Paying off your mortgage vs investing
The second part of our series explores the benefits of paying off the entire mortgage and the impact of changes in home values and interest rates.
This is the second instalment of our series on the financial considerations of paying off a mortgage. You can find the first article here and I would suggest reading it first. The original article assumed that a homeowner began mortgage prepayments at the start of a 30-year mortgage and sold the house 11 years after the purchase. The rationale for this scenario is the average length of homeownership in Australia. According to CoreLogic it is 11 years.
In the first article we calculated the hurdle rate or investment return needed to increase total wealth more than prepaying the mortgage. And from a hurdle rate perspective the length of time a prepayment is made is irrelevant. Even if one prepayment is made the hurdle rate remains the same and is only impacted by the interest rate of the mortgage and the tax situation of the homeowner. More on this later.
The first article satisfies a theoretical view of trade-offs between paying off a mortgage and investing. And that undoubtably has a value. An investor should consider the hurdle rate that must be overcome based on individual tax situations. But starting the exercise at the inception of the mortgage and selling off the property after 11 years ignores one of the most valuable reasons to prepay a mortgage. And that is accelerating the time needed to pay it off completely. That is the focus of this article.
What is the impact of paying your mortgage off in full
Mortgages are governed by an amortisation schedule. The schedule dictates the portion of each mortgage payment going to interest and the portion that goes to principal. The amortisation schedule for a 30-year mortgage will last 30 years until the last payment. Prepayments accelerate the homeowner along the amortisation schedule. In other words, the term of the mortgage is shortened.
We can use the scenario from the first article as an example. Prepayments of $1000 a month on an $800,000 30-year mortgage shortens the term to just less than 20 years. And paying off your mortgage early can be a game changer.
Paying off your mortgage provides a huge boost to cash flow. In my $800,000 30-year mortgage at 6% this means an extra $5,796 a month. Spread over a decade that is a significant amount of money that can be dedicated to investing.
One way we can assess the value of paying off a mortgage early is to explore the impact on total wealth of investing the mortgage payments that don’t need to be made. If you invest $5,796 a month at a 7% return for a decade that would be a total of $992,100. That is before any taxes that are owed.
But the real question is what investment return are needed to exceed the total wealth created from the prepayments and the decade of investing the money saved on mortgage payments. The following chart outlines the investment hurdle rate at various marginal tax rates and with concessional and non-concessional contributions into super. The same assumptions in the first article have been applied.
The impact on retirement
Not only does this add a significant amount of cash flow during working years but paying off your mortgage makes saving for retirement easier. Planning for retirement involves estimating spending needs and dividing by the sustainable withdrawal rate to determine the size of a portfolio needed. If $40,000 a year in spending is needed at a 4% withdrawal rate a $1,000,000 portfolio is required. For more on the four step process to estimate retirement needs see this article.
That means the difference between paying $5,796 a month for housing expenses or $69,556 a year reduces the required portfolio size by $1.738m at a 4% withdrawal rate. I’ve always been a fan of cashflows as a true harbinger of financial security over the value of assets that can fluctuate significantly based on market conditions. In a much-derided episode of our Podcast Investing Compass I even compared myself to a cash flow statement rather than a balance sheet.
But from a practical sense we can assess the value of paying off a mortgage prior to retirement by the effort needed to increase super enough to support the eliminated housing expenses. Amassing $1.738m would take more than 35 years of after-tax savings of $1000 a month at a 7% return. And that assumes no taxes were paid. The fact that the time period meaningfully exceeds the 20 years of directing the $1000 a month in prepayments to pay off your mortgage early is an indication of the value of paying off a mortgage prior to retirement.
The case for directing additional payments to your mortgage when the loan is not fully paid off is mixed as demonstrated in the first article. The return hurdles are challenging if the money was instead directed into a taxable investment. The hurdle rate for non-concessional and concessional super contributions is likely to be achievable if future market returns reflect historic returns or Morningstar’s estimation of future returns for growth assets. The case is much more compelling to fully pay off a home.
How do different variables impact the hurdle rate
One question that has come up multiple times is how do housing prices impact the wealth creation of choosing between investing and paying off a mortgage. The short answer is that it doesn’t. As the owner of the house the appreciation in price will be beneficial. But that benefit will occur regardless of any prepayments.
Two things occur when extra mortgage payments are made. The extra payments will decrease the principal owed or the portion of the house that the bank owns. But the extra owner principal that is built up is equal to the amount of money that is prepaid.
If $100,000 in extra prepayments are made total wealth will be increased by $100,000 when the house is sold as less principal is owed to the bank. The net effect on the total wealth of the homeowner is zero. If the house doubles in price it is still zero. If the house drops in value, the total wealth created remains equal to the prepayments made.
The second impact of prepayments is reducing interest payments. The money saved on interest combined with the amount of principal payments is the total wealth increase that must be overcome by investing. The money saved on interest payments will occur no matter how the price of the house changes.
The interest rate on the mortgage does matter. Lower rates will lower the hurdle rate while higher rates will increase the hurdle rate. The other variable that effects the hurdle rate is the tax rate. Lower tax rates will reduce the hurdle rate while higher tax rates will increase the hurdle rate.
The risk of investing rather than prepaying a mortgage
The future is unknowable. Nobody knows what investment returns will be going forward. We can make a reasonable presumption of future returns over the long-term for each asset class but anything can happen. If the decision is made to invest there are lots of ancillary benefits. These include diversification and liquidity. But there is a risk associated with this decision.
The savings from prepaying your mortgage are locked in. How the housing market performs will have no impact on the financial benefit of the prepayment. The future direction of interest doesn’t matter since the savings will be based on the current interest rate when the prepayment is made. A prudent approach is to have a buffer or equity risk premium incorporated into any decision making. If you believe you can achieve 6% returns and the hurdle rate is 5.5% that is not much of a buffer. The wider the gap the better.
I would love to hear your thoughts on prepaying your mortgage. For anyone that is interested in a spreadsheet showing the hurdle rate at different levels of interest rates please just ask. I am available at email@example.com