Mortgage Recovery Portfolio

After living in an apartment for the last eight years, I have decided to buy a house.  When I first began looking, I was adamant about putting 20% down.  I was mostly interested in avoiding Private Mortgage Insurance (PMI) fee.  PMI is required when a borrower doesn’t have a 20% equity in the house. After the previous housing collapse, I assumed that lenders would require 20% at minimum.  It turns out that the lenders I have spoken with require 5% minimum down with PMI.  Once I discovered that 20% wasn’t required, I decided to look into building a portfolio with the remaining amount in my house fund.

The purpose of the portfolio will be to recover the difference in interest between putting down 10% and 20%.  I do not want to take an enormous amount of risk with the dividend payers I choose.  With an interest rate of 4.5%, it would be doable to invest in MLPs, REITs and Preferred shares to beat this number.  If I did that, than there wouldn’t be much to write about or numbers to crunch!  While 4.5% is a high dividend rate, historically this is very low for an individual to borrow funds.  From that perspective, I will be effectively borrowing at a low (relative) rate and investing in securities, that over time, will each yield more than 4.5%.

Using Leverage to make money

My largest position, Phillip Morris (PM), has been very active with this trick.  They are buying back their higher yielding stock and selling bonds that have lower yields.   The vast majority of their debt that matures after 2019 is under 4.5%. To show how this benefits a company, suppose PM sells 1 million in bonds at 3.5% and uses that to purchase 1 million worth of stock which currently yields 4.65%.  PM pockets the payout difference, pays a little extra interest and reduces outstanding share count.  This maneuver saves them a little more money every year (as long as they keep raising their dividend), while the bond interest is fixed for its duration.

Step 1: Avoiding PMI

I initially believed I was going to have to pay PMI.  I went to several lenders and got quotes which ranged from $50 to 85 per month.   After a little more digging, I found that some Credit Unions don’t require PMI.  I attempted to use my search skills to find out why this is the case, but I failed.  After investigating several Credit Unions and banks, I chose to go with a Credit Union due to the favorable tradeoff between closing costs, interest rates and lack of PMI.

If you are interesting in learning more about PMI, read on.

Step 2: How much interest will I pay

The first step to identifying a portfolio is to determine what the difference in payments will be when putting down 10% vs 20%.  The interest rate I will use is 4.625% for a 30 year mortgage, which is the rate I will be borrowing at. The following table is based on a house that costs $225,000.

Loan AmountDown PaymentInterest Initial Interest Payment
202,50022,500172,307780.47
180,00045,000153,162693.75

When I first did this calculation, I was surprised to see that the difference between 10 and 20% down was $19145. For some reason, I had thought that the difference would be much greater. This is a blessing due to the low interest rate environment that has persisted over the last 5 years.  Sadly, I think that will make this exercise less challenging.

Onward! The situation as presented is to attempt to recover 19k with dividends over a 30 year window. This amounts to approximately $638 dollars a year in dividends (19k/30). With a portfolio of size $27,000 (this is what will be left over after down payment plus closing costs), this will require a yield on cost of approximately 2.3%. Not very challenging at all, but inflation must be kept in mind. In 30 years time, 19k will not have the same buying power as it does today. In order to make the challenge a little more interesting, I will attempt to recover 19k in 2044 dollars assuming an inflation rate of 3%. This leads to a value of $46470. In order to collect this in 30 years, we will need to collect an average of 1549 dollars per year. This would require a yield on cost of 6.8%.   This number could be low or high; I can’t tell the future of inflation, but I think 3% is a good target.

A target has been set. Collect $46470 in 2014 money over the next 30 years with 27000 cash to invest.

Step 3: Estimating dividend return

The goal of the portfolio is to start with an initial value of 27000 and produce enough income over the next 30 years to earn the interest difference back.  As described above, this would require a current yield on cost of 6.8%.  There are plenty of investments (Reits, MLPs and Preferreds, Junk Bonds) that make this possible and I want to diversify the portfolio.  I will make up the difference over time with dividend increases.  The dividend increases will eventually raise my yield on cost above 6.8%.  After this crossover point, the portfolio would make up any lost ground over the first few years.   The purpose of this section is to determine what yield and dividend growth is required to realistically solve this problem.  If you read my previous post, a higher dividend growth will be more important over the course of the next 30 years.  I will attempt to achieve an initial yield of 3.5% and dividend growth rate of 8%.

The following table provides an abbreviated dividend return with an initial yield of 3.5%

 

 DividendsTotal DivsReinvested DivsReinvested Total
1945945945945
51,285.665,543.941,475.335,977.25
101,889.0613,689.802,574.5916,408.16
173,237.5231,893.965,613.8145,247.15
183,496.5235,390.486,275.1151,522.26
193,776.2439,166.727,014.3258,536.58
204,078.3443,245.067,840.6166,377.19
214,404.6047,649.668,764.2375,141.42
224,756.9752,406.639,796.6684,938.08
235,137.5357,544.1610,950.7195,888.79
245,548.5363,092.7012,240.70108,129.49
255,992.4269,085.1113,682.65121,812.14
266,471.8175,556.9215,294.47137,106.61
276,989.5582,546.4817,096.16154,202.77
287,548.7290,095.1919,110.09173,312.86
298,152.6298,247.8121,361.25194,674.11
308,804.82107,052.6323,877.61218,551.72

The table contains several important pieces of information.  First, it will take 21+ years without reinvesting dividends to pass the value of $46470, while 17+ years if we reinvest dividends.  This is an important point and can be examined with a much greater difference at year 30.  The “Reinvested Total” is more than twice as large as no-reinvestment total.  This is amazing and demonstrates the value of reinvesting your dividends as soon as possible.  This exercise was done compounding both the dividend growth and reinvestment being done annually at the end of each year.

My methodology for calculating reinvested dividends is as follows.

  1. Take the previous received dividends and multiply by .035. These are the dividends you will be paid from the income received.  Take year 20 as an example. 7840.61 * .035 = 274.42
  2. Add value calculated in 1 to the previous years total. (7840.61 + 274.42 = 8115)
  3. Assume dividend growth at end of year. (8115 * 1.08 = 8764.23).

Mathematically, this makes sense to me.  I have seen vastly different returns (higher) from the various calculators and was unable to determine what equations are being used.  Maybe my calculations are somewhat conservative, but I would rather be surprised, then left wanting.

Step 3.5 Wait! What about total return

I don’t want to make the claim that I am not interested in total return.  I like to see my portfolio higher than where I bought it.  The problem here is that I can’t tell the future.  The market could trade sideways for the next 30 years, but what I can do is invest in companies that have a history of raising dividends through good and hard times.  The first fourteen years of this century have tested many of the historically good dividend payers.  Some fell (GE and most banks), while some dividends flourished (MCD, KO).  As long as I select the proper companies, when their earnings go up, so will their price eventually!  Mr. Market is a fickle man.

Step 4: Building the portfolio and the future

There are many companies that can be selected for this portfolio.  In the coming months, I will begin to research and invest in these securities.  These companies will by and large be blue chips, but I will add some higher yielding securities to help with the overall return of the portfolio.  In a few days I will describe my process of stock company selection.  Since I have been on a Walmart kick lately, I will begin there.

See you in a few days!

Disclaimer: Long PM, WMT, PEP, KO, MCD