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.
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
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.
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.
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.
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
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.
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!