Thursday, October 31, 2019

Should I pay off my mortgage or invest in stocks?

Update: I made an error in one of assumptions, which several readers pointed out to me. The error was related to the option where you put $200,000 into stocks, and you have to pay $11,460 for the mortgage payments each year. The missing part that I did not account for is the $11,460 in fresh contributions for 30 years, which offset the need to pay for mortgage payments out of investing income. Therefore, the best solution is to invest in stocks on a lump sum basis, as it leads to an investment value of over $3.489 million. You may still want to read the article, and see if you can spot where I had errors in logic. 

It is great to admit mistakes, so that I can learn from them. And it is great that I have sharp readers, who can point out development opportunities for me that I can learn from too!

A little over two years ago, I bought a house. My spouse and I decided that we could afford the payments, and also wanted to have a stable place for our offspring.

We took a 30 year mortgage in order to buy the house, after putting in a downpayment equivalent to 20% of the original purchase price.

For the past two years or so, I have had the urge to pay off the debt as soon as possible.

I have never had debt in my life ( before the mortgage). I pay my cards off every month, and try to be frugal, in order to get enough money to put to work in equities. I have learned to invest money every month, whenever I have available cash to deploy in dividend paying stocks.

I always told myself that it doesn’t make sense to pay off the house, because my interest is 4%, while the expected total return on equities is 10%/year (2% dividends, 8% price increase or 3% dividends/7% price increase). So I just made the monthly payments, and sometimes sprinkled in a small extra payment to principal just for the fun of it.

If you are familiar with mortgage amortization tables, you would notice that at the beginning, a larger part of your monthly payment is comprised of interest. The remainder goes to principal.

Approximately a third or less of the monthly payment goes to principal, with the rest going to interest in the initial stages.

In my monthly payment, I also have the taxes and insurance bundled in neatly. However, those are going to be due whether I own my house outright or if I have a 30 year mortgage on it. The same logic goes for maintenance and improvements – these are due no matter what. So the items in this paragraph are not going to influence the decision to pay off the house quickly or to invest.

I have been considering paying my mortgage off quickly in recent months. So I decided to crunch some numbers.

You can download the spreadsheet from this location.

I assumed that we are dealing with a $200,000 mortgage at 4%. The monthly payment on a 30 year mortgage comes out to $955 for 30 years. This comes out to $11,460/year.

We can either pay off the mortgage today, or we can invest the money and use the profits to make the payments.

Paying off the mortgage frees up $11,460 to invest in equities each year. After you pay off the mortgage, you don’t have to make monthly mortgage payments after all. I assume an annual total return of 10%/year when investing the money. I am going to ignore the effect of taxes, and I will also assume a flat 10% annual return. This is a model, and not real life, but the ten percent expectation is closer to the historical annual returns on US stocks.

In other words, in year one we start with $11,460. After a full year of investing, the amount has grown to $12,606. When we add the $11,460 saved from not having to make mortgage payments, we are left with $24,066. After 30 years, we have $1,885,101 invested in equities.

The second option is to invest the full $200,000 in equities today, but to use the investment returns to make the monthly mortgage payments for 30 years. I assume an annualized total return of 10%.

This means that in year one, we turn the $200,000 into $220,000. We then withdraw $11,460 to make the mortgage payments. As a result, we are left with $208,540 by the end of year one. After 30 years of paying off the mortgage from the investment account, we are left with $1,604,779 invested in equities.

This is the point that surprised me. If you pay off the mortgage today, you have $11,460 to allocate towards equities for 30 years. The amount grows to $1,885,101. This is a higher amount than the outcomes where we invest a lump-sum today, but we use the profits to pay off the mortgage. This finding runs contrary to what I originally believed in.

Based on the findings of this study, I will need to work towards paying off my mortgage as soon as possible.

Of course, real life is messier. Things do not go as neatly as a simulation can incorporate. If you pay off a loan quicker, you are left with less money on hand for large and unexpected expenditures. With stocks, you have instant liquidity that can allow you to use the money within a moment’s notice. If the money is spent on a house however, it is very difficult to extract that money from the home equity. In addition, a portfolio of equities worth $200,000 offers some diversification. On the other hand, a house worth $200,000 is a concentrated bet on a single asset class in a single geographic location, which is also not very liquid.

On the other hand, some individuals are paying a large premium for their desire to have liquidity. Some investors hold massive amounts of fixed income directly or indirectly today. These fixed income instruments could pay off their mortgage in a second. However, these individuals seem to have forgotten that a mortgage is part of their personal balance sheet as much as bonds owned in a brokerage account. To add insult to injury, fixed income today doesn’t yield more than 2% ( assuming US Treasury or Agency bonds). This is a much lower rate of return than the interest rates on a 30 year mortgage today of 4%. Even a 15 year mortgage costs around 3% today, which is a higher cost than the yield you can obtain from investment grade bonds today. So in other words, if you invest in bonds yielding 2% today, but pay a mortgage that costs 4% today, you are essentially losing 2% on that capital every year. By paying off your mortgage from that fixed income, you are going to stop the bleeding. Of course, you should still be smart and determine for yourself if perhaps a large cash pile makes you more comfortable through the ultimate ups and downs of life.

Another nice reminder is the fact that people move often. That’s why very few individuals will be able to actually benefit from sitting on a house for 30 years. However, I do believe individuals should focus on buying a house the same way they invest in equities – by having a long-term focus and a holding period in the decades. Plus, not everyone has the amount of cash just laying around, waiting to pay off their mortgage at once. But if you do, it may be a good idea to run the numbers for yourself.

For example, the situation is further complicated by decisions such as investing the money through an employer sponsored retirement plan, which may come with a 401 (k) match and tax deferral on contributions. If you do not invest in a 401 (k), IRA or HSA plan today, you cannot go back in time to use those limits. The decision would also be complicated, if the amounts available to pay off the mortgage are sitting in equities today. Selling those equities could result in a payment of capital gains taxes.

It is nice to mention that in both cases (paying off mortgage earlier or investing earlier), the individual is left with a fully paid off house after 30 years and an investment portfolio. The exercise showed how paying off the house can result in a larger equities portfolio.

Thank you for reading!

Relevant Articles:

Rent Versus Buy - How to decide which one is best for you?
Entering Wealth Preservation Mode
Do I need an emergency fund?
Taxable versus Tax-Deferred Accounts for Dividend Investors

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