Dos Preguntas: Mortgage Selection & Sequence of Returns Risk

Thanks to the fantastic readers of FinanciaLibre, we all get to benefit from amazing comments and questions at the end of FL articles. And it’s a sincere pleasure for me to participate in knowledge-building discourse going on in the discussion section of posts.

So, first, I want to send a big-time gracias to all you readers and commenters out there who make each topic’s exploration much richer. Thank you!

Dos Preguntas: Mortgage Strategy & Sequence of Returns Risk
Dos Preguntas: Mortgage Strategy & Sequence of Returns Risk

Second, there are two discussion points brought up in recent articles I’d like to single-out as particularly thought-provoking.

These two comment/question/discussion threads are super-powerful and likely contain relevant points for many people. So, rather than risk they go unseen by readers who might not always read posts’ comments, I thought I’d reproduce them here and bubble them up to the main stage where they belong.

The first I’ll highlight is a series of questions relating to the FL post entitled “A 15-Year Mortgage Costs $409,112 More Than You Think.”

The discussion relates to strategy in mortgage selection (chiefly between a 30-year mortgage and a 15-year mortgage), taking into consideration things like 401(k) contributions, diversification, inflation and future planning to finance income property purchases.

The discussion comes from reader “wannabelibre,” who I can only imagine is one of the coolest bros out there with a handle like that. Many thanks, wannabelibre!

The second thread relates to the FL post entitled “The 4% Rule, Inflation & Building Wealth in Retirement.”

Here, the discussion covers sequence of returns risk and that risk’s impact on safe withdrawal rates from a retiree portfolio.

This topic was raised by Mr. PIE over at Plan.Invest.Escape. Mr. and Mrs. PIE do some very nice and bro-approved work over on their site, and I’m super-pumped about the groovy comment/question placed here.

All right! Here we go…

1. Mortgage Selection

Wannabelibre: How would you respond to the argument where someone who is maximizing 401k contributions would consider a 15 year mortgage as diversification? In this case, locking in interest savings now is effectively like putting money in a risk-free CD, which still fights inflation.

Also, I think getting a 15 year mortgage for the primary home may be optimal if one is considering buying investment properties to rent out in the future. I didn’t do any math but that’s my instinct. Would you agree?

Anyway, great article! The attention to detail is much appreciated. I subscribed and definitely look forward to checking out those spreadsheets.

FinanciaLibre: Amazing comments/questions as always, wannabelibre! Thanks for adding so much to these discussions here! And thank you for subscribing. I’ll send out the spreadsheets next week.

Let me try to unpack the questions you laid out. First, I’m not sure whether a homebuyer’s level of 401k contributions has bearing on the issue of which mortgage type is superior for that homebuyer. If two identical homebuyers are both maxing out 401k contributions, and one takes a 30Y mortgage while the other takes a 15Y, the 30Y mortgagee can still invest the excess available cash in taxable equities accounts and dramatically outperform the 15Y mortgagee.

Flipping things around, I think we get the same directional result. In the analysis done here, I assumed equities investing in a taxable account, and I assumed those equities are never sold. But if the equities purchases were done, instead, in a tax-deferred account (i.e., both homebuyers could add funds to 401ks or IRAs), the argument for a 30Y would be even stronger because the equities returns wouldn’t have to be tax-effected and the leveraging benefit would be greater. So, whether the homebuyer has room to make more 401k contributions doesn’t seem to matter.

From a diversification perspective, my thoughts are that, when a long-term horizon is considered like 10 or 15 or 20 or 30 years, an investor simply wants to max out total long-run returns; volatility doesn’t matter that much. And so the investor can look to long-run performance of equities versus other asset classes and determine they offer the best bet for maximum gains.

Which means, regardless of whether the homebuyer already is investing in equities via 401k contributions, he is still behooved to take the 30Y to enable more equities investing in a taxable account. (Assuming, that is, the investor’s goal is long-run wealth maximization.) This long-term focus is particularly relevant in considerations relating to 401k/IRA accounts and mortgages because both imply long investing horizons.

As pertains to the ideas of locking in interest savings now and fighting inflation, I think both effects are stronger and more beneficial with the 30Y mortgage than the 15Y. Taking a 30Y mortgage locks in historically low interest rates for twice as long as a 15Y. And the inflation-fighting benefit of purchasing a home is found in the avoidance of rent increases over time. Which benefit is identical for homebuyers regardless of mortgage type.

Now, your last point is a whole different animal. If a homebuyer purchasing his primary residence is planning to buy investment properties to generate rental income in the future, there’s a whole slew of other considerations that apply. Chiefly, for our purposes here, that homebuyer will need to consider his ability to obtain financing for those future property purchases. Although the tests for financing of investment properties can differ from those for primary residences, the buyer’s total debt position would almost certainly be considered (depending on whether the investment property purchases are to be made by a company under the buyer’s control or by the buyer directly).

And if the homebuyer needs to reduce principal on his primary residence rapidly to obtain that new financing, then a lower-interest mortgage could be preferable to a 30Y. But if that’s the plan, then I don’t know the 15Y would be the best option. If the homebuyer knows he’ll pay the thing off rapidly, he’d be better to get the very lowest interest rate possible without regard for duration. And a 15Y probably wouldn’t provide a lower rate than a more speculatively-geared ARM type of product.

Again, though, this whole multi-property question is a very different animal that introduces lots of gnarly considerations. And, for the record, I’m not a tremendous fan of the tenants and toilets business model, even though I recognize the cash flow and tax arguments in its favor.

I hope this all helps. Thank you again for the great thoughts, wannabelibre!

Wannabelibre: Thank you for your thoughtful reply!

2. Sequence of Returns Risk

Mr. PIE: Rather excellent detail, FL! Nice one.

Have any of the aforementioned retirement researchers or your good self modeled the can of worms that is the (poor) sequence of returns issue?

That is, how do you know what degree of “crap returns” should concern you if the crap hits the proverbial air exhaust system in the first few years of retirement ?

I think I may have seen something from Pfau before on this topic but darned if I can put my browser onto it.

FinanciaLibre: Thanks for the great comment and question, Mr. PIE! Exactly the follow-up issue I’m planning to address in detail soon (and it is a complex issue in many ways).

But for now let’s see if we can’t get a pretty good answer just taking one particularly nasty era of history and matching it against the max withdrawal rates from Pfau’s research cited here. I think the example actually goes quite a long way in giving some peace of mind about sequence risk.

Starting in 1929, the S&P 500 suffered annual losses in 9 out of 13 years. Which is “crap performance” of such scale that no known sewage control technology would be able to contain it. The annual performance figures for the S&P 500 starting in 1929 through 1941: -8.3%; -25.1%; -43.8%; -8.6%; 49.9%; -1.2%; 46.7%; 31.9%; -35.3%; 29.3%; -1.1%; -10.7%; -12.8%. Over that same period, the average annual return on the 10-year treasury was a relatively blazing 3.7%.

So, total crap all the way around.

And what are the SWRs from pal Pfau’s table? Well, for a retiree entering the good life as of Jan 1., 1929, all those historically bad returns would mean the maximum withdrawal rate to maintain real wealth over 30 years was 3.8%. And to maintain nominal wealth: 4.3%. Meaning, despite just putrid market performance for pretty much the first half of the 30-year period, that retiree could still have followed something like the 4% Rule and been quite all right.

Hope this helps. There are some other issues with sequence risk, of course. And there are simple ways to mitigate it (since it’s really just an artifact of volatility). But my personal feeling is the fear is often a little overblown.

Mr. PIE: Thanks for the detailed reply. This really helps to assuage some fears. After I posed the question, I also found some stuff I had read before from Michael Kitces

He has a couple of good articles also on the sequence risk issue.

Look forward to reading your post on this very issue also.

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And there you have it, Luchadores! Many thanks to everyone again.

Until next time, stay tucked and stay lean and do it all with a big-ass grin.

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