Pay Off The Mortgage or Invest?
The answer to this question is a contentious one, even for those in the financial advice industry. I have my own preference but thought it would be a good idea to delve into the detail of each scenario.
To be able to pay off the mortgage or invest, we will have saved surplus income or received a windfall. A windfall is an unexpected financial gain such as an inheritance, legal settlement, property sale, bonus or lottery winnings. It is a great financial position to be in and therefore we need to carefully consider our options.
Before we consider paying off the mortgage or investing, we should have achieved the eight financial goals outlined below in order of priority which was discussed in Series 1 Episode 3 of the podcast: https://money-mentor.ie/podcast:
1. Know how much our current lifestyle costs us.
2. Spend less than we earn.
3. Save a €1,000 starter emergency fund.
4. Pay off all non-mortgage debt.
5. Save 3-6 months of expenses in an emergency fund.
6. Insure ourselves against serious illness or death prior to financial independence.
7. Maximize our pension contributions for financial independence.
8. Save for children’s education/future (if applicable)
Having an emergency fund, no non-mortgage debt, protecting ourselves against serious illness &/or death, and maximizing our pension contributions to meet our financial independence goal ensures our financial foundations are solid. For the purposes of this blog post I am going to assume these financial goals have been achieved.
We also need to ask ourselves, is our current home our forever home? Do we plan on renovating, extending, or moving? Are there any other large expenses on the horizon? What are our future plans? If our savings or windfall are surplus to our future needs, we can choose to pay off the mortgage or invest. We naturally assume that our current circumstances will remain unchanged for the remainder of the mortgage term and beyond. The one constant in life is change. When comparing paying off the mortgage or investing it is important we compare apples to apples to avoid giving one an advantage over the other.
Investing
When deciding to invest or not we should review our investment principles. Please see previous blog post on investment principles: https://money-mentor.ie/blog/investment-principles
The decision to invest is based on achieving a positive return over and above the mortgage interest rate we will pay within the same term. Can the investment market provide us with a return better than that of our mortgage interest rate over the same term? When contemplating an investment there are a number of factors to consider. These are time, cost, risk and return:
Time
Our time horizon is a major determining factor in the probability of achieving a positive return. The probability of receiving a positive return increases significantly the longer we remain in the market. Therefore, the shorter the mortgage term and therefore investment term the less sense an investment makes due to market timing. Market timing is an attempt to predict the direction of the investment market in the short term. Investment markets can rise and fall sharply in the near to medium term. At a time of peak market optimism, our ability to see past recent investment market returns can be impaired.
Long term average historical
returns (many decades)
are not representative of actual investment returns year to year. There
is no guarantee of a positive investment return. Zero to five years is
gambling, five to fifteen years is speculating, and fifteen years plus is
investing. The amount of wealth we chose to gamble or speculate with should be
proportionate to what we can afford to lose.
Cost
Before investing we need to determine the required rate of return over the investment term. We start by first determining how much an investment will cost us. At a minimum we invest to beat inflation, investment charges and the government levy. Let’s say we take inflation at 2%, investment charges at 1.5%, and the government levy of 1%. I have chosen an exit tax policy rather than a CGT policy for administrative ease (gross roll up rather than CGT tax return). When we add up inflation, investment charges and the government levy we get 4.5%.
If we add an average mortgage interest rate of 3% to the 4.5% the investment return required to match the return from paying off the mortgage would be 7.5%. An investment return of 7.5% would require the portfolio to hold a significant level of risk. This is before we have made a positive investment return where the gain will be taxed at 41%. Is an average annual return of 10% likely over the next ten, fifteen or twenty years? What happens if we lose money?
Risk & Return
When we invest, we are inviting investment market risk into our lives. Say for example we had a lump sum of €200,000, invested for 20 years, earning 6% annual return with investment costs of 4.5%. The fund would be worth €269,368 after twenty years and the €69,368 gain would be taxed at 41% leaving us with a fund of €240,927. The real return, the return after inflation, investment charges, government levy and exit tax that we receive into our pocket is less than 1%. Is the 1% return worth all that risk? Is the 1% real return better or worse than our mortgage interest rate?
There is the option of increasing the risk within the
portfolio further with the possibility of a higher return. This also comes with
an increased possibility of loss. The more risk within our portfolio the more
flexible and accepting we have to be of when we cash in our investment. If we
are solely focused on investing to beat our mortgage interest rate, we need to
be aware of what we can control and what we can’t control. If we do invest, what
happens if we need the money before the mortgage term is over? Are there exit
penalties? Will the market be down? We are at the mercy of investment markets at the time. Investing is discussed
in detail in Series 1 Episode 8 of the podcast.
Paying Off the Mortgage
Our mortgage repayment is likely to be one of our biggest ongoing expenses. I believe we become accustomed to our mortgage obligation over time and don’t fully appreciate the subconscious security, peace of mind and comfort of owning our own home debt free. Not to mention no longer having that monthly mortgage payment. The emotional and mental wellbeing of knowing we own our own home free of debt is a major milestone in life. A mortgage free property can become collateral against future borrowings, if required. It can also provide a passive income. Property as an asset class appreciates long term and is good protection against inflation. Debt is discussed in Series 1 Episode 5 of the podcast.
Time & Cost
Time is our most valuable asset and more specifically time we are fit and healthy. Our ability to choose what we do with our time is the ultimate freedom. Paying off the mortgage saves us paying interest. For example, €200,000 at 2.5% over 20 years costs us €54,353 in interest. Using our per hour after tax income, how many years will we need to work to pay for the interest alone? Not only that how much more could we enjoy our lives by saving or spending what used to be our mortgage payment?
Interest Rate
It’s impossible to know where interest rates will go ahead of time but part of the attraction of paying off the mortgage is to minimize interest rate risk. If interest rates rise, we will pay more for our mortgage. Interest rates have been at historical lows for the last decade. Regardless of fixed or variable interest rates, if inflation begins to rise interest rate rises usually follow. If we pay off the mortgage our interest rate saving is guaranteed. Regardless of what happens we will always need a place to live, it is a basic need. If we do pay off the mortgage but it isn’t the entire outstanding balance, be sure to reduce the repayment and not shorten the term to maintain maximum flexibility.
Summary
There are a number of variables at play when contemplating which option is best and therefore it will depend on your specific circumstances and appetite for risk.
In my opinion, investing to beat our mortgage interest rate isn’t a valid reason to invest. We wouldn’t borrow money to invest so why do it here? As outlined above there are a litany of hurdles to navigate and potential pitfalls outside of our control when it comes to pursuing an investment return in excess of our mortgage interest rate. It is possible to achieve an investment return that beats the return we would receive from paying off our mortgage, but I don’t believe it is probable. Many people can’t stomach the risk required to beat their mortgage interest rate. A lot needs to go right in the investment markets to obtain the required investment return within a ten-to-twenty-year time horizon. We can still roll the investment dice and hope it lands in our favour. I wish you the best of luck.
We can still choose to invest what would have been the monthly mortgage
repayment once the mortgage is paid off. Whether it makes mathematical sense or not, it's unlikely we will regret paying off our mortgage.
Link to Spotify podcast episode: https://open.spotify.com/episode/487Rzjiy5aBKTMD4uyGFhU?si=90fca81226a04f64
Link to Apple podcast episode: https://podcasts.apple.com/ie/podcast/s2-e5-pay-off-the-mortgage-early-or-invest/id1539630506?i=1000539227122
For personal financial planning advice email team@vantagefp.ie or call (01) 539 2670.