Invest or Pay Off Mortgage

Invest or Pay Off Mortgage

To me, one of the most interesting ways to help diversify a portfolio is through investing in Real Estate. Whether you’re trying to buy/build an entire apartment building to rent out the units or purchasing your first home, you’ll end up with some form of Real Estate holding. The value streams you can create with one or more properties are self explanatory and are quite flexible. You can rent out an entire property to allow it to pay itself over time. You can rent out part of your home to a couple friends to reduce your monthly mortgage. Or you can simply live in it for decades and watch the equity (hopefully) grow. Today we’ll be answering the question of whether it’s best to invest or pay off your mortgage.

Whatever you decide to do, the one thing that’s for sure is that you’re gonna have to pay for it somehow. Throughout my research of personal finance, I’ve always been reading that debt-avoidance is king and paying interest is the devil.

Debt Devil
Debt is THE DEVIL

While in most cases, especially when it comes to credit cards, this is very clearly true. However, considering the relatively low interest rates of a mortgage, I wanted to do the math myself to see the real value of a mortgage.

You Don’t Even Have A House Yet, Why Think About Mortgages?

Admittedly, I haven’t even looked into purchasing a house just yet and as such my experience is inherently limited by this. What better way, though, to gain some of that experience than through going through the thought processes required beforehand? That being said, I’ll try to keep this as advice-free as possible and purely spit out the facts from my analysis.

What initially got me thinking about it was this post over at MadFientist. Clay has enough cash set aside to completely pay off his home, but is choosing to instead invest that amount in the market. At his current position, one year since purchasing the home, he has about $13k more from investing in the fund than if he were to have paid for the house in cash.

My Investing vs Pay Off Mortgage Experiment

This was all fine and dandy, but the sample size is pretty small and the time horizon extremely short. Especially in a decade of insanely favorable market conditions. I wanted to see if this was purely a product from good timing or if this would stand the test of time. I used a similar strategy to when I made this post about investing now versus waiting. Here are the following assumptions I’ve made for my analysis:

  • A Mortgage interest rate of 4%.
  • Payment Period of 30 years.
  • Base Principal of $200k.
  • Base Investment Account of $200k. The home buyer could theoretically purchase the home outright.
  • Dividend Tax Rate of 20%. For the majority of us making below 400k, the numbers are even better.
  • A person paying off their mortgage immediately will invest the saved payments each month.

The combination of 200k Mortgage at 4% principal for 30 Years gives us payments of ~$955 per month. We’re ignoring the cost of insurance and property taxes as these will be paid for regardless of whether or not you took out a mortgage.

In my previous post, I used historical annual returns which were fine. This time around I wanted to get an even more accurate idea of historical performance. Robert Shiller provides month by month Price and Dividend values for the S&P 500. This is the data I used for my analysis. You can check out the Excel sheet I used here as well!

30 Year Mortgage Table Time

Investing Portfolio Value over 30 Years
$200k Portfolio After 30 Year Periods

Taking a look at this table you’ll see the final value of the $200k portfolio after 30 years during each of the sixty-two 30 year periods from 1928-2018. The left side did not reinvest any dividends, maybe to pay for bills or purchasing horse-sized ducks, who knows. The right side, however, left the DRIP mechanism on for the 30 years and let it keep growing. Sorry giant ducks. Let’s not forget that these numbers don’t include the potential equity that your house has gained over the 30 year period. While this happens regardless of how you approach your mortgage, it’s a nice bonus to keep track of.

Portfolio Value versus Mortgage Value
Average Portfolio Value vs Mortgage Payments and the money saved from a lower interest

The second table shown is similar, except we subtracted out the amount paid throughout the course of the mortgage. Between interest and principal payments, the mortgage ended up costing about $343.8k instead of the original $200k. Spending an additional $143k feels really bad at first glance, but consider the average portfolio value you end up with after the 30 years.

At the top you’ll see that on average you’ll have accumulated an additional $141k and $1.6 million with dividend reinvestment even after capital gain taxes are taken into consideration. There are a few negative pockets here and there, primarily around really bad years like the Great Depression, but this make sense. The most important years for investing are the first few due to the nature of compounding. The mortgage payoff has the advantage here because it will be Dollar Cost Averaging heavily during the first few years. Picking up some very cheap shares of stock early on ends up being very fruitful.

All-in-all, however, the bigger picture shows your chance to outperform paying off the mortgage is extremely high with dividend reinvestment. What would you do if you had a 91% chance to outperform your current portfolio on the order of millions?

What About the Future?

It’s hard to say how returns will look in the future. As always mentioned in Finance articles, these returns aren’t guaranteed, but we’re banking on similar gains over a long enough period of time due to the historic results. One thing to make note of, however is the decline of dividend payouts in the S&P 500 over the past 90 years.

Dividend Yield of the S&P 500 over the last 90 years

The last 20ish years have shown pretty consistent dividend yields of around 2%. While it’s not certain whether this decline will continue, we shouldn’t be banking on a big spike in dividends anytime soon.

Other Good News for Investing with a Mortgage

Aside from the numbers above, consider the following points about why a mortgage can be useful.

Tax Deductions

Home owners who have a mortgage can deduct a portion of the interest from their annual tax sheet. This wasn’t accounted for in the above analysis

Inflation

Consider that every year we generally say that the value of the dollar inflates by about 2.5%. Often times our income will increase to match this, but our mortgage won’t! 10 years ago, $955 would have been valued at about $800. Another 10 years back it would be worth about $625. If your mortgage payments don’t increase with inflation, then it’s similar to as if they are decreasing in price. The $955 you’re putting in today will “feel” like less and less as the years go on.

Closing Thoughts

In the end, I’m not telling you what’s best, but the math is pretty self explanatory. Run the numbers yourself and talk with a financial planner to figure out what’s best for you. If you already have a house, how are you handling your mortgage situation? Are you paying it off as fast as possible? Are you leveraging a large sum of cash? Let me know what your experiences have been with mortgages!

This Post Has 9 Comments

  1. I would rather invest in my pension than pay down the mortgage. If I have £1000, I can invest the whole £1000 in my pension and earn around 9% over the long term. Or I can take the cash and pay down the mortgage. But by taking the cash it becomes taxable and my marginal tax rate is over 60%, so I’ll only pay off £400 of the mortgage, saving 2% interest per year!
    I would rather pay into the pension then pay off the mortgage when I draw the pension!

    1. Hey Grizgal!

      I’m glad you commented because I’m pretty interested in how things work on the other side of the pond.

      I’m unfamiliar with the concept of adding money to a pension yourself, since over here in the States we generally only get money added to a pension through an employer and that’s it.

      Is your pension similar to a 401k? Because you mentioned it’s not taxed it makes sense to focus there first even more so as opposed to going for the mortgage.

      Would also be interested in knowing where you’re from to read up more for myself!

      Thanks again!
      WIR

  2. Hi WIR, I am from the UK and yes things are slightly different here, although I believe more similar than different. We have many different types of pension and I think they function in a similar way to your 401K. Money going in is not taxed and then grows tax free. You are limited as to when you can take it out (at present not before 55 but that rises to 57 in 2018 and different pension schemes may have different rules). However, when you want to withdraw it, its taxed as income. You get to take 25% tax free as a lump sum but the rest is subject to the same tax free allowance and tax bands as if you earn’t it.
    Most people will contribute to their company pension scheme (all of which will have different rules). These used to be defined benefit on the whole, whereby you were guaranteed a certain level of income when you retired (ie for 30 years service you would get a certain percentage of your final salary). This is now unaffordable, so they have switched to defined contribution and are subject to the performance of funds invested in bonds and the stock market.
    To complicate matters further, I am self employed, so don’t have access to an employer scheme. I use a SIPP (self invested personal pension), which allows me to pay in before paying a penny of tax and take it out after 55/57 subject to 25% tax free and the remainder taxed at income levels. As my marginal tax is 60%, I would rather pay into a pension than take the cash as Ill only actually get 40% of it!
    I hope that makes sense. I do aim to write more on pensions in the next few weeks but I’m struggling with time right now. Feel free to message me if you want specific details.

    1. Hey Grizgal,

      Love hearing more about the UK financial options. It does seem that the two (401k/UK Pension) are quite similar in nature. The 25% lump sum that you’re getting tax free is awesome!

      If you were curious, we don’t get the same benefit and we’re technically stuck keeping it in the account until 59.5.

      Your marginal tax rate seems really high, so I totally agree with your point on going for the pension first!
      Is the tax rate because you’re in a high income bracket or are taxes just that high in the UK?

      I’ll definitely be reading up on your info, even if some of the material isn’t totally relevant due to the different rules, it’ll still be awesome to learn if I end up somewhere out there one day!

      Best,
      WIR

      1. Tax rate is very high but its due to a quirk of the tax system. Anything over £50k is taxed at 40% for income tax. You also have to pay National Insurance (NI) (basically income tax under s different name that is supposed to pay for the NHS (our state health care) and state pension). NI is complicated and there are bands but its approx 0% on first £166 a month, the 12% until £962, then 2% on everything over that (per month). Added to this we receive child benefit. This is a benefit for families and used to be universal, however it became means tested some time ago and now its tapered over £50k a year and if you earn over £60k a year you have to pay it all back.
        The total result is between £50 and £60k you have a marginal tax rate of approx 60-65% (if you gate child benefit). There are ways of contributing to a pension before paying tax (salary sacrifice etc) and this means the lower salary is taken into account. I am self employed, so I can pay money into a pension as a business expense, before paying business taxes etc. I hope this helps.

        1. Forgive my slowness, I’m now realizing that I should have known you were from the UK right away due to your use of the £ as opposed to the Euro…

          I digress… it seems the base income tax rate is pretty high out there. I’m curious what other kind of benefits you get from that from a citizenship standpoint. Since it seems that the “Child Benefit” and “NHS” are covered through separate taxes.

          Best,
          WIR

          1. Not really. Although they act as though they come from different taxes, in reality they all go into the same pot and pay for everything. Roughly, income tax is 0% up to £12.5k, then 20% up to £50k, then 40% up to £150k then 45% on anything over. NI is another tax (just another income tax basically) and is more complex as bands are different, rates are different and its payed by employees and employers. But we don’t get state and federal taxes. benefits include the NHS (free health care at point of service), free medicines (pay a notional prescription charge of around £8 per drug when needed), state pension of around £168 per week for all who qualify over 67.
            I think overall tax burden is similar to the US but collected in different ways (and spent differently- The last wall we had was built by the Romans to keep out vicious Scottish tribes!!)

          2. Hahaha, I can’t wait for my money to be spent on the totally necessary wall to protect from our terrible southern neighbors… 🙂 🙂 🙂

            In all seriousness though, I see what you’re saying now. U.S income tax brackets are a bit lower overall (we only hit 40% around the $400k mark) but that doesn’t include our state taxes on top of that.

            Additionally, as I’m sure you’ve likely seen our atrocious health care system, that’s an additional financial burden to account for.

            I appreciate you taking the time to share your experiences with me, good sir!

          3. Oh yeah, as I was typing this I forgot to ask. How do capital gains taxes work in the UK?

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