Feb 262012
 

It’s Better to Invest than to pay down Mortgage debt

Many financial gurus will advise home owners to make lump sum payments on their mortgages and pay them down sooner rather than later. However I worry people may be under estimating the power of opportunity cost. 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. Which option will likely make us richer in the end?

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.

mortgage, paying down mortgage

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) over 25 years. So if we then take 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.

mortgage, don't pay down the mortgage so fast

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. Even though 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 it’s pretty clear which choice is the clear winner.

The Simple Concept Behind Leverage

But wait a minute. What accounting sorcery is at play here? How does a 6% investment return dramatically outperform a 7% mortgage rate? Well maybe 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.

Interest Rates Are Super Low

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.

Favorable Market Returns

We also used 6% for our investment returns to be on the conservative side. But North American equity markets have historically returned about 8% to 10% annually, and bonds average about 7% to 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.

Tax Benefits of Debt

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%) because they are not earned income. What a bargain! Even the tax man is giving us an incentive to invest because the interest we pay on a loan for investment purposes is tax deductible.

Inflation Helps Debtors

The rising cost of living can be a pain, but it can also be a blessing to people who have mortgage 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.) This means 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!

Investing in Stocks While Having a Mortgage Reduces Financial Risk

A Pew research center study found that between 2009 and 2011, most American households experienced a decrease in their net worths. However 7% of households saw their wealth grow. 😀 What was 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 we only focus on paying down our mortgage with any savings we have then by the time our mortgage is paid off we’d have 100% of our money in a single asset class. It’s certainly not prudent to have all our eggs in one basket.

This is why we have to be diversified. 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 😀 Regardless of how aggressive we 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 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 😉

Take Advantage of Longer Amortization Periods

Finally, we used a 25 year amortization period. But 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. 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 an investment

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31 Comments on "Why You Shouldn’t Rush to Pay Off Your Mortgage"

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Michelle
Guest

We’ve definitely been thinking about this. At first our goal was to aggressively pay everything off, but I know that’s not always the best option.

Liquid
Admin

Yup. And it also depends on how comfortable you can sleep at night. I’m sure you two will find a balanced approach that’s best suited for your situation.

Daisy
Guest

I don’t have a mortgage, but I think this applies to a lot of things – I have a car loan, for instance, but it’s come to my attention that I would benefit more by saving money into my retirement account than paying off my car loan aggressively.

Liquid
Admin

Exactly, this applies to other kinds of debt as well (^_^)

Theo
Guest
Theo

Very, interesting article and I do 100 % agree that some kind of risk-levarage can lead to bigger riches, I myself have a 40 year mortgage and I use the dividends of my margin account to make the payments, that way $200000
of savings can pay for a $400000 mortgage, mortgage payments go down over time and divident payments go up.

Liquid
Admin

Great strategy Theo, especially considering how tax efficient dividends tend to be >^_^<

starvingartistcanada
Guest

I like the cut of your jib sir.

I’m too poor to own a house or condo in Toronto that meets my needs so I’m doing the apartment thing… AND borrowing money to buy REITs. Borrow at 4% for yields of 7-9%. Monthly carrying costs of $175 which the REITs pay above and beyond.

Yeah, I’m not losing any sleep living “dangerously” as you put it either.

Liquid
Admin

Your jib is pretty cool too. REITs have been one of the best performing asset classes in recent history. Thanks for the mention on your blogroll btw.

Echo
Guest

Interesting post. The trouble I have with this theory is that you can’t really guarantee your investment return, whereas the mortgage pay down gives you a guaranteed return. A couple of other points:

1. If you made a $100k down payment on a house, you wouldn’t be able to convert the entire amount into a line of credit (only 80%).

2. You’re ignoring the fact that once the mortgage is paid off, that monthly payment becomes available to be invested.

Liquid
Admin

Great points Echo. I forgot to think about these things when I wrote the post (>_< ) I like your take about the guaranteed return. There's definitely something to be said about having some piece of mind because you know you're increasing your net worth, rather than speculating on future market returns and hope for the best.

The Passive Income Earner
Guest

I was going to mention the same point as echo. The theory is fine but it’s not so easy for the average investor to pulled the returns. There is something about a guaranteed benefit versus a potential one. I average about 5% yield on my investments and my current mortgage rate is 2.4% – mathematically, I should invest but I also accelerate my payments. I don’t do it with lump sum though but with small increments. The small increments could not easily be invested but they help big time.

My rule of thumb is that in the early year of your mortgage, the extra payments have a major impact but passed 15 years, the ROI diminishes drastically. I don’t do lump sum, that money is better invested as you point out but I will increase my payments ever slightly now and again to reflect my pay increase. I do want the mortgage to be gone 🙂

Liquid
Admin

Very attractive rate on your mortgage Passive 🙂 I like your thinking. The other benefit by accelerating the payments like you do is when interest rates go up in the future, you won’t be left with such a big mortgage still. Thanks for the input.

youngandthrifty
Guest

Hmm so you’re doing a Smith maneuvre? With Vancouver real estate prices?

I agree with Echo- I worry that the investment returns aren’t guaranteed.

Liquid
Admin

Yeah, it never hurts to pay down debt, and not having a mortgage must be a great feeling. I’m thinking about doing the Smith maneuvre but with housing prices so high right now it’s probably better if wait a while first.

Leigh
Guest

To me, paying down the mortgage is about eventually not having that monthly mortgage payment, which makes a huge difference in how much cash flow is necessary while you are financially independent. So really, it’s just a different way of investing that may or may not have a return beyond cash flow.

Liquid
Admin

That’s a pretty interesting way of looking at it Miss (^_-)
And if interest rates today were in the teens like the early 90s then I would definitely be putting every penny I have into my mortgage. Maybe the best approach is a balance between the two extremes depending on the economic environment.

Thanks for dropping by.

Leigh
Guest

A balance between the two extremes is a good way to go 🙂

My plan (once I find a condo to buy and have a mortgage) is to split my discretionary savings equally three ways: mortgage pre-payment (guaranteed return), taxable investments (since I’m already maxing out the tax-deferred ones), and cash savings for slush or future things like a house down payment in case the market drops, I have troubles selling the condo or I want to keep it as a rental property.

If you’re leaning more towards investing, another way might be to split it 25/75 instead and invest 75% of the discretionary savings and put 25% as principal-only payments on your mortgage. Some mortgage pre-payments don’t hurt, especially since you’ll have to renew your mortgage eventually and you don’t know what the rates will be like. (My apologies if you’re actually using a variable rate, not a 5 year fixed or something.)

My Money Talk Online
Guest
My Money Talk Online
You make some great points here which is why this has been my plan of attack for the past year on our mortgage. I used to pay extra but realized that I could possibly do better by investing in some solid blue chip dividend paying stocks with strong fundamentals. I know I’m taking on more risk but I feel confident in my new strategy of investing rather than paying extra on the mortgage. I also like the fact that my stock investments give me the option of selling to raise cash if I ever need it for some emergency or other reason. If I’ve sunk all my extra money in my mortgage, I will be forced to try to take out a home equity line of credit which goes completely against what I was trying to do by paying off the house early, incurs extra unnecessary fees and in rough economic times banks may not be interested in loaning me the money. If you are going the route of paying off your mortgage early I suggest having a home equity line of credit already opened at a bank that you can tap into if necessary in the future. Don’t wait… Read more »
Liquid
Admin

Yup, the extra investments will come in real handy for raising some cash quickly. And that’s a great point about setting up your heloc when you are still employed. A little early planning can go a long ways.

Cassie
Guest
Cassie

This is a great post! While I still intend on putting extra principal payments on my mortgage (I’d like lower payments when I renew), you’ve made a great argument for investing as well while I’m doing so. Thought provoking.

Liquid
Admin

Nice strategy Cas. Variety is the spice of life. By doing a bit of both now you can decrease your debt as well as build up your nest egg for your retirement (^_-)

Phil
Guest
Phil

I strongly disagree with this, for the same reason echo pointed out. If you do the math that for 25 years, you’ll be investing $8406.24 (700.52 monthly mortgage payment times 12) and compounding 6% on that, you would end up with $461 204.26 at the end, compared with the $219 000, that’s over double what you would’ve made if you took the all-investment approach.

If you had a guaranteed 7% after-tax return on your mortgage payment, and only the hope of a 6% average on the stock market before tax, then you should make the mortgage prepayment every time.

Things become a lot murkier when you deal with today’s interest rates which are low (~3%) and you have no-tax accounts. You should strive for the greatest return, the truth is your loan is costing you more than it’s bringing you.

I just bought a house this year, and like you I think a balance of putting some money on a guaranteed return (mortgage prepayment) and some on a possibly higher return (stock market) is a good mix.

Liquid
Admin

Congrats on your purchase. Hope you got a low interest rate. All the bankers are predicting that the prime lending rate will most likely start to increase later this year. I might have to choose a fixed rate when my mortgage comes up for renewal next time.

Maggie
Guest
Maggie

My goal is to pay off my mortgage early. I like the emotional safety of knowing that the house I live in is paid for, and with very little debt, I have much more flexibility if I lose my job. If I were unemployed, I could stay where I am and very quickly find a lower-paying job, I could re-locate for a good job and rent out my house for less than market rate, or re-locate and sell. Less debt = more options. First, the emergency savings. Second, pay off debt. Third, save/invest even more for retirement.

One other point… You indicate that mortgage interest is tax deductible. Correct. But you don’t mention that If I pay $10,000 in mortgage interest, I only realize a tax savings on part of that, a small part.
And once my mortgage is paid off, I still have tax deductions. I can take the standard deduction instead of itemizing. For me, it will work out about the same financially. And the peace of mind I will have from having a paid off home is priceless.

Matt from Saverocity
Guest

Hmm… I have issues with this. Though I agree with the concept of liquidity and like the way it is presented. I think you should take into account the following:

The mortgage rate is fixed (though why you picked 7% when rates are half of that now I don’t understand) throughout the term of the debt. That means you have a perfectly predictable curve.

The stock market – ‘assuming a 6% annualized return’ well, that’s a heck of a gamble assuming you will get that – if you just have one bad year towards the end of the 25 years (like 2008 when the markets fell by 40.9%) then your investment has just gone the way of the dodo.

So comparing a predictable curve with an unpredictable one, the logic isn’t solid. I think it needs to be with a guaranteed rate of return such as Treasury Backed Bonds, TIPS etc.

Gero
Guest
Gero

Very interesting strategy indeed. We have a mortgage of 190k with a savings of 80k. What we did was instead of paying down our mortgage, we invested in real estate. We picked up a newbuild freehold low-maintenance property giving us decent cashflow. 5years from now, both the income property and our primary home will have appreciated (likely 2% annually in our city) along with +ve cashflow whilst paying down our mortgage and saving.

Once we’re mortgage-free, we will re-evaluate investing in the index\REIT vs more real estate.

The key to being successful landlords is education and preparation.

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[…] same quarter. The U.S. economy performed even better growing at 3.5%, wow. This is why I chose a 35 year amortization for my mortgage instead of a shorter term. I want to capitalize on the low interest rate […]

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[…] is why I blogged about my strategy to pay back my mortgage as slowly as possible as long as interest rates remain low. I wrote that post almost 4 years ago and the arguments made […]

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[…] Cash generates income in the form of interest, dividends, or capital gains. Even at 1%, cash in the bank is better for your net worth than mortgage pre-payments simply because cash will earn a compounding return and mortgage pre-payments won’t. Paying your mortgage early will get you out of debt faster and save you interest, but even if you pay off your home 5 years ahead of schedule, it’s not enough time to catch up to the person who’s been letting their investments grow for 20 years. This holds true even if the mortgage interest is higher than what you can earn in your savings account, and if you want to know why, check out this post: Why You Shouldn’t Rush To Pay Off Your Mortgage. […]

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