Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into account your personal situation, circumstances or needs.  

So Shani we had our weekly one on one yesterday.

Shani Jayamanne: But I wasn’t in the office.

LaMonica: You were not in the office and you have moved home with your parents.

Jayamanne: Yes.

LaMonica: Yeah, so Shani’s out there for 8 weeks total and you wanted to take a walk during our call, so you were out walking Priscilla. And I of course can hear if somebody is talking to you. And so this…

Jayamanne: And there a lot of people talking – people are very friendly.

LaMonica: Yes, and Shani is not used to this because she does not like speaking to people. And so she’s walking around, this woman comes up and starts talking about Shani’s dog.

Jayamanne: And I will mention that had headphones in so, and I was obviously on the phone and in a meeting.

LaMonica: No, I was aware, apparently this woman was not.

Jayamanne: Yes.

LaMonica: And so, she talks about your dog which, whatever, is natural – people come up and ask questions. And then I’m listening to this woman saying, “We should set up a play date for our dogs.”

Jayamanne: Yes.

LaMonica: And she asked you like 5 times for your phone number and you refused to give it to her.

Jayamanne: It was very awkward cause you know, sometimes you just know when people don’t want to do it. And you back off. But she didn’t back off.

LaMonica: She did not back off. And eventually you kept saying, “I’m on the phone” and she was like, “Show me your phone number”.

Jayamanne: Yeah.

LaMonica: You were like “I’m on the phone” and she was like, “Call my phone now”.

Jayamanne: I’m like, I’m literally on a phone call right now. Anyway. So, she really wanted Priscilla to meet her dog who was also a Pomeranian, was 2 years old desexed, she promised that it had all the vaxes, but it had never m-

LaMonica: Yeah, Shani asked this woman if the dog was vaccinated.

Jayamanne: Because she was like it’s not desexed and it’s never met another dog before and I was like well why? Anyway, this is going on a tangent but basically what she said is that it’s a very timid dog who’s never met a dog before and she wanted Priscilla to meet this dog and I couldn’t run away fast enough.

LaMonica: I know this could have been your only friend in the suburbs.

Jayamanne: Exactly.

LaMonica: Anyway, the reason obviously you’re out there is because you bought a house and that’s what we’re here to talk about today – housing.

Jayamanne: Yeah, housing is an incredibly popular investment, or purchase for Australians. 

LaMonica: And obviously this is not news to anyone listening to this, but you know since I’ve been in Australia, I’ve certainly seen firsthand that the Australian love of investing in property, certainly more than I saw in the US. So direct property makes up 15 per cent of SMSF asset allocation. A survey by Money magazine found that Australians thought investing in real estate was more secure than the share market, gold, cash and fixed interest. 

Jayamanne: And there is a reason that Australians are so into property. Over the past 25 years median house prices have increased by 412% and median unit prices have gone up 316%. That compares to a return from the ASX All Ordinaries index has risen by 261%. And the size of the capital required means that it is an ultra-long commitment, and almost always involves leverage.  

LaMonica: And so, a question that a lot of investors have is whether they should pay down the mortgage, or invest? 

Jayamanne: And we’ll spoil the ending a little bit here, but it’s worth mentioning that of course, this is a case of opportunity cost that is based on calculations, but it’s also based on what people want to achieve.  

LaMonica: So, what we’ll do in this episode is look at the two strategies for mortgages, and then the considerations that investors should have when making a decision to employ one of these strategies. We’ll also mention a couple of caveats about investment properties in this episode, but we’re really focusing on your PPR – your principal place of residence. 

Jayamanne: And we want to frame this discussion around a PPR not being an investment. It is your home, and therefore, we’re not comparing or including property appreciation as a consideration in this episode. The episode will focus on the decision making process between reducing your mortgage and putting your money into other assets, such as equities. So let’s start with the two strategies first for mortgages and investing.   

LaMonica: They are concurrent or sequential. Concurrent is when you have a mortgage, but you also start putting money into other asset types, like equities. Sequential is focusing your energy on paying down your mortgage, and only then focusing on investing in other assets once you’ve paid it down.  

Jayamanne: There are obviously a lot of other variables that are involved in the decision to take either of these avenues. The first is assuming that you do have extra cash after your expenses and mortgage payments.  

LaMonica: You need to ensure that you are able to afford your mortgage payments in your budget, but you also need to ensure that you have built a buffer to be ahead of your mortgage repayments before you consider investing. You never know what the future holds – wages are never a certainty, you may need to take time off work for unexpected circumstances or you might have unexpected expenses like a car or house repair. We’ll speak a little more about this further along in the episode but the point is that you should ensure that you have enough to cover this.  

Jayamanne: And going to that point of unexpected circumstances, one factor you should consider is how you actually earn your money. If you’re in a cyclical industry, a contractor, or just anyone whose income is uncertain – usually, people prefer to build up a little bit of cash because of the uncertainty of a sustainable surplus in their budget, and the higher chance that they’ll come to a situation where there might be a missed mortgage payment.  

LaMonica: This however, does not mean that you should not invest if you don’t have an iron-clad contract and guaranteed work. We’ll walk through these buffers you can build to help prevent unfavourable situations where you’re not able to meet your commitments. What we will say though, is that investing becomes more attractive when your work is stable. The last thing you want to do is hit a period of low or no income that forces you to sell down your portfolio at an unfavourable time to meet mortgage repayments. But again, those situations are preventable with the right preparation. 

Jayamanne: Then, deciding what to do with this extra cash is dependent on a few main considerations. The first is returns. What returns are you expecting from the asset you are looking to invest in? Does it earn more on your funds than the mortgage rates? Owner occupier rates are sitting around 5-6% for most mortgages, and equity markets have a different risk/return profile. You’re taking on risk, but for a higher reward.  

LaMonica: Some general guidance from Christine Benz, Director of Personal Finance at Morningstar. She mentions that investors need to be aware about whether a need will arise to access your money. Christine Benz is based out of the US, and offset accounts aren’t really a thing there, but this is a consideration for investors that do not have an offset account.  

Jayamanne: You need to bear in mind your need for liquidity – because you’re not able to sell the kitchen sink in a pinch if you need the funds.   

LaMonica: She also mentions tax breaks. But we’d like to add that tax costs and breaks are both a consideration.  

Jayamanne: Depending on the type of loan you’ve taken out, it’ll impact your tax outcomes and deduction eligibility. If the property in question is an investment property, your interest may be tax deductible. This isn’t applicable if it is your primary residence. In the same way, tax should also be a consideration if you looking to invest in equities. 

LaMonica: All of the rates of return that we use in this podcast, that are used by fund managers, or when you look at investment returns are pre-tax. We have marginal tax rates in Australia, so the after-tax returns from investments will vary based on how much you earn, but also the level of franking credits and capital gains you earn. So, tax consequences are definitely a consideration when you’re looking to invest, and you have an outstanding mortgage. 

Jayamanne: I think it’s important to consider that most of us have to balance this choice of paying down a mortgage and investing, meaning that the crux of this argument is that we need to consider the opportunity cost of our decisions. What is better for us? What is going to put us in a better position? 

LaMonica: And so when we think about this opportunity cost, it’s important to look forward. So far, we’ve looked at historical returns, but is that the same opportunity set that investors are choosing from?  

Jayamanne: And the short answer is no. Both equities and housing markets have changed and will continue to evolve as we move forward. We won’t focus on the cases for both of these asset classes in this episode, because they are separate episodes themselves. Our interview with Matt Wacher looked at future expected returns for asset classes, and we did an episode on the sustainability of the growth of the housing market, and more relevant, interest rates. We will link these episodes on our resources page.  

LaMonica: Christine suggests to look at the returns on guaranteed securities, and whether that eclipses the mortgage rate. Guaranteed securities would include savings accounts, term deposits, annuities – anything that gives you a guaranteed return.  

Jayamanne: But again, the next consideration is that these guaranteed returns only matter if you need guarantees. If you’re an investor who is closing in on retirement, you have more reason to value the sure things – either reducing your overhead in retirement by reducing your mortgage, or building up your cash reserves.  

LaMonica: When we look at the current market of guaranteed securities, you are hard pressed to find a guaranteed return that matches the current owner occupier or investment loan rates of around 5-6%. But it is worth diving into this a bit because I think most discussions of paying down your mortgage gloss over what it actually means to pay off your mortgage. 

Jayamanne: Lets start with the basics. When you take out a mortgage part of your monthly mortgage payment goes to interest and part to principal. So a mortgage has something called an amortisation schedule. And that amortisation schedule shows how much of each payment goes to principal and interest. 

LaMonica: And the loan amortises over time. And amortisation is just a fancy word that means gradually paying off the principal. And in a mortgage amortisation schedule you start off paying mostly interest and then gradually over the life of the loan the percent of your payment that goes to principal increases. 

Jayamanne: Now if you make extra payments that are higher than the mortgage – in other words you are paying it down – that whole payment will go to principal. So in effect you are skipping forward on your amortisation schedule which means that more of your future regular mortgage payments will go to principal and less to interest. So you are effectively saving on interest going forward because the principal is less.  

LaMonica: And that means that the return you are getting for those extra payments is equal to the interest rate on your mortgage. What you are effectively doing is shortening your mortgage term. So if you have a 30 year mortgage it is really getting shorter and shorter with each extra principal payment. But the shortening of your term won’t actually impact the amount you owe monthly. From a cash flow perspective nothing changes even as each extra regular payment would increase your net worth more as you own more of your home and the bank owns less. But what you really want is to pay off your whole mortgage because then you have all this extra cash flow. But more on this in a bit.    

Jayamanne: If you have a very long time horizon, you’ve got a mortgage that’s on a decent interest rate, and you’re already saving for retirement in super, you have less reason to prioritise mortgage paydown. Although the returns that you may earn on your equity portfolio may not be that impressive over the next decade or so, they’ll likely beat mortgage interest rates over a longer time horizon.  

LaMonica: Time horizon is the major factor that will determine whether you employ a concurrent or a sequential strategy. As a general rule, it’s said that if you have less than three years on your mortgage, it is worth focusing your efforts on paying down your mortgage. The reason for this is what I discussed above. Even though at the end of your mortgage you are paying mostly principal with each regular mortgage payment you make the finish line is in sight. And the reward when you get there is huge. Because let’s say you are paying $3k a month for your mortgage payment. The minute you make your last mortgage payment all of a sudden you have $3k extra a month in your budget to spend on whatever you want. And so, in this case who cares what your interest rate is – get to that finish line as fast as possible because the reward is huge. 

Jayamanne: And this is where we need to come up with another consideration on paying down your mortgage. What is your intention for your home? The average Australian owns a home for 11 years according to CoreLogic. And this has actually lengthened over time which is a good thing. But if you own a home for 11 years you aren’t getting that far on an amortisation schedule of a 30 year mortgage. You are still paying a lot of interest with each mortgage payment you make. 

LaMonica: And if you don’t intend to own your home forever and have no intention of paying it off the shortening of your mortgage has less of a value for you because making all these extra payments will never get you to the holy grail – which is owning your home outright and wiping that monthly payment out of your budget. 

Jayamanne: And here is the really interesting thing mathematically. What you are doing by making extra payments is you are effectively reducing the leverage on your home. And there is an argument to be made that that is a bad thing if you expect your home to keep increasing in value because the leverage will juice your returns as long as they are positive. If housing prices fall that is a whole different ball game.  

LaMonica: Now this is a bit of tricky concept so let’s walk through an example. Let’s say you buy a home for $1m and you put down 20% or $200k. You own this home for 11 years. In the first scenario you just make the regular mortgage payment on a 5% loan – and we are assuming that interest rate doesn’t change. Let’s say the value of your home increases by 7% a year. In 11 years when you sell it the value of the house will be $2.1m.  

Jayamanne: Now there are lots of ways to think about the return you earn on a house. You’ve paid a lot of interest to the bank over those 11 years. So technically if we were to calculate a return we would have to take that interest into account. But you also get another benefit out of it – you’ve got a place to live. If you didn’t have that home you would be paying rent. So for the purpose of this example we are going to say the payments you made to the bank are just the cost of having somewhere to live. And we are going to calculate the return you earned off of the $200k that you put down. 

LaMonica: So after 11 years the $800k loan that you took out at 5% is now a roughly $648k loan. That is what you still owe the bank. So you sell the house for $2.1m and pay the bank back $648k which leaves you with $1.452m. And you put down $200k. The return you earned over those 11 years is 19.75% a year. 

Jayamanne: Now you might be sitting there trying to figure out how you earned that return when housing prices only went up 7% a year. The reason is leverage. You took out a loan. Leverage is a multiplier on returns – as long as they are positive. If housing prices go down that same leverage will turn the situation into a disaster.  

LaMonica: Lets run a separate scenario. This is the scenario where you are aggressively paying down your mortgage on a house you don’t intend to ever pay off. Let’s say you are putting $1k extra a month or $12k a year into paying down your house. Now when you sell your house after 11 years the loan you have to pay back to the bank is only $497k. Now you get to keep $1.6m in proceeds for the sale. Happy days. But not so quick. Because instead of $200k you have now paid $332k for your house because you had 11 years of paying down your mortgage by $12k. So now the return you earned on that house is 15.37% a year. It is actually less. 

Jayamanne: Now as we said we’ve made some assumptions here. Technically you would apply the interest costs and time weight those extra principal payments but that doesn’t really matter in the big scheme of things. The fact of the matter is that you took $332k of your money and put it into your home through the down payment and extra mortgage payments. That is money you could have invested or done anything with. Your regular mortgage payments were just the cost of not being homeless. Under that scenario with paying down the principal in a home you never expected to pay off you have lowered your return. And you have lowered it by reducing the leverage on an appreciated asset. 

LaMonica: So there are certainly positives in paying down your home. You are building more of an equity buffer in case house prices drop. But if you think that housing prices are going to go up that leverage will increase your return.  

Jayamanne: One last thing to think about. If you are able to save more than a 20% deposit on your home and put down 30% or more you are also reducing your leverage. But the value in doing this is that you are also reducing your monthly mortgage payment and increasing your cash flow. But the second you buy your home you remove your ability to do that even if you are making extra payments. They won’t effect your monthly mortgage payment.  

LaMonica: Let’s get back to the investing side of things. If you do have a long time left on your mortgage and / or aren’t intending to ever pay it off, the more attractive investing becomes as an alternate to paying down your house. Longer time horizons for equity investments have meant that they have time to compound. Compounding is a theme that we discuss a lot, but it’s the key to how people build wealth and become successful investors. The longer you have to keep your money in the market, the higher your return – meaning, you have a greater chance of earning more than the mortgage interest rate.  

Jayamanne: Let’s look at a quick example of how time horizon can impact the growth of wealth. We can use the example of the savings needed to accumulate $1 million by age 65. When you’re 25, you have 40 years til you reach 65. You only need to save $405 a month to get to $1 million. $805,789 of this 1 million dollars comes from investment growth and compounding.  

LaMonica: When you have 10 years left, you need to contribute $5,846 a month to get to 1 million dollars. $298,458 of that comes from investment growth and compounding. This is where we come to opportunity cost again. The opportunity cost of your surplus is not considering the return that you get from your investment, but the compounding of those reinvested returns.  

Jayamanne: This is what Warren Buffet was talking about when he spoke about his $300,000 haircut. If a dollar today was going to be worth 20 dollars in the future, then in his mind the two were an equivalent. His friends and family often heard him equate things like haircuts to large amounts. 

LaMonica: When he spoke about purchasing his house in Omaha for $31,500, he expressed incredible regret and called it Buffett’s Folly, because in his mind, he thought that he had forgone the growth of the $31,500 to a much larger sum after compounding.  

Jayamanne: Now this is not to say we should take Buffett’s perspective on housing and just forego investing in houses or paying the mortgage, but it is illustrative of the decision of the opportunity cost that we must all grapple with. 

LaMonica: And when you have a longer time horizon, the opportunity cost of forgoing investing is larger.  

Jayamanne: I think it’s also important to note how paying down your mortgage impacts diversification of your portfolio. Paying down your mortgage is pure principal, meaning that you are putting more and more money into housing as an ‘asset class’.  

LaMonica: If you look at your net worth holistically, you need to decide if all your taxable wealth should be tied up in a house – and obviously your view of this would change depending on the housing market, but remember that there can be differences between the overall housing market and the suburb or state that your house is in. The local economy can have an impact on housing prices in your area and preferences for where people want to live may impact the desirability – and price – of your particular home. 

Jayamanne: Housing is generally the biggest single investment that people make – just remember that you are adding more of your assets to this investment by paying down your mortgage. This is another case for a concurrent approach- - ensuring that you’re not tying your wealth to once asset 

LaMonica: So these are all considerations for when you decide whether to take a concurrent or sequential approach to mortgages and investing. Ultimately, time horizon is really important to deciding this. We take a long-term look and we are long-term investors at Morningstar. The longer you have in the market, the better chances you have for reaching your financial goals. 

Jayamanne: For many people, owning their house is not their only financial goal. People can have goals attached to travel, a comfortable retirement, education related goals. Investing for a number of goals at the same time makes sense in most situations. For those closer to retirement, reducing their mortgage down may make the most sense in lieu of guaranteed returns that exceed their mortgage interest payments. 

LaMonica: All right. Shani, we made it. You are anxious to move into the home you purchased so that people don’t talk to you when you’re out walking Priscilla. But thank you for listening, any comments about Shani’s etiquette in ignoring this woman or the podcast, we would appreciate.

Jayamanne: I feel awful.

LaMonica: And if she’s listening –

Jayamanne: I’m really sorry.

LaMonica: There we go. Thank you very much.