Investing Vs Mortgage Repayment: Advanced Considerations

Investing vs Mortgage Repayment

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.

Banker On FIRE portfolio

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.

Basic Math

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.

Magic stuff.

But does it really work in, you know…

Real Life?

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:

Bonds vs stocks

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):

Workplace Pension Returns

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)

Never Easy

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.

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Banker On FIRE is a London-based 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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25 Comments

  1. This is highly relevant. I am about to pull the trigger on borrowing circa additional £400k and putting it into the FTSE 250k. Source will be a five year fixed rate mortgage at <1%. I am aware of the risks a) rates can go up b) equities can under perform for a decade c) psychological challenges d) ties you to paid work but a) my leverage post mortgage will be very low still b) no plans to stop work entirely c) interest pavements very comfortable covered – circa 100x as of today. I’ll be around 65% in equities at that point.

    Looking at the ftse 250 as I am up to my gills in global / s&p 500 equities (yes I know active vs world tracker). Can’t face more U.K. property – buy to let in U.K. has got very unappealing to me – (I have a few) and buying more home is not a productive asset. CGT on equities is better than property too and you can choose your moment more easily to exit.

    Background to this is U.K. is implementing massive financial repression given debt levels and it’s an additional hedge against currency debasement.

    Comments very welcome!

    • I think it’s a bit of a no-brainer. We spend a lot of time telling our clients to optimize their own capital structure, and this is just an application of that to our personal finances.

      As could be expected, I am not convinced about the FTSE250. Last time I checked it was <10% of the world market cap, so I guess if you keep it in the same zip code relative to your overall equity holdings, you should be fine.

      On your last point, I think inflating one's way out of a massive debt load is one of the few options left to the governments at this point. A shadow tax the majority of the population doesn't even understand / acknowledge. Owning risk assets is the only hedge.

  2. You left out the biggest curve-ball: rising interest rates. Mortgage rates are at historic lows, and earnings multiples are at historic highs, and the two are somewhat related.

    It wouldn’t take a major increase in interest rates during your 5 year mortgage to: (1) knock house price growth off its spot, potentially impacting ability to remortgage, (2) increase your mortgage interest payments, and (3) cause a value-based correction in global markets.

    To me that’s the biggest reason to overpay on the mortgage in current climate. I certainly don’t want to have to sell out of equities during a correction to support a 5% mortgage.

    • Not quite as my mortgage is a fixed one. Also, you could get a 10-year fixed and in the US one can get a 30-year fixed mortgage locked in at around 3.5% these days.

      That being said, your point is very valid more broadly as some folks will be on variable mortgages.

      No easy answers here to be honest. To me, repaying the mortgage now is akin to buying a 1% yielding asset vs. a 7-8% one. That being said, one needs to have enough room in their budget to support much higher monthly payments.

      I don’t think we’ll see rates go up to 5% though. That represents a 5x+ increase vs. the current levels and letting this happen in a short span of time would be a policy disaster (think absolute market collapse, another massive bailout of the financial system etc.)

      So yes, moral hazard – but that’s just the way it is.

  3. Great post again, like your thoughtful curveballs. Agree with Dave on the rates going up point too. One thing worth considering is the nature of your employment. I worked in hedge funds and banks as a PM/trader and was constantly aware that each bonus could be my last. As a result I paid off the mortgage as soon as I could. Then when I had long periods out of the market with massively lower income I wasn’t stressed by the thought of needing to refinance the mortagage.

    • Thank you – yes, I was very keen to double click on the topic from a few different angles, including early retirement.

      Am painfully cognizant re: your bonus point. Things are looking ebullient now but I remember the times when we had big rounds at least once a year, often just a week or two before bonuses. Left a big imprint on me and I’ve always been at pains to maintain a significant cash cushion equivalent to 1-2 years worth of living expenses.

      At the end, psychological comfort goes a long way. I am less concerned about significant rate rises (see my reply to Dave) but I do think the possibility of lower asset returns as well as higher taxes makes paying off the mortgage far more appealing, especially as one heads into early retirement.

  4. Very interesting article. I wonder whether it applies to someone who doesn’t have the initial capital, but could divert the difference between a repayment mortgage and a interest only one into a S&S ISA with the view that the arbitrage would create value.

    • I think it totally does. You could also arbitrage between an accelerated repayment vs regular repayment.

      Just keep the caveats above in mind as well as Dave’s comment re: interest rates (which I think is quite valid, notwithstanding my personal view on direction of travel)

  5. There are many macro economic factors that could create an environment of quick rate hikes, inflation (up today!) is probably the biggest one.

    I just hope your readers will remind themselves of the early 1970s where interest rates surged and markets collapsed. Of course, it might be different this time :-).

    • Very true. I don’t think that’s a likely outcome, but there’s a non-zero probability we could end up in the same place.

      It’s always different this time 🙂

    • Yes, though that’s only true in the US. Also, as I understand it, that might be replaced with a blanket deduction of some kind? Am not up to speed on the latest tax regs to be honest.

      What is also quite relevant is the fact that mortgage interest on rental properties is deductible in most countries. Hence, makes a lot of sense to lever up the rentals while paying off the primary property.

  6. Is a simple answer that it depends on factors such as age and whether you’re trying to accumulate or consolidate your wealth? If you’re young and have a long term horizon and time to recover from short term hiccups then sure leverage up. There’s going to be a time however when it’s wise to de-risk and paying off your mortgage makes sense. Typically less time to recover from short term blips and less time available to let mean reversion take place etc. Hence I’d argue a good answer to which option is best depends on your circumstances.

    • Broadly speaking, yes. But I guess what I am saying is that it also depends on things like your SWR assumptions, your tax rate in retirement, and your ability to tap the mortgage market once you no longer have a job.

      As you correctly point out, for someone who is relatively young and is just starting out, paying off the mortgage ASAP is unlikely to be a good money move…

  7. For this reason, I am convinced that paying down about 50% of your mortgage if you are looking at investing vs. mortgage paydown is the best way to go. You accelerate your mortgage quite significantly, but then can continue to push any extra funds you have towards your investments. I put together an entire spreadsheet to run the calculations: https://accidentallyretired.com/resources/mortgage-prepayment-analysis-calculator-spreadsheet/463

    Keep in mind that this is all looking at a 10 year time horizon. Investing will always be the better option for anything longer, but if you are considering paying down your mortgage at all, then it is worth a look.

    And one other thing that I have found, is that it is possible and quite easy to get a mortgage in the US in retirement with an Asset Based Mortgage. Freddie Mac and Fannie Mae have slightly different requirements, but if you qualify, you can get standard rates.

  8. Interesting and helpful comments. So in response and welcome further feedback

    – Need to constantly remind myself that no-one knows at all what is going to happen.

    – There is clearly a risk in five years that interest rates could have materially increased, for some reason the mortgage market is closed and that equities are say 50% of their current value. In that rather poor situation, the effect of borrowing the additional £400k wouldn’t be that bad. I’d need to find £200k (to cover the 50% fall), which isn’t going to be a problem as I am in a fortunate position. The chance of insolvency or having to change our lifestyle is near zero albeit the chance of a loss to my personal NAV is materially higher I accept

    – My central case though is that governments continue to use increasing amounts of financial repression to run negative real interest rates. If that doesn’t happen there is an awful lot of pain coming to the UK/US and no one likes pain. I think if you owe money govt is on your side and the rubicon has been well and truly crossed on money printing. Savings in the bank – govt not on your side so much. It’s a hedge against currency debasement that’s running on official figures at 3% a year and on my personal inflation rate a lot more. I just can’t see rates rising to say 5% but appreciate the future is unknowable. If they do – the banks will own an awful lot of UK residential property!

    – It seems generally that if you say to someone, I’m borrowing £400k to buy a property then people go smart move and yet if you borrow the same amount to invest in equities there is a shaking of the head. I don’t really get that tbh. It’s a different asset obviously but beyond that I’m not seeing the issue myself as the debt situation is unchanged. To be clear there is no way I’d do this on a margin loan……

    – I don’t have the data but the FTSE 250 must be <0.5% of world market cap. I'll probably invest it in a global tracker having thought a bit further here given anything else is classic cognitive dissonance on my part. The 250 is not a bad index compared to the turgid 100 index though and has done rather well historically. No way am I going all in on the S&P 500 at that CAPE ratio…..

    – the tax shield on interest for BTL is still useful but it's capped at 20% so it effectively reduces your borrowing by 20 bps or so Set aside the fact that the entry cost into BTL is high with extra stamp duty, the tax on income is higher (at least for me) than dividends and CGT is worse and your exit options are much easier / more flexible. Plus landlords are clearly in the x hairs still of govts (witness labour's wittering on about landlords again this week) and as Finumus explained well the party is over. I remain envious of people (include the author of this blog) who make it work well as the ones I have are a pain in the behind.

    – It's very clearly dependent on your personal situation, so sure if I was fully retired on a SWR then no way would I do this as you have enhanced exposure to negative sequence of return risk. Equally if I was starting out in my career, I am sure I'd be much more aggressive.

  9. One curveball that massively favours investing is pensions. Anyone paying higher rate, not maximising 40k pensions is simply wasting money. 43.25% tax saved to start with, 25% tax free on the way out and years of growth that can potentially be taken at a lower rate.
    All the other curveballs make an impact only if someone has already maximised their pension and ISA allowances.

    • Great point, thank you.

      I talk about higher investment returns above, but it’s worth double-clicking on. Have now called out pensions separately and added a return table.

  10. I looked at your calculation based on 1.7% interest and 7.0% investment return. It looks like there is a breakeven point of interest at 3.38% if investment returns stay at 7.0%.
    Many years ago, I paid off the mortgage when interest rates were 7.9%. I have no regrets.

    • I wouldn’t either. It wasn’t until mortgage rates dipped towards low single digits that the option of not repaying the mortgage started gaining any traction in personal finance circles.

      Before Greenspan turned on the printing press, getting rid of the mortgage was the default choice.

  11. Thanks for the fantastic write up. It’s really helpful to see the numbers down on a screen and despite being a different league to mine helpful none the less.

    I recently sold my online educational business and deliberated the whole pay off the mortgage vs invest the money. Like you pointed out investing such a lump sum isin’t easy; particularly in a tax efficient way.

    In any event, I decided to hedge my bets a little and paid off a healthy lump sum; thus reducing my LTV to just 30% while retaining an interest only mortgage, fixed for 5 years. I now have the security of a tiny mortgage payment (it’s less than some pay for a gym) whereas I still have substantial capital to invest into stock/property/new business opportunities.

    The mortgage doesn’t feel like a mortgage it’s such a small figure and a weekly shop can get close to it sometimes!

    The timing was key as with the sale i’ve lost a substantial part of my monthly earnings and as you alluded to banks don’t like this. Fortunately my tax returns for the past 5 years are high so I was able to secure this now.

    Again, thanks for writing. I’ve been enjoying your journey for some time now and even though our level of wealth is completely different (as I imagine is our cost of living) I still find you incredibly relatable.

    Thanks again and keep writing 🙂

    Ryan

    • Thanks for the kind words Ryan. Very happy to hear you found an option that works well for you – after all, that’s what personal finance is all about.

      And you are spot on about the cost of living. London is a good place to make money but it sure is a tough place to minimize expenses. I think there are many folks in lower-cost locations that end up in the same place financially (or better) than some of the bankers I know!

  12. Out of interest, what lender are you using that allows borrowing against real estate to invest in equities? I recently tried to go down this path and found most lenders specifically prohibit this. I’d love to know if you’ve found one that allows it.

    Thanks,

    Juan

    • That’s not exactly how it works in practice

      You simply take out a bigger mortgage against your property and that’s where the lender’s involvement stops

      Up to you what you use the money for – buying another house, renovations, other investments or even a trip to Vegas!

  13. It’s interesting to note that the best 5y fixed mortgage rate is currently 0.97% while the best 5y fixed rate deposit is 1.80% (FSCS protected). That’s a risk free pre tax 83bps spread which presumably exists due to the different funding costs across banks.

    From a quick look, this spread increases to c.140bps using structured deposits (e.g. after 5y if the FTSE is above its starting level you get a fixed return, if it’s below you get your capital back albeit with counterparty risk).

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