In general, I’m a fan of paying off your mortgage, no matter the situation. However, paying off your mortgage is a bad move whenever the yield curve is inverted. I’ll use a case study to explain why.
If my quest to refinance my primary home mortgage doesn’t make my views obvious, I believe paying off your mortgage is a bad financial move when the yield curve is inverted.
I’m in an interesting position where I have both, paid off properties and mortgaged properties. I also have the ability to pay off my mortgages tomorrow. Therefore, I can argue both the quantitative and the qualitative side to paying off a mortgage or not without much bias.
At the end of the day, I want everyone to make the best financial moves in order to decrease financial anxiety, boost wealth, and increase happiness. As a family man now, I care about these three things for readers more than ever before.
Why You Shouldn’t Pay Off Your Mortgage
When the yield curve is inverted we have some serious economic implications to consider. Let’s talk about the primary reason why you shouldn’t pay off your mortgage along with a few other reasons.
1) Best relative value to borrow.
The yield curve is normally upward sloping at all time intervals due to the time value of money. As a lender, you require a higher rate of return for longer duration loans due to inflation and the increased risk of not being paid back.
The yield curve very seldom inverts and when it does, it means that longer duration borrowers are getting the relatively best deal.
Let’s study a normal yield curve from 2015 below. Short-term rates during this time period were very low partially because the Federal Reserve kept its Fed Funds rate at near 0%.
The spread between the 10-year yield and the 3-month yield was 2.1%. In other words, as a borrower, you had to pay a 2.1% premium to borrow for 10-years.
Now let’s look at a slightly inverted yield curve on July 1, 2019. Instead of paying a 2.1% premium to borrow for 10 years, you’re getting a 0.12% discount to borrow for 10 years (2.12% – 2%).
Borrowing for three years (1.71%) might seem to be even more enticing given the larger discount (2.12% – 1.71% = 0.41%). However, you would be losing seven years of a fixed rate, so there is a tradeoff.
The inverted yield curve is screaming at you to take advantage of the point of inversion and to save as much money as possible in short-term money market accounts and treasuries.
2) Best relative risk-free return.
Back in 2015, your money market account and short-term treasury bonds paid practically nothing. I clearly remember when I was only getting 0.1% at my main bank where I had seven figures in assets.
As a result, logical investors decided to take on more risk by buying stocks and real estate. Stocks and real estate have performed handsomely ever since but hit a rough patch in late 2018 as investors pulled back.
With short-term rates higher than long-term rates, investors are naturally reconsidering the wisdom of taking so much risk when expected future profits and economic indicators are slowing.
Investors can now earn 0.4% risk-free in savings and <1% in 3-month treasury bonds. Not that great any more.
Since the end of 2015, the total added value a consumer has been getting is roughly 4.6% (2.2%from borrowing at the point of inversion and 2.4% from saving). This value increase is significant.
3) Liquidity grows in value.
Although an inverted yield curve does not guarantee the U.S. economy will go into a recession, every recession has been preceded by an inverted yield curve.
During a recession, companies naturally reduce capital expenditure and hiring. If the recession gets bad enough, as it did in 2008-2009, potentially millions of people will lose their jobs.
With uncertain times, the value of cash goes up because cash provides individuals with more options. Cash allows people who get laid off to wait out the storm until the economy recovers.
The people who were forced to sell stocks and real estate between 2008 – 2012 probably did not have a high enough cash balance. They are surely trying to kick themselves in the face today.
Unless you pay off your mortgage in full, you will continue to have the same mortgage payment amount each month. The only difference is that the percentage of your payment going to principal will be increasing.
Therefore, one of the riskiest scenarios is for you to pay down your mortgage without fully paying it off and then experience a job loss. If this happens, you will probably feel a tremendous amount of financial anxiety because your investments are likely taking a hit while your housing expenses are still the same.
4) Vulture buying firepower.
Whether in a bull market or a bear market, there are investment opportunities every day. You always want to have at least 10% of your investable assets in liquid cash ready to pounce.
However, after a 10-year bull market and/or when the yield curve inverts, you probably want to have at least 30% of your investable assets in liquid cash. After all, your cash is earning at least 2.45% risk-free.
The investment opportunities during the 2001-2002 dotcom bubble crash and the 2008-2010 housing bust were plentiful. There will be more plentiful opportunities again. You just need to have the courage to leg in when everyone is running the other way.
Recessions only last for about 18-22 months on average. If you’ve paid off your mortgage and didn’t buy any bargains during the recession because you didn’t have enough money, you will likely feel bad about your inactivity once the economy picks up.
5) Peace of mind is overrated.
You will feel at most six months of excitement after you’ve completely paid off your mortgage. After six months, it’s back to business as usual. The same thing happens after you get a promotion, a raise, a business win, or win a championship.
The highs never last forever. Likewise, your peace of mind will not last forever either.
When times are really bad, you might actually have more peace of mind if you don’t have a significant amount of your net worth tied up in one asset.
When times are really good, you may start feeling bad that you aren’t more levered to earn a greater return on your property.
After paying off a condo in 2015, I wrote about the mortgage payoff fees and procedures to expect so folks don’t get blindsided. But after about a month, I no longer felt any joy from having no mortgage.
When it came time to do my taxes eight months later, I wondered where my 1098 mortgage interest statement was because I had forgotten I had paid it off! I actually felt a little dismayed I didn’t have that deduction anymore.
Arbitrage The Kink
You want to save aggressively in money market accounts or short-term treasuries to take advantage of higher rates and borrow money at longer-term durations to take advantage of the inversion.
To go the opposite way and borrow short-term money at a higher rate and lend longer term money at a lower rate is completely illogical. Only non-savvy financial readers do this.
But this is exactly what banks are being forced to do, which is why since the yield curve inverted, the banking sector has started to significantly underperform the S&P 500.
Notice in the below chart how XLF (banking ETF) started to underperform the S&P 500 once the yield curve inverted.
If you don’t want to take my advice, then at least be aware of what the stock market and billions of dollars of lost value is telling you.
A Lower Mortgage Balance Is Better
In general, less debt is better than more debt. To not have debt in retirement is a wonderful thing.
But if you are like most people who are still working and who don’t have unlimited funds, then hanging onto your mortgage or refinancing into a mortgage with a fixed duration that matches the point of inversion makes the most financial sense.
If the yield curve gets extremely inverted, then it’s up to everyone to go all-in and arbitrage the kink. Can you imagine if the 3-month bond yield stayed at 2.5% while the 10-year bond yield collapsed to 1.5%?
Banks would be paying us 1% to live in our homes.
Don’t buy when things are full price. Always buy when things are on sale.
An inverted yield curve only comes around about once every 10 years. Refinancing your mortgage during this sale is the most logical conclusion if the numbers make sense. Make sure to run the after-tax results as well.
The Yield Curve Today
Post pandemic, the yield curve is now upward sloping and relatively steep. The Fed slashed rates to 0% – 0.25% and long-bond yields have risen from their 2020 pandemic lows. As a result, there is a very bullish feeling in the air.
I’m personally very positive on the housing market and am investing as much as possible in the space. I believe the mortgage rates will stay low for a long time, even though they are up from 2020. The economy is recovering, wages are growing, and corporate earnings are rebounding aggressively.
With a steepening yield curve and potentially rising rates, paying off your mortgage is incrementally better. However, also beware of the biggest downside to paying off your mortgage. That downside is losing the motivation to hustle since you have less debt and increased cash flow.
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