Buy The Bubble Or Pay Down The Mortgage?

Includes: SPY
by: Income Machine

Interest rates remain near historic lows deterring investors from prepaying principal on their mortgage.

However, a quick glance at any chart and valuations demonstrate that upside for dollars invested at today's market prices are likely minimal.

Is it better to let cash accumulate in a brokerage account, continue dollar-cost averaging, pay down the mortgage or some combination? What are you doing?

This must be what they mean when they say stuck between a rock and a hard place. As a long-term buy and hold investor, I have been awfully quiet lately because I simply cannot find equities worth purchasing. The insatiable bull market roars onward where no crumb of good news ever seems quite priced in and digested. Bad news is shrugged off dismissively. Tell me if you notice a difference between the following two S&P 500 charts courtesy of Schwab:

They look pretty similar, no? But wrap your head around the fact that the first chart is a direct continuation from the second chart. Put them together and viola, below is the indomitable bull the past 6 years:

Irrational exuberance? Unquestionably.

This is the kind of market where people are buying an oceanfront property in Kansas (check junk bond prices). A rising tide lifts all boats prompting an Economist cover declaring: “The Bull Market in Everything.” Markets tend to go up over time, but they don’t often rise parabolic without interruption. I’m not a doom and gloom Faber-ite, but for the health of the market long-term, I am hopeful a day of reckoning arrives sooner than later.

In the meantime, cash is accruing in my brokerage account patiently waiting for even a modest decline to add to my positions. I set a weekly transference of funds from my checking account to my brokerage account. In years past, the cash balance was extremely low, but as it has inched up lately, I have pondered whether I would be better suited aggressively paying off my ARM before it resets in 2021.

Pay Down Mortgage Alternative

Most investors make their money in bonds, stocks, real estate or some combination thereof. I’ve wanted to diversify into real estate but have not purchased any rental residential or commercial properties since real estate prices seem to be floating in the clouds themselves. I do however have a fairly large principal balance remaining on my mortgage note and I am probably not alone in that regard.

Let me provide a close approximation to my situation.

My house was purchased for $425,000 in 2016 with 20% down. I selected a 5/5 ARM, which means my interest rate will adjust every five years by no more than 2% with a lifetime cap of 5% above the initial rate. I locked in my rate (by chance) during an opportune window through my credit union where I am paying 2.375% for the current 5-year period. The amortization schedule is favorable since the interest rate is so low. In fact, within 6 months of origination I was already paying more toward principal than interest each month.

Yet have I really leveraged this opportunity to my advantage?

As a dividend growth investor, I believed my money was better allocated into the market rather than making extra principal payments. I can write off a portion of the interest and I can obtain a much higher return than 2.375% invested in the market. And for the most part, that line of thinking held water over the past 12-16 months.

But recently, I’ve come to believe that the stock market has lost touch with reality. I’m starting to believe stocks will reach Mars before Elon. The yield for the S&P 500 (SPY) has dwindled to 1.8%. Money invested at today’s inflated prices may produce negative returns for the remaining duration of my mortgage. Take a look at the Shiller P/E ratio for the S&P 500:

So why not divert some money away from stocks and start applying it toward my principal?

What’s The Most Prudent Option?

Here are some pertinent facts to help guide my decision:

  1. There are no prepayment penalties assessed with my mortgage.
  2. The adjustment rate will most assuredly rise the full 2% after the first 5 years based on Federal Reserve forecasts. That will lift the rate to 4.375%.
  3. My house is susceptible to elevated present valuations and perhaps is worth only $400,000.
  4. The mortgage adjusts based on the remaining principal every 5 years, not on the original loan amount.
  5. As a buy-and-hold investor, I plan on renting the house out at some point once mortgage payments are small enough where I am cash flow positive thereby providing direct real estate exposure using the cash as a ‘dividend’ proxy.

What’s A Dividend Investor To Do?

I love few things more than scouring world markets in search of undervalued corporations the market is sleeping on. I am also a conservative investor with a moderately low risk tolerance. I’d prefer to earn a safe 6% than reach for 12% with significant downside exposure. And right now, I see not a lot of upside for every dollar placed into the market and a lot of potential downside.

I can continue to invest/dollar cost average into stocks and bonds. I can continue to let cash build in the brokerage account. I can pay off my mortgage early, or I can do some combination of those options.

I have found that many folks are taken aback when I mention that I would even consider paying off the mortgage early since I secured such historically low financing. Financing is still so cheap that big corporations are tacking on additional debt just to pay dividends since the cost of financing is so low.

But I am not a revenue-generating corporation, and investing at current prices is just not palatable any more. Here are a list of pros for paying off the mortgage:

If I aggressively pay off the mortgage, I accelerate the chances of becoming cash flow positive on a potential rental by 2021 when the note adjusts. I eliminate the potential for being underwater or anywhere close (if real estate prices were to tank). If I decide to keep living in the house, then my payments will be smaller, thereby freeing up cash to direct elsewhere and minimizing any adverse impacts due to job loss/health issue. I could also sell the property and use the proceeds to buy a new house tax free.

I have a feeling I am not the only investor who is debating these very issues. My question is, what are you doing yourself?

Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.