Many financial “gurus” advise home owners to make lump sum payments on their mortgages and pay them down sooner rather than later. I agree with this to an extent. However I worry people may be under estimating the power of opportunity cost here. Let’s work through the numbers and look at some facts instead of listening to main stream opinions.
Let’s say we won the lottery and became $100,000 richer! Let’s decide if we want to put this money towards the down payment for a house in order to have a smaller mortgage, OR, invest all our winnings in the stock market index and take on a bigger mortgage.
First we must find out what is the cost of borrowing $100,000. Assuming our mortgage rate was 7% every year, by the time we pay off a $100,000 mortgage over 25 years, we would have paid a total of about $210,000 (according to RBC’s calculator). Which means we will be paying $110,000 in interest alone. So if we increase our down payment by $100,000, we save $110,000 on interest in the long run.
But now let’s see what happens if we invest all of that $100,000 into the stock market index instead. Let’s say over 25 years we make an average of 6% a year. In the end our $100,000 would turn into roughly $429,000. But since we invested our $100,000 instead of adding it to our down payment, we have to borrow $100,000 more for our mortgage. From the last paragraph we know the cost of taking on an additional $100,000 mortgage loan will cost us $210,000 total (including interest.) So if we then took our stock investments after 25 years ($429,000), and paid off the extra cost of having a bigger mortgage ($210,000), we would still walk away with a $219,000 profit, in addition to paying off our mortgage as planned! Hey-Ooh!Below is a chart of our investment returns.
In the first example we left extra capital sitting in our house doing absolutely nothing, except to save us 110% in interest over 25 years. In the second example, we invested that capital instead so although we had to pay the 110% interest over 25 years, we also made 429% on our investments during the same time using the same capital. So maybe investing our money instead of aggressively tackling our mortgage isn’t such a bad idea 😀
But wait a minute. What accounting sorcery is at play here when a 6% investment return can dramatically outperform a 7% mortgage rate? Well I’m sure you’ve figure it out by now. Each time we make a mortgage payment, our principle decreases. It’s the opposite of compound interest, because we pay less interest each time (not more) until eventually the entire loan is paid off. But investment returns on the other hand are the exact opposite and actually compound and grow, giving us higher returns year after year (not less.) Annual Compounding x 25 years = major win.
But it gets better! Our mortgage calculations are based on a 7% interest rate which is higher than average, even compared with long term historical rates. Not to mention rates are super low today. My current mortgage rate is just 2.6% as of 2014. So chances are we’ll probably end up paying a lower rate than 7% on average over the span of our mortgages. A cheaper borrowing cost means we’ll end up even further ahead.
But wait, there’s more! I used 6% for our investment returns to be on the conservative side. But North American equity markets have historically returned about 10% annually, and bonds average about 8% annually. Market returns are not guaranteed, but as long as we can average more than 3.1% return per year for our investments (since that will give us $210,000 which is equal to the cost of the mortgage) then we’ll be better off investing all of our extra cash, than trying to pay down the mortgage. The worst total return ever for any 20 year period in the history of the stock market is still a positive 3.1%, which was around the Great Depression years. What do you think are the chances of a balanced portfolio averaging less than 3.1% annual return over the next 25 years when that has never happened in the history of North American stock markets before? And are you willing to miss out on such a great risk to reward opportunity.
But it gets EVEN better! The interest paid on the $100,000 mortgage loan can be made completely tax deductible. Just use the $100,000 as part of the initial down payment first. Then take that $100,000 out as a home equity loan to invest in stocks, and now the interest on the loan can be claimed for earning investment income proposes. So if your marginal tax rate in the 30% tax bracket like me then that 7% mortgage rate has just automagically dropped down to 4.9%. Meanwhile, our investment returns from capital gains and dividends receive preferential tax treatment (less than 30%) What a bargain! Even the tax man is giving us an incentive to invest because interest we pay on a loan for investment purposes is tax deductible.
And don’t forget about Inflation! The rising cost of living can be a pain, but it can also be a blessing to people who have debt. If you owe the bank $100 for example, then by next year if you haven’t touched the principle, that $100 balance you owe will only have $98 of purchasing power (assuming a 2% inflation rate) which means for all intends and purposes that $100 is now worth less, and it’s EASIER for you to pay it back. So a $100,000 mortgage, assuming a 2% inflation rate again, will only be worth $98,000 by next year. Wow, we just increased our wealth by $2,000 in REAL terms by simply sitting on a mortgage. 😀 Thank you inflation! The more debt we have the more we’ll benefit from the devaluing affects of currency. The U.S. has over $16 trillion of national debt. And its growing by billions of dollars every day because its government continues to spend more than they take in. Inflation is a method used by many central banks around the world to deal with their nation’s debts. They print money so their currency won’t be worth as much. Inflation will slowly chip away at debt, which will decrease the debt’s real value over time making it easier to pay back Debt is a depreciating liability, but real estate is an appreciating asset, so buying a home using debt is a double win!
And it reduces our financial risk! A Pew research center study found that between 2009 and 2011, most American households experienced a decrease in their net worths, and only 7% of households saw their wealth grow 😀 What’s the secret of these successful households? The study points out that the these 7% of households have most of their wealth held in stocks, bonds, and retirement accounts. But the other 93% of Americans have on average just 33% of their wealth in the markets, while half their net worth comes from their homes. We all know that between 2009 to 2011, stocks rebounded from the recession, however U.S. housing prices remained flat to negative. So if we make extra payments on our mortgages then we risk over exposing ourselves to the real estate market and deny ourselves the opportunity to properly diversify our investments. And diversification, as the study points out, was how the top 7% got wealthier. If we want to become wealthy too we have to invest in stocks and bonds like the rich do. Some people may argue it’s risky to invest while still in debt, but they don’t realize that it’s also risky to aggressively pay down a mortgage and not diversify their asset portfolio (^_-)
If Canada’s home prices have a major correction in the future, at least we would have other financial assets to cushion the blow to our wealth. But here’s the brilliant part – even if real estate prices continue to increase we would still benefit because our homes will be worth more money! So it doesn’t matter if home prices rise or fall. We win no matter what direction the real estate market goes in 😀 This is because regardless of how much money we allocate to pay down our mortgage it will not affect the future market value of our home. However, whether or not we invest in the stock markets today WILL have a direct impact on the future profits of our stock portfolio. If we miss an opportunity now to capitalize on the financial markets then that potential profit is lost forever. But if as long as we have a home, then 100% of it’s future market gains goes directly to us whether we have a huge mortgage on it or if it’s been completely paid off. This is why diversification is so important, and why we shouldn’t underestimate opportunity cost. Besides, even by simply making the minimum mortgage payments, we are STILL adding equity to our homes anyway. So even if we allocate 100% of our savings to invest in the financial markets the real estate portion of our asset allocation will still be growing in dollar terms 😉
Finally here’s one last tip. We used a 25 year amortization period. Think about how much more our investment returns can grow if we gave it 30 years to compound instead. A longer time horizon will also decrease our investment risk. For the record, my current mortgage is amortized for 35 years (ʘ‿ʘ) The longer we spread it out the better our returns will be.
So when people say they want to increase their mortgage payments by $500 a month, or make a lump sum payment of $10,000, or aim to pay off their mortgage 10 years in advance, it all sounds good on paper, but I hope they understand just how much money they’re potentially NOT making, and how much asset allocation risk they’re taking on, by being overweight in real estate
My mortgage in 2009 when I bought my condo was $215,000. Today, in 2014, the balance is only down to $200,000. So I’ve paid on average just $3,000 a year towards the principle which I made sure was the least amount possible. I could have easily shortened my amortization period, doubled-up my payments, etc, to have a principle balance of just $150,000 today. But instead of doing that I invested every spare penny I saved. My condo is now worth $50,000 more than my purchase price. And I have over $100,000 in the financial markets thanks to the last several years of better than average stock market performance. My net worth would not be nearly as high today if I had aggressively tried to pay down my mortgage.
That being said, borrowing money from a home, or investing rather than paying down debt, could increase your financial risk. We are talking about leverage after all, which is what a mortgage is. So if you don’t want to risk losing your home, or not being able to finance the extra debt, then please pay off your house as soon as you can. But if you want to live dangerously like me and don’t mind the risk, then invest your extra cash instead of leaving it tied up in your home. Focus on investing and only make the minimum payments on your mortgage, and by the time you retire there’s a pretty good chance that you’ll be much better off than other home owners who only prioritize on paying off their mortgages. 😀 Good luck!
- stock market index – A weighted average of some of the largest and most popular stocks. An ETF that one can buy to track this performance would be the IVV for example.
- capital – Money which can be put to good use
- 30% tax bracket – In Canada, if your annual income is between $40K and $70K then there’s a good chance your marginal tax rate is around 30%.
- leverage – Borrowing money to buy something or to invest