The trade-off between investing and repaying your mortgage might be the easiest question in personal finance. And the hardest one at the same time.
There are those who swear by investing.
To illustrate the point, they stick two numbers right in your face: historical investment returns and current mortgage rates.
By the time they are done, even the blind feel like calling up the bank asking for a mortgage extension.
For full disclosure, I’ve once set my foot in the above camp.
In the early days of this blog, I penned my own mini-opus on this very subject. Always fun (and slightly embarrassing) to go back and read some of my earlier posts on this blog!
And then, there are those who swear by living mortgage-free.
Their arguments, while impossible to support by calculus, usually center on the psychological advantage of severing the umbilical cord between you and your bank (the bank being the obvious beneficiary of that relationship).
Being a quantitative person at heart, I have long wanted to revisit the argument. As it happens, I now have a good excuse to do so.
When we bought our last property, we’ve taken out a c.$1.3m mortgage on it. There’s a high likelihood that property will become our primary residence over the next few years.
At the same time, our cash balances have continued to grow, to the extent that I am now in a position to clear that mortgage out.
To state the obvious, there are many other things I could do with that cash, like continuing to get rich off real estate or increasing our equity exposure.
In today’s post, let’s use my situation as a case study to think about mortgage repayment versus investing.
We will start by revisiting some basics and follow that by throwing a few curveballs your way. As usual, that’s where the real fun begins.
Let’s kick off.
Rules Of The Road
In order to minimize the mathematical brain damage, let us round the numbers we will be working with.
Assume a mortgage of $1m, currently locked in at a 1.7%, five-year fixed rate. This mortgage has a 30-year term.
Some basic math tells me that the annual interest cost on this mortgage is $17k.
Now, the actual payment is far higher – roughly $42.5k.
However, the “extra” $25.5k accrues to me, not the bank. It goes towards paying down the mortgage as opposed to interest cost – which is how I end up with a paid off house in 30 years.
Thus, the true “cost” of carrying the mortgage is just the interest payment to the bank, not the entire payment.
The other assumption is that I can get a zero-down, interest-only mortgage.
As you will see below, it doesn’t matter if you can’t. Problem is, where most folks lose the plot on mortgage paydown is by confusing interest and principal payments.
To get around that mental rabbit hole, let’s frame the two bookends as follows:
Option 1: Pay down the entire mortgage on Day 1.
Option 2: Carry a zero-down, interest-only mortgage forever.
That way, if you choose to get a “regular” (i.e. an amortizing) mortgage, the answer (from a mathematical perspective) will be somewhere in between Option 1 and Option 2.
Here are some bread and butter calculations to kick us off.
If I go with Option 1 above, I will free up $17k of cash flow per year.
Assuming I can invest that cash at a long-term rate of 7%, in 30 years I will end up with roughly $1.6m.
If I go with Option 2, the math is a bit more complicated.
The first part is the $1m I get to keep – and invest in equities.
Assuming the same 7% return as in Option 1, that $1m will compound to a very neat $7.6m by the end of year 30.
However, there’s also the incremental cost of the interest payments.
After all, every year I had to cough up an extra $17k to pay my bank. What is the forgone opportunity cost of investing that money?
Easy-peasy. As can be seen in Option 1, the aggregate value of all those payments is about $1.6m.
In other words, I could have taken out a line of credit – or visited my neighborhood loan shark once a year for all those years.
But assuming they charged me 7% interest, $1.6m is what I would end up owing them by year 30.
As a result, if I go with Option 2, I don’t actually end up with $7.6m. Once I settle my debts, I end up with $6m.
As a side note, the value of the house in 30 years is irrelevant. I still own it and get to live in it.
The only difference is that in 30 years’ time, I either have:
Option 1: A $1.6m investment portfolio AND a paid-off house (who hoo!), or,
Option 2: A $6m investment portfolio AND a $1m mortgage on which I keep making $17k of interest payments per year
Still think the value of the house makes a difference? Let’s talk through it step by step.
For simplicity, let’s say the house didn’t grow in value at all.
In Option 1, my net worth is $2.6m ($1.6m in investments plus a $1m equity in the house)
In Option 2, my net worth is $6m ($6m in investments and zero equity in the house)
All in, Option 2 leaves me $3.4m ahead.
But what if house prices shoot through the roof and my house is worth $10m in 30 years?
Well, with Option 1 my net worth is $11.6m ($1.6m in investments plus $10m equity in the house).
With Option 2, my net worth is $15m ($6m in investments plus $9m equity in the house).
Once again, scenario (ii) leaves me exactly $3.4m ahead.
But does it really work in, you know…
Here’s the thing – most folks don’t necessarily have $1m lying around.
If they do, they might not want to take the liquidity hit associated with handing all of that money to the bank.
So the real choice comes down to mortgage terms.
Do you try to pay that sucker off ASAP? Or do you extend the terms for as long as possible and keep refinancing along the way?
As the math above shows, the latter option, while psychologically far more uncomfortable, will leave you miles ahead financially.
Intuitively, it makes total sense. You essentially borrow at 1.7% – and invest at 7%.
Those who can ride out the volatility (big assumption, I know) stand to benefit in a very meaningful way.
At the end of the day, this is what the private equity model boils down to. You buy assets, lever them up, and realize outsized returns on the tiny sliver of equity invested.
The real challenge here is to go through long stretches where interest rates might be up significantly, while asset returns are down.
And that’s EXACTLY what the $3.4m gain above compensates you for.
So far, so good. And if I was an investing maximalist, this is probably where I would finish this post off. Hold the mortgage, suck it up, walk away with $3.4m.
But… I did promise you some curveballs, didn’t I?
Curveball #1: Investment Taxes
I don’t know about you, but there’s no way I can put $1m to work at once in a tax-sheltered vehicle.
Most people simply don’t have that kind of room available in their tax-deferred accounts. Say hello to the HMRC, IRS, and whoever else is reaching for your money with their sweaty palms…
Even a relatively benign 20% tax on your investment gains takes your returns from 7% down to 5.6%.
(Note: The situation is further compounded by the fact that while you always have to pay tax on your gains ASAP, you don’t get an offsetting tax refund on your losses.
Rather, you’ve got to bank those losses and carry them forward against future gains. But I digress.)
Now, if you think that 5.6% isn’t that much lower than 7%, I’ve got news for you: it actually wipes out about $2.5m of gains from your investment pot.
And so, instead of ending up with $6m, you end up with $3.5m.
This means that instead of being $3.4m ahead in Option 2 above, you are only “up” $900k.
In other words, taxes make a massive difference.
In fact, if you are bearish on the direction of travel for taxes (I am), and squint hard enough, you just might see a scenario where repaying your mortgage is the value-maximizing option…
Curveball #2: Return Rates
The other thing to remember is that not everyone is racy enough to go 100% equities.
Some folks like them bonds to soften out the inevitable ups and downs. You’ll certainly end up sleeping better – but damn if those returns won’t take a hit:
On the flip side, you could also be looking at higher investment returns.
For example, workplace pensions here in the UK offer effective return rates well into double-digits (once you factor in the employer match and the tax break):
Alternatively, if I can put that $1m to work in real estate at a 12% annualized return, I will end up with $30m in 30 years.
Talk about a home run.
Or perhaps you use the $1m to start a business that will generate a much better ROI than the stock market ever could – at a much higher risk, of course.
Once again, it’s a bit of a wild card. Your wife wants to pay off the mortgage ASAP while you want to start a penguin farm.
Tough to say which one leaves you ahead financially, though I do know which one will result in marital bliss.
Curveball #3: Early Retirement And Safe Withdrawal Rates
Here’s another funny thing about mortgages:
While most people like to pay off their mortgage before they retire, doing so actually increases their FIRE number.
In my example, repaying the mortgage reduces my annual expenses by $17k, which lowers my “number” by $425k ($17k divided by 4%).
But… I just used up $1m to do that!
Put another way, if you believe in the 4% SWR, you should keep the $1m pot, take $40k from it every year, pay $17k of mortgage interest – and use $23k as your heart desires.
Heck, you could even use it to pay down your mortgage! After all, the annual payment is around $42k.
In 30 years, you have the house and your pot.
However, if you believe in lower SWRs, the math becomes far less appealing.
At a 2.5% SWR, paying off your mortgage reduces your “number” by a whopping $680k ($17k divided by 2.5%).
Extending the logic, if you think the “right” SWR is 3% while long-term mortgage rates are 4%, it becomes a no-brainer to get that mortgage cleared before you pull the plug.
Once again, small changes in assumptions can turn the entire concept of “only idiots pay their mortgage early” on its head.
Curveball #4: Early Retirement And Income Taxes
Speaking of early retirement, here’s a slightly different spin on curveball #1 (see what I did there?):
Let’s say you are aiming for what is known as FatFIRE (i.e. $100k+ of annual income from your pot). I certainly am.
At these levels, unless you are drawing 100% of your retirement income from tax-sheltered vehicles, you will have to pay some income tax.
At a 20% tax rate, you need to draw down $21,250 every year to fund your $17k interest payment.
At a 40% tax rate, that number goes up to $28,333.
You can see where this is going. The higher your effective tax rate in retirement, the stronger the case for repaying the mortgage.
Curveball #5: Getting A Mortgage
Here’s the other thing many retired folks struggle with – banks absolutely HATE lending to people without a job.
Ditto for people who may be older and not able to work.
And if the banks do lend in these situations, the interest rates are FAR above 1.7% or whatever the “prime” rate happens to be at that time.
So while it’s great to have a paid-off house but you need to be mindful of the fact you may struggle to tap the equity in that house at a reasonable cost.
In other words, holding a mortgage into retirement may or may not be a value-maximizing option. But it sure is liquidity-maximizing.
(As a side note, if you happen to be based in the US, there is a way to get an asset-backed mortgage in retirement, provided you meet the criteria set out by one of Freddie Mac / Fannie Mae)
We are now 2,000+ words into today’s post. At this point, I am tempted to wrap things up by saying “there’s a lot to consider” – and leaving the rest to you.
Thing is, I don’t want to do that, because it would be useless. At the same time, there is a lot to consider, and I hate being dogmatic about personal finance.
Thus, let me offer some guiding principles that I think work well in today’s market and interest rate environment:
- If you are just starting out on your investing journey and have a high risk tolerance (reflected in your asset allocation), investing probably beats mortgage repayment
- If you have a lot of room left in your tax-sheltered accounts, investing probably beats mortgage repayment
- If you are about to retire and believe in high(er) SWRs and low(er) mortgage rates, investing probably beats mortgage repayment. Even better if you will have a low (or zero) tax rate in retirement
And in case you don’t fall into any of the above categories, paying off your mortgage might not be a bad idea – regardless of what all the personal finance bloggers have to say.
In case you are curious, I have decided to take that $1m and use it to buy more real estate while holding a significant chunk as a liquidity cushion of sorts.
Then again, I am not planning to retire yet. And when I do, I will probably clear the mortgage on our primary residence – courtesy of conservative SWR and pessimistic tax assumptions. But that decision is still a few years away.
As always, thank you for reading – and happy investing.
About Banker On Fire
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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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