meaningful impact to your plans and outcomes. You need to keep a eye on it.

Real Estate returns can be decomposed into 2 legs.

Rent: Or if you own your own home, imputed rent. This gets consumed by the owner. I would categorize the size of consumption, and the choice of consumption verse investment, as a lifestyle choice. I think we are in agreement here.

Principle Appreciation: If you have your mortgage on your balance sheet you also want the house. Otherwise the asset / liabilities ratio will be out of whack. Historically houses have diversifying asset with a expected market return of 0%. It also can represent a Plan B in case things go sidewise.
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Re: "Mortgage is a negative bond" - please help me understand

Post by KlangFool »

willthrill81 wrote: Fri Apr 23, 2021 9:19 am
sureshoe wrote: Fri Apr 23, 2021 7:46 amIn my opinion, a home is LIFESTYLE choice, not an investment.
By the strict definition of 'investment', a house certainly qualifies. It is an asset purchased to produce something. Now in the case of a personal residence, the housing that the house provides is immediately consumed by you. The fact that it doesn't directly produce cash leads many to falsely conclude that that disqualifies it as an investment. It's just that we consume what the house provides. Imputed rent is very real, which is why, as vineviz pointed out, it is taxed in some places.

It's true that housing is an expense. But it's false to conclude that a house is purely an expense and not an investment. Our lifestyle choice is what type of housing we choose to live in. A home that provides our desired housing is an investment. It's no different from determining how much we want to spend in retirement and then determining what assets (or income streams) we need in order to cover those spending needs.

Now whether a home is a good investment is whole other matter entirely and very situation specific. Many Americans have been sold the lie that their home is the best investment they can make, so they should spend as much on a home as possible, but this is backwards thinking. For most, the first question regarding housing is to determine what type of housing you want/need. Once you've determined that, you can then figure out what the most effective financial means of achieving your desired housing is. Buying a home that is more expensive than needed means that one is buying an asset that is producing more than you need; it's a financial waste unless you can convert the unneeded portion of the housing to an income stream (e.g., through renting out a portion of the home).
willthrill81,

Now, if we want to go down this rabbit hole, what do you call the housing expense far exceed the imputed rent? Annual expense to maintain an investment? And, if we want to count the investment return, don't we need to count this extra expense to maintain this investment?

For example, if it takes $1,500 to rent this house but the PITI to buy the same house is $2,000 per month, the house cost at least $6,000 per year extra. This is an increase in housing expense.

So, if the down payment is 100K and the house is pay off in 30 years and sold for 500K, the nominal return rate is 2.69%.

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Re: "Mortgage is a negative bond" - please help me understand

Post by Kenkat »

alex_686 wrote: Fri Apr 23, 2021 10:14 am Ehh. Like I said, it is a complex argument. You should model your finances as whatever makes sense. But let me lay out my argument one more time, tailored to your concerns. You want your mortgage as a negative bond, and your house as a diversifying asset with a expected market return of 0%

Mortgage: Should be on your balance sheet and treated like a negative bond. It acts like a negative bond. It acts independently of your house. It tends to be a huge liability and has real meaningful impact to your plans and outcomes. You need to keep a eye on it.
This all makes sense to me.

There’s been a lot of discussion about how to represent the house. Is it real estate, is it bond-like, is it annuity-like? In spite of some of my arguments arguing it’s bond-like qualities above, I like “a diversifying asset with a expected market return of 0%” with the following caveat (or recognition):

While a house had it’s own inherent risks, in general, it represents a de-risking asset in relation to equities. If the negative bond increases your allocation to equities, that’s ok, because the house as an asset has the effect of reducing the risk of holding a higher equity allocation.

That’s where I finally landed at least after all of the discussion :wink:
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Re: "Mortgage is a negative bond" - please help me understand

Post by KlangFool »

Kenkat wrote: Fri Apr 23, 2021 11:12 am
alex_686 wrote: Fri Apr 23, 2021 10:14 am Ehh. Like I said, it is a complex argument. You should model your finances as whatever makes sense. But let me lay out my argument one more time, tailored to your concerns. You want your mortgage as a negative bond, and your house as a diversifying asset with a expected market return of 0%

Mortgage: Should be on your balance sheet and treated like a negative bond. It acts like a negative bond. It acts independently of your house. It tends to be a huge liability and has real meaningful impact to your plans and outcomes. You need to keep a eye on it.
This all makes sense to me.

There’s been a lot of discussion about how to represent the house. Is it real estate, is it bond-like, is it annuity-like? In spite of some of my arguments arguing it’s bond-like qualities above, I like “a diversifying asset with a expected market return of 0%” with the following caveat (or recognition):

While a house had it’s own inherent risks, in general, it represents a de-risking asset in relation to equities. If the negative bond increases your allocation to equities, that’s ok, because the house as an asset has the effect of reducing the risk of holding a higher equity allocation.

That’s where I finally landed at least after all of the discussion :wink:
Kenkat,

Let me throw you a curve ball, why do you care about the mortgage if the house pays you? So, how does this "negative bond" stuff matters at all?

You bought a house at PITI of $1,800 per month. The market rent is $2,300 per month. You save/earn an imputed rent of $500 per month. So, why do you care that you have a mortgage? Or, whether the mortgage is "negative bond"? You make money every month. You improve your "cash flow" by buying the house.

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Re: "Mortgage is a negative bond" - please help me understand

Post by vineviz »

KlangFool wrote: Fri Apr 23, 2021 10:50 am Now, if we want to go down this rabbit hole, what do you call the housing expense far exceed the imputed rent? Annual expense to maintain an investment? And, if we want to count the investment return, don't we need to count this extra expense to maintain this investment?
If you own a house that you live in, and you want to fully account for all of your household income and expenses related to the house then what you end up with is something like the following.

Income = imputed rent

Expenses = cash expenses associated with ownership (taxes, maintenance, insurance, etc.) + imputed rent

Subtract expenses from income and you have your housing income, though this is a negative number for most people unless you're adding capital appreciation to the income (i.e. using mark-to-market accounting).
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Re: "Mortgage is a negative bond" - please help me understand

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vineviz wrote: Fri Apr 23, 2021 11:40 am
KlangFool wrote: Fri Apr 23, 2021 10:50 am Now, if we want to go down this rabbit hole, what do you call the housing expense far exceed the imputed rent? Annual expense to maintain an investment? And, if we want to count the investment return, don't we need to count this extra expense to maintain this investment?
If you own a house that you live in, and you want to fully account for all of your household income and expenses related to the house then what you end up with is something like the following.

Income = imputed rent

Expenses = cash expenses associated with ownership (taxes, maintenance, insurance, etc.) + imputed rent

Subtract expenses from income and you have your housing income, though this is a negative number for most people unless you're adding capital appreciation to the income (i.e. using mark-to-market accounting).
vineviz,

1) I am not most people.

2) If housing income is positive without capital appreciation, then, what is the point of calling the mortgage as "negative bond"? The house is a net cash generating asset.

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Re: "Mortgage is a negative bond" - please help me understand

Post by alex_686 »

KlangFool wrote: Fri Apr 23, 2021 11:32 am You bought a house at PITI of $1,800 per month. The market rent is $2,300 per month. You save/earn an imputed rent of $500 per month. So, why do you care that you have a mortgage? Or, whether the mortgage is "negative bond"? You make money every month. You improve your "cash flow" by buying the house.
If the market rent is $2,300 per month than the imputed rent is $2,300 per month, by definition.

PITI is irrelevant. Imputed rent is based off of the asset value. How you finance the asset is irrelevant. Does it matter to a renter if there is a large mortgage on it or not?
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Re: "Mortgage is a negative bond" - please help me understand

Post by vineviz »

KlangFool wrote: Fri Apr 23, 2021 11:50 am 1) I am not most people.
Clearly, but you're most people in every way that matters to this discussion.

Do you own a house that never needs maintenance?
Do own a house that is uninsured?
Do you live in a locality with no property tax?

KlangFool wrote: Fri Apr 23, 2021 11:50 am 2) If housing income is positive without capital appreciation, then, what is the point of calling the mortgage as "negative bond"? The house is a net cash generating asset.
A) It's not positive without counting capital appreciation, unless you're renting out part of your house for cash.

B) Home ownership is a distinct matter from financing.
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Re: "Mortgage is a negative bond" - please help me understand

Post by willthrill81 »

KlangFool wrote: Fri Apr 23, 2021 10:50 am
willthrill81 wrote: Fri Apr 23, 2021 9:19 am
sureshoe wrote: Fri Apr 23, 2021 7:46 amIn my opinion, a home is LIFESTYLE choice, not an investment.
By the strict definition of 'investment', a house certainly qualifies. It is an asset purchased to produce something. Now in the case of a personal residence, the housing that the house provides is immediately consumed by you. The fact that it doesn't directly produce cash leads many to falsely conclude that that disqualifies it as an investment. It's just that we consume what the house provides. Imputed rent is very real, which is why, as vineviz pointed out, it is taxed in some places.

It's true that housing is an expense. But it's false to conclude that a house is purely an expense and not an investment. Our lifestyle choice is what type of housing we choose to live in. A home that provides our desired housing is an investment. It's no different from determining how much we want to spend in retirement and then determining what assets (or income streams) we need in order to cover those spending needs.

Now whether a home is a good investment is whole other matter entirely and very situation specific. Many Americans have been sold the lie that their home is the best investment they can make, so they should spend as much on a home as possible, but this is backwards thinking. For most, the first question regarding housing is to determine what type of housing you want/need. Once you've determined that, you can then figure out what the most effective financial means of achieving your desired housing is. Buying a home that is more expensive than needed means that one is buying an asset that is producing more than you need; it's a financial waste unless you can convert the unneeded portion of the housing to an income stream (e.g., through renting out a portion of the home).
willthrill81,

Now, if we want to go down this rabbit hole, what do you call the housing expense far exceed the imputed rent?
As I noted above, it would be wasted, akin to a 'lost dividend'.
KlangFool wrote: Fri Apr 23, 2021 10:50 amAnnual expense to maintain an investment? And, if we want to count the investment return, don't we need to count this extra expense to maintain this investment?
Expense ratios are common for investments of all types. And yes, when calculating the return, the expenses should be taken into account.
KlangFool wrote: Fri Apr 23, 2021 10:50 am For example, if it takes $1,500 to rent this house but the PITI to buy the same house is $2,000 per month, the house cost at least $6,000 per year extra. This is an increase in housing expense.

So, if the down payment is 100K and the house is pay off in 30 years and sold for 500K, the nominal return rate is 2.69%.
As I noted above, the house is still an investment. In that instance, it would just be a poor one.

Basically, the question comes down to what is the most effective means of meeting one's housing needs: through renting or owning. One's stocks, bonds, and other investments could be used to pay rent, or a home one buys can be used to meet those housing needs, keeping in mind that home ownership comes other expenses.
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Re: "Mortgage is a negative bond" - please help me understand

Post by KlangFool »

alex_686 wrote: Fri Apr 23, 2021 12:00 pm
KlangFool wrote: Fri Apr 23, 2021 11:32 am You bought a house at PITI of $1,800 per month. The market rent is $2,300 per month. You save/earn an imputed rent of $500 per month. So, why do you care that you have a mortgage? Or, whether the mortgage is "negative bond"? You make money every month. You improve your "cash flow" by buying the house.
If the market rent is $2,300 per month than the imputed rent is $2,300 per month, by definition.

PITI is irrelevant. Imputed rent is based off of the asset value. How you finance the asset is irrelevant. Does it matter to a renter if there is a large mortgage on it or not?
alex_686,

<<Does it matter to a renter if there is a large mortgage on it or not?>>

No as the renter. But, if you buy the house with PITI of $1,800, as the house owner aka landlord to yourself, you save/earn $500 per month.

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Re: "Mortgage is a negative bond" - please help me understand

Post by KlangFool »

vineviz wrote: Fri Apr 23, 2021 12:01 pm
It's not positive without counting capital appreciation, unless you're renting out part of your house for cash.
vineviz,

Why can't I as a house owner rent the house to myself? And, if the housing expense as an owner is significantly cheaper than market rent, I am saving/earning money as imputed rent. Then, I do not need to count capital appreciation in order to have positive housing income.

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Re: "Mortgage is a negative bond" - please help me understand

Post by vineviz »

KlangFool wrote: Fri Apr 23, 2021 12:08 pm Why can't I as a house owner rent the house to myself? And, if the housing expense as an owner is significantly cheaper than market rent, I am saving/earning money as imputed rent. Then, I do not need to count capital appreciation in order to have positive housing income.

As a homeowner you DO effectively rent the house to yourself, but the (imputed) rent you pay as an occupant equals the (imputed) rent you receive as the landlord. Income can't magically appear or disappear merely though the act of accounting for it.

Don't confuse yourself by comparing a cashflow statement entry (PITI) with an income statement statement entry (imputed rent).
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Re: "Mortgage is a negative bond" - please help me understand

Post by Kenkat »

KlangFool wrote: Fri Apr 23, 2021 11:32 am
Kenkat wrote: Fri Apr 23, 2021 11:12 am
alex_686 wrote: Fri Apr 23, 2021 10:14 am Ehh. Like I said, it is a complex argument. You should model your finances as whatever makes sense. But let me lay out my argument one more time, tailored to your concerns. You want your mortgage as a negative bond, and your house as a diversifying asset with a expected market return of 0%

Mortgage: Should be on your balance sheet and treated like a negative bond. It acts like a negative bond. It acts independently of your house. It tends to be a huge liability and has real meaningful impact to your plans and outcomes. You need to keep a eye on it.
This all makes sense to me.

There’s been a lot of discussion about how to represent the house. Is it real estate, is it bond-like, is it annuity-like? In spite of some of my arguments arguing it’s bond-like qualities above, I like “a diversifying asset with a expected market return of 0%” with the following caveat (or recognition):

While a house had it’s own inherent risks, in general, it represents a de-risking asset in relation to equities. If the negative bond increases your allocation to equities, that’s ok, because the house as an asset has the effect of reducing the risk of holding a higher equity allocation.

That’s where I finally landed at least after all of the discussion :wink:
Kenkat,

Let me throw you a curve ball, why do you care about the mortgage if the house pays you? So, how does this "negative bond" stuff matters at all?

You bought a house at PITI of $1,800 per month. The market rent is $2,300 per month. You save/earn an imputed rent of $500 per month. So, why do you care that you have a mortgage? Or, whether the mortgage is "negative bond"? You make money every month. You improve your "cash flow" by buying the house.

KlangFool
I care about the mortgage because I am still on the hook for it regardless of what happens with the house. And part of that payment is interest expense at a certain interest rate.

The negative bond stuff matters because, if, in my situation, I have bonds paying 1.5% or a savings account paying 0.4% and a mortgage charging me 3.5%, I should think about whether I can reduce my expenses by paying down that debt. I don’t think it’s necessary to call the mortgage a “negative bond” to do that, but I do agree that it does function in that way and if it is helpful for people to think of it that way, fine. In your example, where the cash flow is actually increased by holding a mortgage (and you make a great point there), paying down that debt could still change that +$500 to +$800 every month. So even better.

In terms of asset allocation, I don’t really care about the mortgage affecting my equity percentage because of the reasons given above - i.e., the house de-risks the equity holdings. I am ok considering it however, as long as all of the positive aspects of the house that the mortgage offsets are considered as well.

I personally think of my home and mortgage as an asset and liability on the balance sheet, with my asset allocation separate, but I concede that I am indirectly considering it in my asset allocation decisions - i.e., the house allows me to take greater equity risk due to its inherent properties as a de-risking asset that pays your rent or rent+ every month.
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Re: "Mortgage is a negative bond" - please help me understand

Post by grabiner »

alex_686 wrote: Fri Apr 23, 2021 12:00 pm
KlangFool wrote: Fri Apr 23, 2021 11:32 am You bought a house at PITI of $1,800 per month. The market rent is $2,300 per month. You save/earn an imputed rent of $500 per month. So, why do you care that you have a mortgage? Or, whether the mortgage is "negative bond"? You make money every month. You improve your "cash flow" by buying the house.
If the market rent is $2,300 per month than the imputed rent is $2,300 per month, by definition.

PITI is irrelevant. Imputed rent is based off of the asset value. How you finance the asset is irrelevant. Does it matter to a renter if there is a large mortgage on it or not?
And the principal part of PITI is not an expense. If your PITI exceeds your rent (which it usually does in the early years of a mortgage), you may still be getting a benefit from owning the house, because the principal payment does not reduce your net worth. The principal payment has the net-worth benefit that it reduces future interest payments.

Interest is an expense, but it is an expense based on the mortgage, not the house. If you hold a bond portfolio which has the same duration and interest rate as your mortgage, you could use the bond portfolio to pay principal and interest, and be in the same financial position as if you had only taxes and insurance.
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Re: "Mortgage is a negative bond" - please help me understand

Post by KlangFool »

grabiner wrote: Fri Apr 23, 2021 4:27 pm
alex_686 wrote: Fri Apr 23, 2021 12:00 pm
KlangFool wrote: Fri Apr 23, 2021 11:32 am You bought a house at PITI of $1,800 per month. The market rent is $2,300 per month. You save/earn an imputed rent of $500 per month. So, why do you care that you have a mortgage? Or, whether the mortgage is "negative bond"? You make money every month. You improve your "cash flow" by buying the house.
If the market rent is $2,300 per month than the imputed rent is $2,300 per month, by definition.

PITI is irrelevant. Imputed rent is based off of the asset value. How you finance the asset is irrelevant. Does it matter to a renter if there is a large mortgage on it or not?
And the principal part of PITI is not an expense. If your PITI exceeds your rent (which it usually does in the early years of a mortgage), you may still be getting a benefit from owning the house, because the principal payment does not reduce your net worth. The principal payment has the net-worth benefit that it reduces future interest payments.

Interest is an expense, but it is an expense based on the mortgage, not the house. If you hold a bond portfolio which has the same duration and interest rate as your mortgage, you could use the bond portfolio to pay principal and interest, and be in the same financial position as if you had only taxes and insurance.
grabiner.

If rent is an housing expense and buying a house reducing the expense, what do you call it? Negative expense? Income? Savings? Especially when the PITI is significantly lowered then the market rent. Yes, if a person want to be more precise. the person could count only ITI and exclude the P portion. But, the point is still there.

<<Interest is an expense, but it is an expense based on the mortgage, not the house.>>

Which does not change the fact that it is the part of the expense of owning the house. Aka, part of the housing expense. If I do not buy the house, I do not need to take the mortgage. When I rent, I do not need a mortgage.

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Re: "Mortgage is a negative bond" - please help me understand

Post by willthrill81 »

KlangFool wrote: Fri Apr 23, 2021 4:39 pm Which does not change the fact that it is the part of the expense of owning the house. Aka, part of the housing expense. If I do not buy the house, I do not need to take the mortgage. When I rent, I do not need a mortgage.
But outside of most HCOL areas, renting an equivalent property will cost you more every month.
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Re: "Mortgage is a negative bond" - please help me understand

Post by KlangFool »

willthrill81 wrote: Fri Apr 23, 2021 4:44 pm
KlangFool wrote: Fri Apr 23, 2021 4:39 pm Which does not change the fact that it is the part of the expense of owning the house. Aka, part of the housing expense. If I do not buy the house, I do not need to take the mortgage. When I rent, I do not need a mortgage.
But outside of most HCOL areas, renting an equivalent property will cost you more every month.
Personal finance is personal. It won't matter whatever someone else do. If someone can find a deal like this, the person buy. If not, the person can keep on renting. For others that choose not to wait, they can pay a lot more.

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Re: "Mortgage is a negative bond" - please help me understand

Post by vineviz »

KlangFool wrote: Fri Apr 23, 2021 4:39 pm If rent is an housing expense and buying a house reducing the expense, what do you call it? Negative expense? Income? Savings?
Purchasing house is a form of savings, and is accounted for the same way as putting money in the bank, purchasing a savings bond, or investing in an ETF. Note that in this context, an investment is simply one form of savings.
KlangFool wrote: Fri Apr 23, 2021 4:39 pm <<Interest is an expense, but it is an expense based on the mortgage, not the house.>>

Which does not change the fact that it is the part of the expense of owning the house. Aka, part of the housing expense. If I do not buy the house, I do not need to take the mortgage. When I rent, I do not need a mortgage.
But it is NOT "part of the expense of owning the house". It is an expense related to the mortgage, not the house. This is the point that grabiner was making.

Lots of people own houses who don't have mortgages and, therefore, pay no interest.
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Re: "Mortgage is a negative bond" - please help me understand

Post by Thesaints »

csmath wrote: Thu Apr 22, 2021 3:35 pm
vineviz wrote: Thu Apr 22, 2021 3:27 pm
sureshoe wrote: Thu Apr 22, 2021 3:01 pm But I go back to the "so what"? Are people suggesting I do a different stock/bond mix to adjust my risk? I consider investment mix 1 decision. Then, your housing and lifestyle is a different risk/cost decision. The negative bond stuff just sounds like distraction.
The "so what" is that you can have a different stock/bond mix WITHOUT changing your overall portfolio risk. This is true because stocks and bonds represent only a subset of the portfolio for people who have a mortgage
Selling bonds that pay 1.3% and using that money to pay down a mortgage with a rate of 3% is a risk-neutral action that increases expected return.
I don't understand what it is that keeps people from seeing this fact. Whether you consider your mortgage / home equity as part of your AA or not (I don't), it does still impact the amount of risk that you are taking financially.

If we are being really picky, I'd say it is relatively risk neutral due to all the duration / liquidity nuances but in practice, yep, pretty neutral.

Edit to add: Maybe the problem really IS that the home isn't being considered part of the AA which conceals the fact that Going from 70/30 w/ mortgage to 80/20 without mortgage may be the exact same risk level.
Home equity is not a risk, if one uses their home as a place to live, rather than as a financial vehicle.
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Re: "Mortgage is a negative bond" - please help me understand

Post by junior »

Thesaints wrote: Fri Apr 23, 2021 5:27 pm ]

Home equity is not a risk, if one uses their home as a place to live, rather than as a financial vehicle.
Presumably anybody who might want to sell their house to pay for a nursing home one day would care if their home equity drops in value.

Of course if you save a whole lot of money and over fund your retirement you can pretend the house isn't a financial vehicle, but that has trade offs in sacrificing consumption for greater security.
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Re: "Mortgage is a negative bond" - please help me understand

Post by alex_686 »

junior wrote: Sat Apr 24, 2021 1:33 pm
Thesaints wrote: Fri Apr 23, 2021 5:27 pm ]

Home equity is not a risk, if one uses their home as a place to live, rather than as a financial vehicle.
Presumably anybody who might want to sell their house to pay for a nursing home one day would care if their home equity drops in value.

Of course if you save a whole lot of money and over fund your retirement you can pretend the house isn't a financial vehicle, but that has trade offs in sacrificing consumption for greater security.
Or plans on selling one day. People have been known to get a different job far away. Or to get married and have a child or three - and need a upgrade.

A home is a asset. Closing your eyes and pretending that a risk is not there won’t cause the tiger around the corner to go poof.
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Re: "Mortgage is a negative bond" - please help me understand

Post by rossington »

willthrill81 wrote: Fri Apr 23, 2021 8:59 am
rossington wrote: Fri Apr 23, 2021 4:23 am
vineviz wrote: Thu Apr 22, 2021 7:05 pm
Right. Imputed rent is a form of income, and it is properly accounted for like other forms of income and expense (including rent and dividends).
No it is not. It is neither tangible nor intangible. It is simply a theory.
So me living in my house without paying rent is 'simply a theory'? :oops:
By owning your home you are theoretically assuming or inferring an estimated amount you are saving or not spending. The point is that this presumed "income" should not be taxed by any standards.
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Re: "Mortgage is a negative bond" - please help me understand

Post by vineviz »

rossington wrote: Sun Apr 25, 2021 5:34 am By owning your home you are theoretically assuming or inferring an estimated amount you are saving or not spending. The point is that this presumed "income" should not be taxed by any standards.
Yet it IS taxed under several sets of accounting standards.

This is far from common, but imputed income is definitely sometimes taxable income.
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Re: "Mortgage is a negative bond" - please help me understand

Post by acegolfer »

USAFperio wrote: Thu Apr 15, 2021 9:29 pm Hi all, I'm the OP and am very appreciative of the diversity of thought and copious replies. I've learned quite a bit.

Quick follow-up scenario -- I'd appreciate your wisdom on this one:

I have $1M in retirement savings in a 60/40 stock/bond ratio, including $600K in VTSAX and $400K in bond index funds. I also owe $400K on my home mortgage. From what I've read in this thread, any dollar I spend toward paying off my mortgage is probably more beneficial than a dollar spent buying new bonds due to low bond interest rates. I therefore choose not to buy new bonds, but rather to sell my bonds to pay down my mortgage.

1. If I sell $200K in bonds to pay down $200K of my mortgage, I now have a $200K mortgage, $200K in bonds, $600K in stocks. Would I still consider my current AA to be 60/40? Or 75/25?

2. If I sell $400K in bonds to pay down the entire $400K mortgage, I now own a house with zero debt, $0K in bonds, and $600K in stocks. Would I still consider my current AA to be 60/40? Or 100/0?

If paying down the mortgage equates with buying new bonds, you'd think I should still consider my AA to be 60/40 in every scenario.

(For purposes of this example, I'm not including my home equity as part of my stock/bond AA . . . and I don't tend to think most people do so either, unless I'm mistaken.)
This is a "personal" finance question so it depends on the individual. Here's my take.

1. I don't include debt balance towards my AA calculation. I don't even include my bank balances. My AA is based on investment accounts. I have a target AA and monitor it. But unlike others, I'm not religious about it. I don't rebalance every month and the target can change.

2. I do consider making extra principal pmt on 4% mortgage as equivalent to investing in a 4% CD. It's an investment decision to me despite it may not affect my AA ratio.
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Re: "Mortgage is a negative bond" - please help me understand

Post by csmath »

Thesaints wrote: Fri Apr 23, 2021 5:27 pm
csmath wrote: Thu Apr 22, 2021 3:35 pm
vineviz wrote: Thu Apr 22, 2021 3:27 pm
sureshoe wrote: Thu Apr 22, 2021 3:01 pm But I go back to the "so what"? Are people suggesting I do a different stock/bond mix to adjust my risk? I consider investment mix 1 decision. Then, your housing and lifestyle is a different risk/cost decision. The negative bond stuff just sounds like distraction.
The "so what" is that you can have a different stock/bond mix WITHOUT changing your overall portfolio risk. This is true because stocks and bonds represent only a subset of the portfolio for people who have a mortgage
Selling bonds that pay 1.3% and using that money to pay down a mortgage with a rate of 3% is a risk-neutral action that increases expected return.
I don't understand what it is that keeps people from seeing this fact. Whether you consider your mortgage / home equity as part of your AA or not (I don't), it does still impact the amount of risk that you are taking financially.

If we are being really picky, I'd say it is relatively risk neutral due to all the duration / liquidity nuances but in practice, yep, pretty neutral.

Edit to add: Maybe the problem really IS that the home isn't being considered part of the AA which conceals the fact that Going from 70/30 w/ mortgage to 80/20 without mortgage may be the exact same risk level.
Home equity is not a risk, if one uses their home as a place to live, rather than as a financial vehicle.
You're putting blinders on and trying to only see equity instead of the big picture. I agree with alex_686 who posted shortly after you did responding to someone else:
alex_686 wrote: Sat Apr 24, 2021 3:32 pm A home is a asset. Closing your eyes and pretending that a risk is not there won’t cause the tiger around the corner to go poof.
Try not looking at equity as an isolated thing. Look at the funds it takes to build equity. When you have money and are determining where to put it, you have options. Each of those options have risk involved. All of those risks don't magically disappear once you make the transaction.

Do each of the below examples demonstrate people with the same risk profile?
  1. $1,000,000 Stocks / $0 Bonds / $1,000,000 home equity / $0 mortgage
  2. $1,000,000 Stocks / $0 Bonds / $0 home equity / $0 mortgage
  1. $500,000 Stocks / $500,000 Bonds / $1,000,000 home equity / $0 mortgage
  2. $500,000 Stocks / $500,000 Bonds / $0 home equity / $0 mortgage
  1. $1,000,000 Stocks / $0 Bonds / $500,000 home equity / $500,000 mortgage
  2. $1,000,000 Stocks / $0 Bonds / $0 home equity / $500,000 mortgage
I'm assuming that since you don't think home equity belongs in the risk equation at all, that you think each pair of these investors have the same risk profile. I however, I would argue two things. First, that the home equity does change the risk profile as they have an asset with value and higher home equity leads to lower future expenses. The ability to meet future expense needs is a risk.

Second, these comparisons are apples to oranges. Obviously person #2 is short on money compared to person #1 in all of these scenarios. What happened? Well, he likely made a decision where to put those extra funds. Where did they go? Maybe it looks something like this:
  1. $1,000,000 Stocks / $0 Bonds / $1,000,000 home equity / $0 mortgage
  2. $2,000,000 Stocks / $0 Bonds / $0 home equity / $0 mortgage
  1. $500,000 Stocks / $500,000 Bonds / $1,000,000 home equity / $0 mortgage
  2. $1,500,000 Stocks / $500,000 Bonds / $0 home equity / $0 mortgage
  1. $1,000,000 Stocks / $0 Bonds / $500,000 home equity / $500,000 mortgage
  2. $1,500,000 Stocks / $0 Bonds / $0 home equity / $500,000 mortgage
I'm intentionally not putting the funds into bonds in any of these cases. If you think that in order to balance the risk profiles I should have done something more like this...
  1. $1,000,000 Stocks / $0 Bonds / $1,000,000 home equity / $0 mortgage
  2. $1,000,000 Stocks / $1,000,000 Bonds / $0 home equity / $0 mortgage
  1. $500,000 Stocks / $500,000 Bonds / $1,000,000 home equity / $0 mortgage
  2. $500,000 Stocks / $1,500,000 Bonds / $0 home equity / $0 mortgage
  1. $1,000,000 Stocks / $0 Bonds / $500,000 home equity / $500,000 mortgage
  2. $1,000,000 Stocks / $500,000 Bonds / $0 home equity / $500,000 mortgage
Then you likely see that risk does need to be taken to build equity and that a mortgage sure does act a lot like a negative bond.
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Re: "Mortgage is a negative bond" - please help me understand

Post by HootingSloth »

Are we just confusing two different questions?:

(1) How does your risk profile change when you move from renting to purchasing a home and taking out a mortgage?
(2) How does your risk profile change when you make a prepayment on an existing mortgage?

The answer to (1) is: it is quite complicated and does not easily compare to changes in your risk profile that come from "asset allocation" decisions. The answer to (2) is: the change is very similar to purchasing a bond (with a caveat about liquidity and perhaps some other minor caveats).

When I bought a home, I had to think long and hard about the impact on my desired asset allocation, because the changes in risk were complex. Viewing the mortgage as a negative bond at this stage was somewhat helpful but only a small piece of the picture.

When I decide whether to prepay my mortgage (once I reached sufficient liquidity), I just look at the interest rates and send all of my new "fixed income" contributions towards the mortgage because it is higher. Viewing the mortgage as a negative bond at this stage is basically the whole picture.
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Re: "Mortgage is a negative bond" - please help me understand

Post by alex_686 »

HootingSloth wrote: Sun Apr 25, 2021 2:51 pm Are we just confusing two different questions?:

(1) How does your risk profile change when you move from renting to purchasing a home and taking out a mortgage?
(2) How does your risk profile change when you make a prepayment on an existing mortgage?
I would disagree with both points. I know where you are going and I broadly agree. But you are mixing up home ownership and mortgages together in a single line item and that confuses things.

#1 should be how does adding/purchasing a home change your risk and return profile.

#2 what should you AA be? Do you want a under leveraged portfolio? i.e., one with a next bond exposure. Or a leveraged portfolio? i.e. one with a net negative exposure due to the mortgage.

#2a, embedded in #2 is how you want to finance the purchase of a large illiquid asset.
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Re: "Mortgage is a negative bond" - please help me understand

Post by HootingSloth »

alex_686 wrote: Sun Apr 25, 2021 3:17 pm
HootingSloth wrote: Sun Apr 25, 2021 2:51 pm Are we just confusing two different questions?:

(1) How does your risk profile change when you move from renting to purchasing a home and taking out a mortgage?
(2) How does your risk profile change when you make a prepayment on an existing mortgage?
I would disagree with both points. I know where you are going and I broadly agree. But you are mixing up home ownership and mortgages together in a single line item and that confuses things.

#1 should be how does adding/purchasing a home change your risk and return profile.

#2 what should you AA be? Do you want a under leveraged portfolio? i.e., one with a next bond exposure. Or a leveraged portfolio? i.e. one with a net negative exposure due to the mortgage.

#2a, embedded in #2 is how you want to finance the purchase of a large illiquid asset.
I am perfectly fine with looking at things this way, and agree that it can be clarifying. My point is that the questions people ask themselves in practice as they go through their life are first (1) and then (2) above. The fact that (1) is ("under the hood") doing a combination of two different things is a big part of why the practical question is complicated.
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Re: "Mortgage is a negative bond" - please help me understand

Post by Hector »

For average folks who consider mortgage as a negative bond, do you not hold bonds?

By average, I mean loan amount is bigger or a huge compare to total bond value in your total stock/bond allocation.

Assume your effective loan is higher than effective bond interest.

Let's say your total stock/bond is worth $200k. At 60/40, that is $80k in bonds. Your remaining loan is $200k. Let's say you take 10 years to save $120k. Would you use $80k in bonds and all savings for the next 10 years to pay off your loan? For the next 10 years, would you be in 100% stock and not make any new investment into either stock or bond?
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Re: "Mortgage is a negative bond" - please help me understand

Post by steve r »

Hector wrote: Tue Aug 15, 2023 6:08 pm For average folks who consider mortgage as a negative bond, do you not hold bonds?

By average, I mean loan amount is bigger or a huge compare to total bond value in your total stock/bond allocation.

Assume your effective loan is higher than effective bond interest.

Let's say your total stock/bond is worth $200k. At 60/40, that is $80k in bonds. Your remaining loan is $200k. Let's say you take 10 years to save $120k. Would you use $80k in bonds and all savings for the next 10 years to pay off your loan? For the next 10 years, would you be in 100% stock and not make any new investment into either stock or bond?
Opinions may vary, but probably not. In ten years, you would be 100 percent in stock with no debt if you did this.

What I might do is use the $80k to pay down your higher rate loan, and then with your savings split it 60/40 buy stock / pay down loan. This option would leave you more in stocks but have a loan for more time.

In other words, you could be too conservative by paying off loan. It is a balancing act that varies from person to person and situation to situation.
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Re: "Mortgage is a negative bond" - please help me understand

Post by Hector »

steve r wrote: Tue Aug 15, 2023 6:24 pm
Hector wrote: Tue Aug 15, 2023 6:08 pm For average folks who consider mortgage as a negative bond, do you not hold bonds?

By average, I mean loan amount is bigger or a huge compare to total bond value in your total stock/bond allocation.

Assume your effective loan is higher than effective bond interest.

Let's say your total stock/bond is worth $200k. At 60/40, that is $80k in bonds. Your remaining loan is $200k. Let's say you take 10 years to save $120k. Would you use $80k in bonds and all savings for the next 10 years to pay off your loan? For the next 10 years, would you be in 100% stock and not make any new investment into either stock or bond?
Opinions may vary, but probably not. In ten years, you would be 100 percent in stock with no debt if you did this.

What I might do is use the $80k to pay down your higher rate loan, and then with your savings split it 60/40 buy stock / pay down loan. This option would leave you more in stocks but have a loan for more time.

In other words, you could be too conservative by paying off loan. It is a balancing act that varies from person to person and situation to situation.
It is hard to see how this negative bond work in practice. We often compare its return with bond interest. Comparing loan interest with expected return from overall AA might be more useful.
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Re: "Mortgage is a negative bond" - please help me understand

Post by patrick »

Hector wrote: Tue Aug 15, 2023 6:08 pm For average folks who consider mortgage as a negative bond, do you not hold bonds?

By average, I mean loan amount is bigger or a huge compare to total bond value in your total stock/bond allocation.

Assume your effective loan is higher than effective bond interest.

Let's say your total stock/bond is worth $200k. At 60/40, that is $80k in bonds. Your remaining loan is $200k. Let's say you take 10 years to save $120k. Would you use $80k in bonds and all savings for the next 10 years to pay off your loan? For the next 10 years, would you be in 100% stock and not make any new investment into either stock or bond?
In that scenario your bonds add up to -120K. If the home is worth $400K, then your net worth is $400K and your asset allocation is 100% house, 30% stock, -30% bond.

If the loan interest rate is higher than bond interest, holding both is a losing proposition. You unnecessarily pay more interest than you receive on the portion of the mortgage you could have paid with the bonds. It may well be worth keeping a little cash to cover expenses. You might want to keep the mortgage so that you'll have more liquid assets in case you face a sudden large unexpected essential expense at a time that a HELOC is unavailable, but note the significant interest cost.

On the other hand, note that the portfolio is leveraged. There is a total of 130% in stocks and housing combined. If you don't want to use this level of leverage, then it would be prudent to sell some or all of the stocks to pay down the mortgage rather than waiting 10 years to finish paying.

Finally, note that current interest rates may be higher than the mortgage rate. If you got (or refinanced) the mortgage a couple of years ago it might only be 3%. In this case it would be worth making only minimum payments while you are collecting a higher rate of interest on your bonds (or your cash for that matter).
It is hard to see how this negative bond work in practice. We often compare its return with bond interest. Comparing loan interest with expected return from overall AA might be more useful.
The point in practice is that the mortgage is already part of your portfolio and thus part of your AA. If you sell bonds to pay down the mortgage, your overall AA does not change. However, if you sell from both stocks and bonds to pay down the mortgage, then your overall AA does change.
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Re: "Mortgage is a negative bond" - please help me understand

Post by alex_686 »

Hector wrote: Tue Aug 15, 2023 6:08 pm For average folks who consider mortgage as a negative bond, do you not hold bonds?

By average, I mean loan amount is bigger or a huge compare to total bond value in your total stock/bond allocation.

Assume your effective loan is higher than effective bond interest.

Let's say your total stock/bond is worth $200k. At 60/40, that is $80k in bonds. Your remaining loan is $200k. Let's say you take 10 years to save $120k. Would you use $80k in bonds and all savings for the next 10 years to pay off your loan? For the next 10 years, would you be in 100% stock and not make any new investment into either stock or bond?
Quick answer is yes.

So there are lots of points that I want to make.

Your calculations are a bit off. If you have assets of 200k and liabilities of 200k then your net worth is zero. If you wanted to have a 60/40 split than you would invest all 200k into bonds. This would leave you with a net bond value of $0. New money added would be split 60/40 between stocks & bonds.

Next.

Treating a mortgage as a negative bond belongs to the school of high rationality, of Homo Economicus. The 60/40 asset allocation is probably coming from a heuristic, a rule of thumb. As such there are going to be mismatches, so let us examine them.

First batch of considerations. 60/40 is probably not the answer.

If you are going to included your mortgage on your balance sheet you should also include the value of your property. Your property is probably more bond-like than equity-like.

You may also consider your human capital and Social Security. These are more bond-like then equity-like.

Lastly consider the theory of Life-Cycle investing. If you have a large mortgage then you are probably early in your life. Life-Cycle would suggest that you leverage up your portfolio (i.e., get a mortgage on your house) and be risk-on (i.e. heavily skewed towards equities). Younger people tend to be able to take more risks due to longer time frame, lots of human capital, low amounts of financial capital, as referenced above.

Second batch of considers. Why is 60/40 the answer?

The generic answer is that the 60/40 portfolio is the most efficient, the highest return for the least amount of risk.

That being said, your Asset Allocation should match your goals. Having a efficient portfolio is a important goal but maybe not your only goal. Maybe you have a liquidity goal as well. Maybe you want a slug of your assets in liquid safe assets in your taxable account. i.e. your emergency fund. (There is a debate if you should include your emergency fund as part of your asset allocation. From a rational viewpoint you should, but this does add additional complexity. I would argue if you are adding your mortgage you might as well go all the way but everyone is different.)

A "Unconstrained Portfolio" always one to use leverage, and thus one cash have asset allocations above 100% or asset allocations below 0%. However there are some accounts that require a "Constrained Portfolio". For example, most retirement accounts. I can't freely transfer money into and out of my retirement accounts. My retirement accounts may have access to unique assets such as a stable value fund. My I-bonds purchases are limited. Tax drag calculations may push the optimal AA.

So yeah, I have always had a modest amount of bonds even considering mortgages, student loan debt, etc. Most of my liquidity needs were meet using equity in taxable accounts (with a 50% haircut) and a HELOC line. Stable value funds in my 401k, TIPS in my IRA.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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Re: "Mortgage is a negative bond" - please help me understand

Post by Hector »

patrick wrote: Wed Aug 16, 2023 2:37 pm
Hector wrote: Tue Aug 15, 2023 6:08 pm For average folks who consider mortgage as a negative bond, do you not hold bonds?

By average, I mean loan amount is bigger or a huge compare to total bond value in your total stock/bond allocation.

Assume your effective loan is higher than effective bond interest.

Let's say your total stock/bond is worth $200k. At 60/40, that is $80k in bonds. Your remaining loan is $200k. Let's say you take 10 years to save $120k. Would you use $80k in bonds and all savings for the next 10 years to pay off your loan? For the next 10 years, would you be in 100% stock and not make any new investment into either stock or bond?
In that scenario your bonds add up to -120K. If the home is worth $400K, then your net worth is $400K and your asset allocation is 100% house, 30% stock, -30% bond.

If the loan interest rate is higher than bond interest, holding both is a losing proposition. You unnecessarily pay more interest than you receive on the portion of the mortgage you could have paid with the bonds. It may well be worth keeping a little cash to cover expenses. You might want to keep the mortgage so that you'll have more liquid assets in case you face a sudden large unexpected essential expense at a time that a HELOC is unavailable, but note the significant interest cost.

On the other hand, note that the portfolio is leveraged. There is a total of 130% in stocks and housing combined. If you don't want to use this level of leverage, then it would be prudent to sell some or all of the stocks to pay down the mortgage rather than waiting 10 years to finish paying.

Finally, note that current interest rates may be higher than the mortgage rate. If you got (or refinanced) the mortgage a couple of years ago it might only be 3%. In this case it would be worth making only minimum payments while you are collecting a higher rate of interest on your bonds (or your cash for that matter).
It is hard to see how this negative bond work in practice. We often compare its return with bond interest. Comparing loan interest with expected return from overall AA might be more useful.
The point in practice is that the mortgage is already part of your portfolio and thus part of your AA. If you sell bonds to pay down the mortgage, your overall AA does not change. However, if you sell from both stocks and bonds to pay down the mortgage, then your overall AA does change.
How do I maintain AA between house, stock and bond?

Sure, houses are assets, but on paper for a few reasons, especially when we include house in investment related AA. A lot of folks don't sell primary residences for income. You sell stock and bonds to fund retirement. Folks rarely sell houses gradually to fund retirement or rent part of it. Many people rarely generate income from their primary house. Also, why does it matter what the market value of the house is if someone will not sell it?

For me, a house is an expense. If nothing else, I would pay the mortgage, property tax and other expenses associated with it. Yes, I can sell stock/bond to reduce or pay off my mortgage. But I am struggling how not to compare the mortgage loan with an expected return from stock/bond AA. If I sell bonds (because they are yielding lower than mortgage), am I a capable of hainvg a very high stock allocation and risk of not adding new money to stock for a few years for my invested $$.
Last edited by Hector on Wed Aug 16, 2023 6:34 pm, edited 1 time in total.
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Re: "Mortgage is a negative bond" - please help me understand

Post by SpaghettiLegs »

Well this is a bump of a 2 year old thread but I’m glad as it’s something I’ve never considered or heard of but an interesting thought exercise. I like the negative bond argument for the simple reason it gets me to think about my mortgage as something other than a simple expense but I otherwise disagree. A house does not change value in response to the same forces as a bond. As others have argued, my bond money isn’t necessarily flowing in and out of the same pot as my house money, although for some people it might.
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Re: "Mortgage is a negative bond" - please help me understand

Post by steve r »

SpaghettiLegs wrote: Wed Aug 16, 2023 5:01 pm Well this is a bump of a 2 year old thread but I’m glad as it’s something I’ve never considered or heard of but an interesting thought exercise. I like the negative bond argument for the simple reason it gets me to think about my mortgage as something other than a simple expense but I otherwise disagree. A house does not change value in response to the same forces as a bond. As others have argued, my bond money isn’t necessarily flowing in and out of the same pot as my house money, although for some people it might.
The discussion will not likely come back up in force because the rates people receive from bonds are now higher than the rate they pay on their mortgages. The discussion had a lot more traction when one could reduce there bond holdings paying like 1 percent and reduce mortgage that was 3 percent. The math made even more sense when ones bond earnings were taxed but the mortgage became (for many) not deductible.

You are correct that houses do not change based on the same forces as bonds. But that was not really the point which was more of an interest rate play.
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Re: "Mortgage is a negative bond" - please help me understand

Post by patrick »

Hector wrote: Wed Aug 16, 2023 4:23 pm
patrick wrote: Wed Aug 16, 2023 2:37 pm
Hector wrote: Tue Aug 15, 2023 6:08 pm For average folks who consider mortgage as a negative bond, do you not hold bonds?

By average, I mean loan amount is bigger or a huge compare to total bond value in your total stock/bond allocation.

Assume your effective loan is higher than effective bond interest.

Let's say your total stock/bond is worth $200k. At 60/40, that is $80k in bonds. Your remaining loan is $200k. Let's say you take 10 years to save $120k. Would you use $80k in bonds and all savings for the next 10 years to pay off your loan? For the next 10 years, would you be in 100% stock and not make any new investment into either stock or bond?
In that scenario your bonds add up to -120K. If the home is worth $400K, then your net worth is $400K and your asset allocation is 100% house, 30% stock, -30% bond.

If the loan interest rate is higher than bond interest, holding both is a losing proposition. You unnecessarily pay more interest than you receive on the portion of the mortgage you could have paid with the bonds. It may well be worth keeping a little cash to cover expenses. You might want to keep the mortgage so that you'll have more liquid assets in case you face a sudden large unexpected essential expense at a time that a HELOC is unavailable, but note the significant interest cost.

On the other hand, note that the portfolio is leveraged. There is a total of 130% in stocks and housing combined. If you don't want to use this level of leverage, then it would be prudent to sell some or all of the stocks to pay down the mortgage rather than waiting 10 years to finish paying.

Finally, note that current interest rates may be higher than the mortgage rate. If you got (or refinanced) the mortgage a couple of years ago it might only be 3%. In this case it would be worth making only minimum payments while you are collecting a higher rate of interest on your bonds (or your cash for that matter).
It is hard to see how this negative bond work in practice. We often compare its return with bond interest. Comparing loan interest with expected return from overall AA might be more useful.
The point in practice is that the mortgage is already part of your portfolio and thus part of your AA. If you sell bonds to pay down the mortgage, your overall AA does not change. However, if you sell from both stocks and bonds to pay down the mortgage, then your overall AA does change.
How do I maintain AA between house, stock and bond?

Sure, houses are assets, but on paper for a few reasons, especially when we include house in investment related AA. A lot of folks don't sell primary residences for income. You sell stock and bonds to fund retirement. Folks rarely sell houses gradually to fund retirement or rent part of it. Many people rarely generate income from their primary house. Also, why does it matter what the market value of the house is if someone will not sell it?

For me, a house is an expense. If nothing else, I would pay the mortgage, property tax and other expenses associated with it. Yes, I can sell stock/bond to reduce or pay off my mortgage. But I am struggling how not to compare the mortgage loan with an expected return from stock/bond AA. If I sell bonds (because they are yielding lower than mortgage), am I a couple with a very high stock allocation and risk of not adding new money to stock for a few years for my invested $$.
Houses are indeed not as liquid or divisible as stock and bond investments. They still have value and in the scenario above are the whole net worth. It may be easier to ignore house price changes, but when living in the house you get the equivalent of income by avoiding having to pay rent to someone else. Also note that mortgage payments are not an expense inherent to the house as they are come from the debt instead.

Ignoring the house won't change the result unless you also ignore the mortgage. In this scenario, non-house assets add up to 120K in stocks and -120K in fixed income for a total of 0. Selling 80K in bonds to pay 80K of mortgage leaves 120K in stocks and -120K in fixed income. However, selling half the stocks to pay the mortgage reduces to 60K in stocks, a shift from stocks to fixed income.
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Re: "Mortgage is a negative bond" - please help me understand

Post by Hector »

alex_686 wrote: Wed Aug 16, 2023 2:38 pm
Hector wrote: Tue Aug 15, 2023 6:08 pm For average folks who consider mortgage as a negative bond, do you not hold bonds?

By average, I mean loan amount is bigger or a huge compare to total bond value in your total stock/bond allocation.

Assume your effective loan is higher than effective bond interest.

Let's say your total stock/bond is worth $200k. At 60/40, that is $80k in bonds. Your remaining loan is $200k. Let's say you take 10 years to save $120k. Would you use $80k in bonds and all savings for the next 10 years to pay off your loan? For the next 10 years, would you be in 100% stock and not make any new investment into either stock or bond?
Quick answer is yes.

So there are lots of points that I want to make.

Your calculations are a bit off. If you have assets of 200k and liabilities of 200k then your net worth is zero. If you wanted to have a 60/40 split than you would invest all 200k into bonds. This would leave you with a net bond value of $0. New money added would be split 60/40 between stocks & bonds.

Next.

Treating a mortgage as a negative bond belongs to the school of high rationality, of Homo Economicus. The 60/40 asset allocation is probably coming from a heuristic, a rule of thumb. As such there are going to be mismatches, so let us examine them.

First batch of considerations. 60/40 is probably not the answer.

If you are going to included your mortgage on your balance sheet you should also include the value of your property. Your property is probably more bond-like than equity-like.

You may also consider your human capital and Social Security. These are more bond-like then equity-like.

Lastly consider the theory of Life-Cycle investing. If you have a large mortgage then you are probably early in your life. Life-Cycle would suggest that you leverage up your portfolio (i.e., get a mortgage on your house) and be risk-on (i.e. heavily skewed towards equities). Younger people tend to be able to take more risks due to longer time frame, lots of human capital, low amounts of financial capital, as referenced above.

Second batch of considers. Why is 60/40 the answer?

The generic answer is that the 60/40 portfolio is the most efficient, the highest return for the least amount of risk.

That being said, your Asset Allocation should match your goals. Having a efficient portfolio is a important goal but maybe not your only goal. Maybe you have a liquidity goal as well. Maybe you want a slug of your assets in liquid safe assets in your taxable account. i.e. your emergency fund. (There is a debate if you should include your emergency fund as part of your asset allocation. From a rational viewpoint you should, but this does add additional complexity. I would argue if you are adding your mortgage you might as well go all the way but everyone is different.)

A "Unconstrained Portfolio" always one to use leverage, and thus one cash have asset allocations above 100% or asset allocations below 0%. However there are some accounts that require a "Constrained Portfolio". For example, most retirement accounts. I can't freely transfer money into and out of my retirement accounts. My retirement accounts may have access to unique assets such as a stable value fund. My I-bonds purchases are limited. Tax drag calculations may push the optimal AA.

So yeah, I have always had a modest amount of bonds even considering mortgages, student loan debt, etc. Most of my liquidity needs were meet using equity in taxable accounts (with a 50% haircut) and a HELOC line. Stable value funds in my 401k, TIPS in my IRA.
I agree that if I have assets of 200k and liabilities of 200k, then my net worth is zero. But don't we focus on total liquid assets, mainly stocks and bonds, for investing? The reason I want to have some AA between stock and bonds from liquid assets is that I can sleep well at night (bond) and attain 5-7% growth (stock).

I am having a hard time including a mortgage on my balance sheet. I see it as an expense because I need to keep paying the mortgage and property taxes. Even after the mortgage is paid off, I will need to keep paying property tax. I would like to have a primary residence that I can live in as long as I can.

I think my risk profile is changing overtime. My AA used to be the age in the bond. When I reached that age, I stopped increasing my bond %. I dropped a separate EF a few years ago. I also dropped separate down payment and treated everything as overall AA. Did that for a few years before taking a mortgage. Today, my mortgage rate is lower than the effective bond interest rate. But who knows where things will be in the future? I want to understand this "Mortgage is a negative bond" concept. So when bond interest rates go lower than the mortgage rate, I might have an idea what to do, if anything.
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Re: "Mortgage is a negative bond" - please help me understand

Post by Minderbinder »

The issue is the mortgage creates leverage. Simplistic example, supposing one has a $1mm portfolio entirely in stock.

They then borrow $1mm mortgage to buy a $1mm house.

Their net worth is still $1mm. However they have $2mm of assets that are positively correlated to the economy ($1mm stocks and $1mm housing) and debt of $1mm.

If thinks go south and say both house and stocks lose 60%, the investor now has a negative net worth of $200k.

The asset side of the ledger and the real estate exposure usually don't come up in "pay down mortgage or invest" threads, even though it is entirely a question of how much leverage is truly appropriate. If more is always better, spx futures for example provide the same at a cheaper cost than mortgages.
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Re: "Mortgage is a negative bond" - please help me understand

Post by Stormbringer »

The S&P 500 companies owe trillions. Every share of stock comes with its own "negative bond" if you want to go down that rabbit hole.
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Re: "Mortgage is a negative bond" - please help me understand

Post by alex_686 »

First, you should construct your AA so that it provides clear insight and actionable information to you. As such there is not right way of doings things - but there are wrong ways of dong it.
Hector wrote: Wed Aug 16, 2023 6:32 pmI am having a hard time including a mortgage on my balance sheet. I see it as an expense because I need to keep paying the mortgage and property taxes. Even after the mortgage is paid off, I will need to keep paying property tax. I would like to have a primary residence that I can live in as long as I can. But don't we focus on total liquid assets, mainly stocks and bonds, for investing?
So more points.

While we might have multiple accounts and assets we have only a single portfolio. To think otherwise is to engage in mental accounting.

https://en.wikipedia.org/wiki/Mental_accounting

This falls into the "cognitive load" class of errors. That is we take hard problems and break them down into simpler problems. We have direct control over liquid assets so they are easier to think about. Because money is fungible compartmentalization leads to sub-optional optimization.

We have lots of big stones in our financial lives. Social security, business ownership, insurance policies, employee stock options and restricted stock are but a few examples. They may not be liquid, they may be hard to measure, but they have a high impact.

So, above, when I said that AA should provide information? Adding these items to your balance sheet adds complexity. It also allows you to address complex questions using a coherent set of logic, allowing to avoid behavioral and cognitive errors. Having formal training in this area makes the answer easy for me - add them.

Examples:

Mortgage and property taxes as expenses - true, but are they in the same class? Property taxes are fixed, your mortgage interest payments are not. You could pay down or pay off your mortgage, refi it, take out a new one with cash out. If you break things out you can see what bits you have control over and what parts you don't.

You can see risk and optionality. How leveraged is your home? While you may think of the home only as a expense lots of people back in 2008 thought of it as a ball and chain. I was in this situation. My house was underwater. I wanted to move to a bigger house but really couldn't. All of my assets where locked away in tax advantaged accounts. On the flip side I know lots of people who have a fair slice of equity in their homes. This gives them the option to sell their house, take the cash, and move to a low cost of living area for retirement.

Lastly their is the fungibility of cash. You have $1,000 to invest from your last paycheck. Do you put it in your taxable account, tax advantaged account, or pay down your mortgage? If in a brokerage account do you invest in bonds or equities? If you are highly leveraged and your taxable account is thin you are going to get one answer. If your mortgage rates are low you are going to get a different answer. If inflation is high you are going to get a different answer. If your mortgage rates are high you are going to have a more complicated question vis a vis equities verse paydown.

So, long way around.

It is more complex on the front end to pull everything onto your balance sheet. However once the stuff is on your balance sheet things become much simpler. All of your information is in one spot. This allows you to make decisions based on your total situation instead of ad hocking things.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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