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How to Compute a Mortgage Free Portfolio

When preparing a FIRE budget, it gets confusing when you compute your mortgage expenses.

Assuming a 30 years fixed interest mortgage, payable each month, the following happens:

  1. Some of the payment goes to principal (illiquid savings)
  2. Some of the payment goes to interest (potentially deductible)
  3. Some of the payment goes for taxes (potentially deductible).
  4. The payment (except for taxes) is not inflation adjusted.
  5. The payment ends after a certain period of time (ex: 30 years).
  6. The portion of the payment to the principal increases for each payment. In other words, each month, the portion that goes to the principal increases, while the portion that goes to the interests decreases.

Inputting the mortgage payment as an expense in FIRE computation leads to an invalid portfolio requirements number. Using the 4% rule, assuming the mortgage payment is $2,000 per month. Do you need a $2,000 * 12 * 25 = $600,000 portfolio to sustain it? The answer is no.

One part of the expenses of the mortgage goes into the principal, you’re paying yourself, it’s forced savings. Furthermore, the 4% rule assumes inflation adjusted expenses, which is not the case for the mortgage. To understand this better, in 20 years from now, you will still be paying $2,000 for the mortgage, but that amount in future dollars will be less compared to present day dollars.

So how do you compute the savings amount required? It is similar to the question of “Should you pay off your mortgage?”.

From a cash-flow perspective (ex: I need $2,000 each month), you need to compute the portfolio amount which will generate enough income to pay $2,000 each month for the duration of the mortgage, 30 years in our example. 

As you will see, the portfolio required depends on factors such as the mortgage interest rate, the borrowed amount and the expected market return.

I use cFireSim to compute the required portfolio. Wait, what? This is a retirement calculator, how does it help compute the portfolio required for a mortgage? Consider the mortgage payment as a retirement expense. Then consider the mortgage duration to be the retirement duration and finally, make the expenses not inflation adjusted.

Start with the Initial Yearly Spending. Put how much you pay for the mortgage there. Put the interest and principal amounts, but do not put the taxes if you pay them through an escrow. Those taxes will have to be computed separately and will be part of normal retirement expenses.

For Spending Plan, choose Not Inflation Adjusted. This is important since the mortgage amount will not increase over the years.

For Retirement Year, put the current year, which was 2022 for me. For Retirement End Year, put the year where the mortgage will end. In my case a 30 years mortgage, this is 2052. Remember, this is not an endorsement of keeping a 30 years mortgage, but just a way to compute it, input the values that match your situation.

Now, update the portfolio equities and bonds composition to match your risk tolerance. As an example, 75:25.

And finally, here comes the interesting part, the portfolio value. Your goal is to find which portfolio will have a 95% success rate. 

You can start by plugging in how much money you still owe on the home. If your mortgage interest rate is great, it will likely yield 100% success. Now reduce the portfolio value, say by 50k and look at the success rate again. If the success rate is too low, increase the portfolio value. If the success rate is still 100%, reduce the portfolio value again. This is like finding a word in a dictionary going back and forth as you figure out the correct amount.

Note: I used 95% success rate because I am comfortable with that number. 100% feels too conservative to me as there are always other events that happen in life that may derail this plan. Feel free to use a lower or higher number that matches your risk tolerance.

Finally, you got your portfolio amount. Congratulations! In my case, the number is 385,000. Since I owe more than this on the mortgage, it makes no sense for me to pay it off since the expected returns on this investment will, 95% of the time, generate enough returns to pay the owed amount.

What if the portfolio amount is higher than the mortgage owed amount? This means you should try to pay it off immediately or renegotiate your interest rate. You are essentially losing money on that loan. If you have existing investments, it may even make sense to sell some of them to pay-off your mortgage.

Now that you have computed the portfolio amount to pay the mortgage, you can remove this amount from your retirement portfolio and you can also remove the mortgage expenses (principle + interest) from your monthly expenses.

In other words, your retirement portfolio is composed of two buckets. The first bucket takes care of paying off the home. The second bucket takes care of your normal expenses, inflation adjusted. If you want, you can even open a brokerage account for the mortgage portfolio to separate it. But you don’t have to. It is just mental accounting.

You can repeat this exercise yearly to see how the plan is going.

I have updated my own spreadsheet to separate the mortgage expenses from the general expenses. This allows me to get a more accurate target for retirement.

Further discussion

It is possible to push this idea further. Afterall, once you are done paying with your home, you could, technically, borrow against your home and repeat the process. Assuming the investment returns are still higher than the loan, it could make sense.

Some folks would even suggest an interest only mortgage. In this case, your principal will never be paid off, but your interest amount will stay fixed. It is better for the cash-flow, but the duration will be forever.

Finally, another strategy is similar to an interest-only mortgage where you reborrow against the new value of your home every few years. This may make sense if the closing costs of the new mortgage are not too high, and if the value of the home is increasing, and the interest rates are decreasing.

Finally, there are tax strategies that can be used to make the loan completely deductible. These are out of scope for this article.

I find these strategies to be a bit too complicated, I would rather just own my home outright at the end of this process. I will be able to decide then if I want to sell it, re-borrow against it, or down-size and move somewhere else. Plus it feels good knowing you own your home with no debt. 

Tools Used

  • Crowdsourced Financial Independence and Retire Early Simulator (cFIREsim)

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