Should You Pay Off the Mortgage Early?

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

Brand spanking new year, and Jackson Cantrell, our audio producer, has something to tell us.

Jackson, this is a great cold open, uh, there.

Emphasis on the spanking.

It's our 200th episode.

That sounds like a shocking number. If we were to compare that with, say, fire up Google for me, look up how many episodes they did of, let's say, ALF. For people who don't know, that's a 1980s sitcom about an ordinary American family joined by, like, a little furry sarcastic alien. Jackson?

102 episodes.

Nice. We've hit double ALF levels. Not bad for a show that we started basically the week everyone got sent home for the pandemic. And this is the part where we drop the party streamers and the balloons and the marching band comes through and we announce our very special slate of guests.

But I kind of only kind of snuck up on us.

Yeah, frankly, kind of just kind of just realized all of a sudden it's a bit of a holiday week, a short week, and we had planned to do what we're going to do, some listener questions, going to answer some listener questions even better.

Some might say our listeners are better than any guests we could have rolled out.

Well, let's, let's not pander. They're, they're way too smart for your pandering and good looking, might I add. Who do, who's up first for our questions?

We've got Doug from Iowa.

My financial advisor is worried about a recession. Mohamed El-Erian recently said on Wall Street Journal's Take on the Week podcast, he's worried about a 2024 recession too. The Buffett indicator is a metric I recently learned about, and it says even with the recent pullback, the US markets remain 30% overvalued. Can you explain the Buffett indicator to listeners and offer your perspective? Are you worried if Mohamed is worried? I hope your voice has recovered and appreciate your show.

Thank you, Doug, from Iowa, and go Hawkeyes and/or Cyclones, depending on whether you're an Iowa or Iowa State man. You asked about recession and valuations. Let me take those in order. I think the chances of recession— there's always one coming, of course, but will we have one in 2024? Maybe the chances are receding a little bit. I saw a beginning of the year note from Goldman Sachs and they said the coast does look clear for the US economy. They point out that the 10-year Treasury yield, it was up over 5%. Now it's back down below 4%. And the Federal Reserve is widely expected to pivot from raising interest rates to lowering them. Goldman's economists expect to exit 2024 with GDP growth of 2%. US stock valuations do look concerning. The S&P 500 is back up to about 20 times earnings. That's high historically speaking. I would say the average, depending on which data set you're using, which time period, which measure of earnings, is somewhere in the neighborhood of 15 times earnings. You mentioned the Buffett indicator. That's where you take the value of the entire stock market and you divide it by gross domestic product, or the size of the economy in the U.S. It's basically whenever you have a valuation ratio, it's usually a measure of the price of something compared with either what accountants say it's worth or the economic productivity of it. So price-to-book value, that compares the price of a stock with what the accountants say that company's assets are worth, net of its debt. And price to earnings, that's a comparison of the share price of a company with how much earnings per share that company can generate in a year. And the Buffett indicator is kind of the same thing, just for the entire economy. You compare the value of the stock market with the economic output in a given year. And when you look at the Buffett indicator, just like when you look at the P/E ratio, it says things are expensive. I recently saw that the Buffett indicator stood at 175% and that that ranked as significantly overvalued historically speaking, that suggested that returns from here for the stock market are likely to be below average. And that's really the rub here. We can say that things are expensive, but that doesn't necessarily mean that stock prices are set to fall right away. The market could continue rising for some time. Earnings could outperform expectations and that could give some support to stocks. It's really hard to time the market and to say, "Hey, things are expensive now, so I'm gonna bail out here and I'll buy back when things are cheaper." It's easy to get burned trying to time the market doing that. The best thing an investor can do is say, the market looks expensive now. Over the next 10 years, it's reasonable to assume that returns will be lower than I've come to expect. I'd better save harder, or I'd better reduce my spending expectations going forward. I hope that helps answer your question. By the way, you asked about my voice. I think I'm turning the corner on it. Thank you. I had that thing where you're like sick for 2 days, and then it takes you 8 weeks for your voice to come back, but starting to feel a little better. How do I sound, Jackson? How's my— how's my timber?

Timber is great. Smooth and clear.

Good. Thank you. Let's have another question.

This one comes from Jeff in South Carolina.

Hey, Jack and Jackson, which for the record sounds like the name of a great law firm. I'm an educator from Florence, South Carolina. I have a question that I wanted to ask about bonds. I'm trying to better diversify my investments in the upcoming year. I invest small amounts of money in the stock market each month, but want to start investing more in the bond market as well, even though I know how crazy the bond market is right now. My understanding though is that most bonds are very expensive, or at least beyond the amount I'm able to invest in. Any advice on how to invest in the bond market for a small-time investor like myself? Thank you and keep up the great work.

Great question, Jeff. When you hear you should have, I don't know, 30% in bonds, 40% in bonds, what have you, how do you actually get that percentage? What do you buy? Do you buy individual bonds? Do you buy funds? Jeff, you mentioned that buying individual bonds would be expensive, as you say, and you don't mean valuation. You mean it takes a lot of money. Single bonds often have a face value of $1,000. You're not going to buy just one bond. You don't want to pay too much in fees. For your trades, you're going to buy, I don't know, 10, 20, 30 bonds. So that's $20,000 or $30,000 just for one issue. Now you have to buy a bunch of different issues to diversify. And maybe that's just your corporate bonds. What about your government bonds? What about overseas? I tend to think of $1 million as a starting point for a properly diversified bond portfolio. If you're investing less than that in bonds, maybe well less than that in bonds, you have a few choices. Unit Investment Trusts, or UITs, are for investors who want the diversification that you get from a big bond portfolio. They want it with a smaller dollar amount and they want to have a defined portfolio. They want bonds that come due at a certain date. They know when they're going to get their money back. The other option is a mutual fund of some sort. There are open-end funds, there are closed-end funds. Increasingly, there are exchange-traded funds for bonds. Closed-end funds are kind of a special animal that can trade at a premium or a discount to the value of the underlying bonds.. We'll talk about those another day. Open-end funds and ETFs are similar in that the value of a share price more or less tracks the value of the underlying bonds, although the mechanics are a little different. Now, the big decision to make is index or active. With the stock market, you can buy into an index like the S&P 500, or you can buy an actively managed fund where there's a professional out there who picks stocks. And we've talked for a long time about how difficult it has been for active managers to beat the stock market. And we generally mean large-cap US stocks, the S&P 500. So I think money has poured into S&P 500 funds because investors figure, look, the fees are low on these funds. Active managers mostly don't beat the S&P 500. There doesn't seem to be a lot of downside here. It's a little different when you're talking about bonds. With a stock index, the companies are weighted according to the stock market value of the company. As companies become more successful, they get a higher weighting in the index. With a bond index, the bonds tend to be weighted according to how much the issuer has borrowed. That's not quite the same thing as success. So the most heavily weighted entities in a bond index tend to be those that have borrowed the most, which maybe that's not what you want. Now, the good thing about a bond index fund is that the fees are very low. How long are we talking about, Jackson?

We're talking, for example, the Vanguard Total Bond Market ETF.

BND is the ticker on that one.

Has a fee of 0.03%.

That's— you take the elevator all the way down to cheap, you get out, you go down 2 more flights of stairs, and that's where you end up. 0.03% is mighty cheap.

And they have $302.4 billion of assets under management.

Cheap and popular. Now I'm going to read from a Barron's item that was published last August. This is from Lauren Foster. She writes about new options that are popping up for actively managed bond ETFs, and she pointed out at the time that in 2022, half of the actively managed bond ETFs outperformed their Morningstar category. And last year, at the time of this story, about two-thirds of this growing pool of actively managed bond ETFs had beaten their indexes. So the numbers there much better than they are for large-cap US stock funds. The story mentions two relatively new bond ETFs from companies that are massive players in active bond management. One is from PIMCO, and it's called the Multi-Sector Bond Active ETF, and the ticker there is PYLD. The manager of that fund oversees a massive amount of money for the firm, including in its flagship fund, which is the world's largest bond fund, PIMCO Income. The ETF was relatively small at the time of this story. And the manager points out this is not a clone of any particular strategy. It's just the bond team looking for the best yield-oriented strategies. Another fund the story mentions is BlackRock Flexible Income. That's another ETF. The ticker there is BINC. Here again, the manager oversees trillions for BlackRock. That's the world's largest asset manager. And this ETF, the story says, is investing in harder-to-reach fixed income sectors such as high-yield bonds, emerging market debt, and securitized assets. Now, the fees on these funds are around half a percentage point. It's 0.55% for the PIMCO one and 0.4% for the BlackRock fund. So well above the level of that Vanguard bond index, but lower than you see in a lot of active management where fees can top 1%. Here's one way to frame your decision. That Vanguard Total Bond Market ETF has 46% in Treasury and agency issues and another 20% in government mortgage-backed securities. So in other words, the fund gives you about two-thirds exposure to the US government. Maybe that's what you want and maybe it's not. If you want to go for active management in your bonds and you don't want to get wallow too badly on fees, one option is to do the Treasury portion yourself. You can do that quite cheaply. You don't have to go to a broker or buy existing bonds where there may be markups built in. You can go to TreasuryDirect.gov and buy bonds on the auction. You don't know the yield ahead of time, but you get whatever the market rate is and you don't pay any fees. And the minimum investment is low. So you can either ladder some bonds with the money coming due each year or so., or you can use a barbell approach, buy something short like a 1 or 2-year Treasury combined with something longer like a 10-year Treasury. Then you pair that with the active fund of your choice and those free Treasuries pull your overall expense ratio lower. And that is how to create a pretty diversified bond portfolio without a ton of money and while keeping fees fairly low. I hope that helps, Jeff, and thanks for your question. Jackson, this has been an action-packed listener question special so far, and I think you know what time it is. Marching band? If by marching band you mean a parade of helpful information from our podcast sponsor, then you're right.

We'll be back right after this break.

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Is the, uh, is the break over? That's it, right?

Ready to go? It's over.

Yeah, we're ready. I'm gonna get some post-break enthusiasm in my voice, a little razzle dazzle. This is, uh, This is how you make it to 200 episodes.

You got to really, you got to.

Welcome back to the big listener questions special. I think we've got time probably for one or two. It depends on how fast I go. I think we do two more questions. Jackson, who do we have next?

We have Mark from Birmingham, Michigan. This is a written question, so there's no audio. So I'm going to paraphrase it and do my best Mark impression.

Does it start off with any praise?

Sometimes people—

Yeah, yeah, yeah.

That part, that part you hit word for word.

After that, you can sum it up.

Hi, Jack.

I love your podcast. One of the things I like most about Fridays is the newest edition of your podcast.

Some people are calling it the best thing about Fridays.

Go ahead. Mark mentions the 60/40 rule and wonders if a different rule can make better sense depending on an investor's situation. He says he keeps 3 years' worth of living expenses in cash. Uh, then he has 7 years' worth of living expenses in a bond index fund and the rest in equity funds or stock funds. And that brings him closer to 80/20 than 60/40. And so he was wondering if that makes sense as an investment strategy.

Thank you, Mark. So the question is about the 60/40 portfolio. That's the classic example. Of the stock and bond mix because you want that long-term growth. But you know that the value of your stock holdings can go up or down sharply in any given year. So you need something to help smooth out those returns. You put the 40% in bonds, the returns there over time are not expected to be quite as high, but your bond holdings will hold their value better in any given year. They'll be less volatile. Okay. So as you say, Mark, you can certainly dial those percentages up or down according to your individual circumstances. Circumstances. We've talked in the past on this podcast about Warren Buffett in a letter to his Berkshire Hathaway shareholders when he outlined the instructions given for the money he leaves to his wife, that it be put 90% in an S&P 500 index fund and 10% in treasuries. And I guess he meant that to say that he's a big proponent of indexing, that you can do just fine there. But I think it also serves as an example of how Your age is not the key thing that should determine your mix. Warren Buffett is an older fellow, so if we were only going by age, you might say, well, he should have 70% in bonds. But of course, Warren Buffett is also preposterously wealthy. So the chances that he's going to fall on hard times because of a downturn in the stock market are nil. And that's really what you have to protect against. That's the whole purpose of the allocation, to protect yourself against the event that you don't have enough money at some point in the future when you need it. So the richer you are, the more that you can afford to put in stocks, all else being held equal. Also, the less you can live off of, the more you can afford to put in stocks, all else held equal. If you're the breadwinner for a young family and you might need to use this money at some point several years from now, then you better keep a pretty conservative asset allocation. If you're a single person living out in— where are you, Jackson?

Joshua Tree National Park?

I'm here. Living off the land. What do you do? You're roasting armadillos out there?

What do you do? That's illegal.

That's highly illegal. That's the desert. Yeah.

Leave the armadillos alone.

I don't know what they have out there, but maybe you're not the best example. But anyhow, the ability to live leanly and having fewer people who depend on you, that's another thing that allows you to be more aggressive in your investment approach. Mark, I don't know exactly what you have in your mix, but I like the way you're discussing it. You're talking about having a certain number of years' worth of money that you can fall back on if you need to, which allows you to invest the rest of your money for growth. I'm guessing that your 80/20 mix is just fine for you. Jackson, I was so quick in that question, even with the armadillo part, I think we have time for another.

Yes. Definitely. This one comes from Conrado.

Let's hear it.

Hey, Jack. Long time listener, first time asking a question. Love the show. Hey, I have two questions, actually. So I have four properties. Three of them have mortgages with interest rates below 3%. And the fourth one I just bought has interest rates of 7.3%.

5%.

This last one I bought, I bought it because I'm relocating for work. So two questions that I have. The first one is, what's your latest take on real estate as an investment? And the second question is, I'm going to receive some bonus this coming March, and I wanted your opinion about paying off some of the mortgage on that fourth house, the one with the 7.35% Thanks, Jack.

Thank you, Conrado. I'm not sure that I have a blanket opinion about investing in real estate. There are pros and there are cons. If we're talking about buying real estate that trades publicly like stocks, in other words, real estate investment trusts, I'm of the general belief that you don't really need them as part of your asset allocation. The regular stocks you own represent companies that already have real estate. Some of those companies are even REITs in the funds you might have. So you probably already have real estate exposure through your stocks. But I also don't think it's particularly harmful if you're an investor who wants to buy a sliver of REITs for income. Now you're talking about buying individual properties and that's just so highly localized. I don't know what types of property you have. I don't know what the cash flows on them look like. Generally speaking, managing property can be a lot of work. So it's not for everyone, but it also allows you to use a tremendous amount of leverage which could be a great thing for building up wealth over time. Some of the wealthiest people on Earth have made their money in real estate. Your second question is more straightforward. Should you pay off your mortgage that has an interest rate of 7.35%? In a word, yeah, probably. You have to ask yourself a few questions. Number one, are there any fees associated with paying off your mortgage early? Sometimes there are in the first few years. If so, wait. Number 2, will paying off the mortgage early put you in any kind of bind financially? In other words, will you have too little funds available in case you need them? The third question then is, can you do better on a different investment? You basically treat your mortgage like it's a bond, 7.35%, but you might be getting some tax breaks on your mortgage interest. If so, that 7.35% for you is the equivalent of something lower. You're going to have to do that math yourself. Let's say it's the equivalent of 6.5% on your mortgage. So the question then becomes, can you do better than 6.5% elsewhere? And before you say that you can make 10% long term in the stock market, just remember that we have to account for risk. Stocks are risky, returns there are volatile. Your mortgage rate, if you're treating it like a bond, is an absolutely pristine credit. There's nothing in this world that's a better credit than you paying yourself with your own money. So the question really is, can you do better than 6.5% on something that has next to no risk? Probably not. So it's probably a good idea if you have plenty of funds available to pay down that mortgage early. Of course, I'm making some generalizations here. This will really depend on your individual circumstance. You might be someone who has an appetite for risk and a tremendous number of attractive investment opportunities available to them. So you might see something out there where you can earn a double-digit return. And yes, it's riskier than this, but that's an amount of risk that you're willing to take on. What do you think, Jackson? Did we answer Conrad's question? Yeah, definitely. I always feel like there should be a mechanism. Maybe this is a horrible idea. I feel like there should be something out there for people. He says he has mortgages with rates below 3%, and then he has one at 7.35%. So I'm assuming that's a more recent purchase. The— if you have a rate locked in, let's say for 30 years under 3%, the bank would certainly much rather have you paying more than 7%. There ought to be a product or a mechanism available by which you can say to the bank, hey, dump X amount of cash in my account in exchange for the right for you to refinance my mortgage and give me the new market rate, whatever it is, 7% and change. Don't you think then you could— it's a way for people to tap cash and then, uh, you know, and then they just—

that's how it works in the bond market, right?

That's how it works in the bond market. This would just allow for market repricing of that mortgage before it hits the securities market.

Probably people, probably people would abuse it and get themselves into hot water financially.

That—

it also sounds like an awful thing when it's, it's like even—

it's a more difficult sell than a reverse mortgage. It sounds like you're doing something horrible to people, but There might be people out there who'd say, you know what, I could use that cash right now. Let me put that in my account. Maybe someone will make that product.

I think the low rates of the past are keeping a lot of people from selling their homes. And that's why you've seen so few, I guess, movement in the real estate market. And it's hard to find homes that are available.

Right. So you say turn this 3% mortgage into a 7% mortgage, dump $80,000 or $100,000 into my account, and now I'll be free to sell my house and to move on to another house. That would help maybe unstuck stick the housing market. We've solved something big here today. What should we call this new financial product?

Probably the Conrado.

The Conrado. Thanks for the idea, Conrado. And I want to thank Mark and Jeff and Doug. Jackson Cantrell is our producer. He's filling in for Meta. He'll be rejoining society next week. Is that right? Back from the desert to Los Angeles.

Back to LA.

And speaking of rejoining society, we'll be back with a regular episode next week, probably sprinkle in some listener questions as we go. So keep those coming, please. You can record on your phone, use the voice memo app, and you can send it to jack.hough@barons.com. Anything else, Jackson?

Subscribe, like. Here's a fun fact. Next week we'll be totaling 201 episodes, which puts us right in line with The Office.

Minus, minus the enduring joy that it brings people. Well, it's good to know just the same.

Thanks and see you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.