Why I’m in No Hurry to Pay Down My Mortgage
The personal finance community has some kind of love on for paying down your mortgage early. I can understand why too. Not having a mortgage payment is attractive, since you’re no longer paying interest to an evil, evil bank. You get to live practically for free, excluding utilities and property taxes, but you’d have to pay them anyway. And, usually, the most important reason given is the flexibility someone gets once they pay the thing off. Suddenly you can have $1000 or $1500 a month to save towards retirement, or just to blow on golf and cheeseburgers. I can see why that appeals to people.
I bought my current residence back in August 2008. Now, 3 years later, I owe approximately $150,000 on the place. My mortgage is a variable rate of prime minus 0.3%, meaning I’m currently paying 2.70%. I originally signed up for a 25-year amortization but increased my mortgage payments the maximum 20% when rates collapsed in 2009. The remaining amortization is approximately 17 years.
I’ve had extra cash over the past two years that I could have easily contributed towards my mortgage, paying down some principle. Instead, I took that money and invested it, mostly into the stock market, but also in some high yield bonds as well. What’s wrong with me? Shouldn’t I be taking the guaranteed return of paying off my mortgage?
Nope, and here’s why.
Compounding Is Your Friend
Let’s look at two hypothetical borrowers. One absolutely hates his mortgage, so he takes a 15-year amortization to make the thing go away quickly. The other one isn’t so opposed to the thing, so he signs up for a 30-year amortization. Each imaginary person borrows $200,000, and for the interest of simplicity, they pay 4% interest for the life of their loan.
Borrower A has mortgage payments of $1476. Borrower B cuts down his payments considerably, paying $951 per month. That means borrower B has an extra $525 to invest each month, for the whole 30 years. Meanwhile, borrower A doesn’t have anything extra for 15 years but can invest quite aggressively after he pays off his mortgage, so he can invest $1476 each month from year 15 to 30. Which person comes out ahead, assuming they can both earn an average of 8% on their investments?
- Borrower A: $1476*180 months*8% = $519,391
- Borrower B: $591*360 months*8%= $867,676
Hopefully, this results of my hypothetical situation don’t come as a surprise to most of you. The magic of compound interest is that the earlier you get started, the better off you’ll end up.
Borrower B is using leverage to his advantage as well. If he can borrow at 4% and get an 8% return on his investments, he should do this all day long. This is how wealthy people end up the way they do. As is the nature of investments, they just won’t go up in a straight line, but that’s okay for the long term investor. Besides, he’s built himself in some flexibility by not maxing out his mortgage payments.
Record Low Mortgage Rates
Like I explained above, I’m paying 2.7% on my mortgage. Since most of the globe is in such poor economic shape, I don’t envision that rate going up any time soon. Mortgage rates are touching record lows in the United States. Variable rates have gone up some in Canada, but are pretty darn close to the record low rates seen in 2009.
If interest rates are at record low rates, why would I choose to pay off those really low rates? Take advantage of the situation to borrow money at a great rate, and then plow all your excess money into other investments.
I recently wrote a post over at my own blog highlighting 10 Canadian stocks that have a dividend yield of over 5%. I can invest in a nice diversified basket of stocks like these ones and get dividends that are twice the return I pay on my mortgage. Knowing that most of the companies who pay out these dividends will also have stock prices that will slowly go up in value, I can easily invest in something that will beat the pants off paying down my mortgage, even after factoring in taxes.
Security
I haven’t even touched on the main reason why people choose to pay down their mortgage early- security.
And hey, I get that. People would rather take the risk-free return of paying down their mortgage than risk their hard-earned capital in the stock market. Maybe they’ve been burned by a falling market or a mutual fund with a sky-high fee. If you’re the kind of investor who can barely sleep at night when taking on the risk of investing in the stock market, then you probably should pay down that mortgage. It’ll usually get you better returns than the other risk-free alternatives like government debt or bank GICs.
For the rest of us though, maybe we shouldn’t be in such a hurry to get rid of an opportunity to borrow money so cheaply.
Comments
This is part of the reason I’m so torn about paying off my student loans. On the one hand, I just want them GONE! On the other, the top interest rate is 3.5%. So, I know that’s pretty low, and I can put my “extra” money into my retirement funds. I could also put them in savings, but at measly 1%, there’s no advantage except just building the savings account.
When I think about it, I know I should increase my 401(k) contribution. But the “untouchable until I’m old” part of that makes me a little anxious. So I might just keep saving (I do want to buy a house eventually) or pay a little extra on the loans…just so I’m getting somewhere!
I agree with you Nelson, but I still find myself doing the opposite. Of course, my brand new mortgage is twice the size of yours. I’m throwing an extra $500/month towards paying down my mortgage, at least for the first 3-5 years, which I think are crucial to reducing the amortization period.
That puts me on track to pay off my mortgage in 16 years…which is enough for me. That’s nothing crazy like trying to pay it off in 5 years or anything. I’ll use any extra cash flow to top up my RRSP and max out my TFSA. If I can accomplish all three, I’ll be happy.
As you mentioned these are hypothetical cases. In real life, the situation is quite different. Folks who go for 30 year mortgage cannot pay the extra $591 if they were to take 15 year mortgage. Most cannot spare a dime that they can invest. They want to live in a house that they can pay the monthly installment on. You did not mention how much money either is making. There must be huge difference in their income status. One can afford 15 year while the other cannot. Income (affordability) is the overwhelming reason why folks choose one or the other.
It’s a valid point. Most people can’t afford to invest the difference between a 15 year amortization and a 30 year one. So, let’s change the variables a little.
Instead of Person A and B, let’s assume they’re the same person faced with two different choices.
Good points! You recognize opportunity costs and invest appropriately. 14 years ago, I downsized and banked my equity which is the best use of the no mortgage home.
Although these numbers look very promising, and they are, I felt like it may mislead some people so I decided to run some numbers myself.
You hailed the value of compound interest so I wanted to compare apples to apples and see how much of the benefit was from the compound interest and how much was from the 8% interest rate (not guaranteed) you randomly chose vs. the 4% of the mortgage.
When I ran the numbers with a 4% mortgage and investing with a 4% return the numbers are MUCH closer.
Person A choosing not to pay off their mortgage would have $365,590.52 at the end of 30 years.
Person B who paid off their mortgage in 15 years and then invested what they had been paying on their mortgage for 15 years would have $364,440.00.
It’s true that person A still wins by $1150.52 – but that’s nothing when you think of the 30 year term. Not only that but Person B can invest larger sums in their later higher income years, which creates a potentially bigger tax advantage (RRSP).
Of course, Person A gets the normalization benefits of investing for 30 years instead of 15 and if annualized interest rates are higher, then they do have a clear advantage as your example shows.
Another choice might be to pay down your mortgage aggressively and build equity in your house and then use that equity to make a tax deductible investment in the stock market after there has been a large correction in the markets to make sure you are buying low.
All kinds of ways to do it and it’s hard to really say what the “best” way is. To some, the guaranteed tax free returns of paying off their mortgage helps them sleep better at night during volatile markets.
I didn’t randomly choose 8%. I chose it as a conservative approximate return over a 30 year period. Over the past 100 years the stock market has done better than 8%. As I said in the post, investments don’t go up in straight lines. But dollar cost averaging over time will help smooth those movements.
Taking the excess cash and investing it in something that has the same interest rate as the mortgage is silly. Why wouldn’t you just pay down the mortgage then?
If you’re the type of person who can’t handle the risk of the stock market, then pay the crap out of that mortgage. What do I care what you do? Numbers dictate that you should be doing what I suggest. Emotion isn’t going to get me rich, numbers are.
Fair enough.
I guess I was just trying to point out that even though historical returns on the stock market have been 8%, it’s far from guaranteed and you get potential tax advantages by paying the mortgage off first: no tax due on the money saved by paying the mortgage off and bigger RRSP refunds by investing in higher earning years. You also get the opportunity to leverage your home equity if you see a good investment opportunity and get a tax deduction from that.
Nice post Nelson!
Like Echo, I see your points, but I’m paying down my mortgage more aggressively. We’re plowing at least $200/month extra on it. We’re also buying more stocks, via DRIPs every month. We figure there is a balance to be walked here – since as you say – compounding is your friend 🙂
Yes, interest rates are very low and will be for the foreseeable future, but 30 years is a long time. I’d rather be mortgage free when the rates creep up to who knows what, then stressing about paying a monstrous amount of interest.
Also, you should deduct all of the extra interest that Borrower B pays over the course of his mortgage vs. Borrower A. That would even out the numbers quite a bit!
Is there a guarantee you will be keeping the same level of income for the next 30 years?
What if the market returns 1% in the next decade?
You also forgot that you can recover the taxes of the interest you saved over the years not counting what you saved in interest from potentially higher rates.
Your scenario is no sure thing.
You make the claim that folks easily make 8% return after taxes on their investments. As a tax accountant for many decades I have seen thousands of investors returns and I can assure you IT IS RARE TO MAKE 8% AFTER TAXES. Most people are lucky if they break even after paying commissions and management fees.
If you want to know what people are really earning from investments, ask your accountant.
I think the idea of paying off your mortgage also has to do with what your goals are in the next few years. For example, Stephanie, if you are looking to purchase a home you may need to check your debt service ratios and if the student loan is throwing them off, then you may need to consider paying it off. But then you also need to factor in your credit too…Also, if you’re really serious about making money, then why not consider keeping your house leveraged, and use the money in to invest…it’s one way to make your house tax deductible.
Not for me! One reason for paying it off is the squeeze on expenditure that it requires. The lower your sustained expenditure, the lower the passive income you need to aim for. By ‘playing’ with borrowed money you are not bearing down strongly on the key variable – your expenditure. Also the less debt you have the less exposed you will be when things suddenly change (like losing your job).
I like your thinking outside of the box. I think most people are programmed into thinking they have to pay off their mortgage ASAP. You have to consider the opportunity costs.
Even if you accept your 8% figure you are forgetting two major variables that will have a huge effect on your equation.
1) Saved interest a) will pay $65,694 in interest
b) will pay $142,373 in interest
Difference of $76,679
2) Investment income is taxed!!! Depending on your level of current income (or tax deferred income) the rate can be anywhere from 20%-40%
a)’s taxable income is $257,711 @ 25% = $64,427.75
b)’s taxable income is $654,916 @ 25% = $163,729.00
Difference of $99,301.25
Therefore, B would be pay $76,679 more in interest and approximately $99,301.25 more in tax. This would bring the two totals must closer together. Put in the risk factor or a higher taxable income rate and paying down the mortgage starts to look damn good.
Re-financing is a great way to pay your mortgage down early. We are in the process of moving from a 30-year (5.875%) loan with 25.5 years remaining to a 15-year (3.375%) loan.
I see your point, but for many there’s a desire to become completely debt free. My goal was always to have my mortgage paid off by the time my oldest child (he’s 2) starts college. That would have meant a very aggressive schedule with the 30-year mortgage, but with the 15-year mortgage, it will be acheived without needing a single extra payment!
It’s amazing what math can do! I do, however, think your 8% is *way* off track for the average person. I’m no great investor — I claim no great knowledge of the markets — I can just relate my own experience.
Our first mortgage was 8.875%. Second house, mortgage was just over 5%, then at 4.75% before we paid it off. We did agressively pay that sucker off in 6.5 years. Yes, you have 2.7% — but for how long?
Hubby’s professionally managed pension plan…..currently at -3% this year, -2%, 0%, 1%……hasn’t seen the magic 8% you speak of in years. Circle of friends haven’t realized 8% in years (some have -8%!) — both aggressive and timid portfolios — especially after management fees.
So enjoy your 2.7% mortgage — hopefully it will last a long time. And if you can send some 8% my way, I’d appreciate it! Heck, I’d even take 5% 😉
Don’t blame Nelson because you and your friends have high management fees. You’re probably buying advice from people who are more interested in making money off you than for you.
I think its worth some arguing.
The mortgage interest you pay is based on your $150,000 owned, the small investment you made is compounded on your $200/month.
If you look at the absolute out-of-pocket cost, you will be a loser in the first decade. You have to remember the base number if not at the same level.
If you have your property under the bank’s name, you will forever be vulnerable to any market ups and downs.
You are totally wrong if you think this is how you will get wealthy. Don’t be misled by what the media told you, especially what the bankers told you. Investment should come after you don’t owe things. Otherwise, you are asset negative. That can’t make you rich.
If you pay off your mortgage, you are immediately asset rich.
@ Nelson Smith:
I tried running your numbers in several compounding calculators and using formulas in excel and were not able to come up with your numbers of $519,391 for Borrower A & $867,676 for Borrower B.
Can you please explain how you got these numbers?
(Was the 8% earned once a year, or was it earned monthly?)
Thanks.
Confused Compounder