With mortgage interest rates at all-time lows it got me thinking about the age-old debate of: pay off your mortgage or invest the money? So, let’s look at this issue through the lens of achieving financial freedom.
The benefits of reducing/eliminating mortgage debt
Reducing/eliminating mortgage debt helps move a household closer to financial independence primarily through the reduction in cost of living. Once your mortgage is paid off you earn yourself a guaranteed reduction in interest and principal payments.
The secondary benefits of this include:
- Reduced exposure to upward interest rate movements. If your home loan is variable, then increasing interest rates mean loan repayments will increase.
- A decreased cost of living results in an increase in excess cash flow, which allows more money to be invested
- You will have increased home equity, which you can borrow money against for investment purposes
- The psychological benefits that come with owning your own home outright
Investing – the opportunity cost of paying your mortgage
The main opportunity cost to paying down your mortgage is investing the money at a higher rate of return. For example, reducing your 3% interest rate home loan by $20,000 saves $600 per annum in interest payments; however, if this money was invested at a 4% rate of return it could produce $800 per annum in passive income. Here we see that an argument can be made in favor of increasing passive income instead of decreasing cost of living.
Further to this, choosing to pay down your mortgage before investing means forgoing time in the market and compounding returns. As a result, you’ll need to invest larger chunks of money at a later date (once your mortgage is paid off) to catch up to the same portfolio value. When it comes to which achieves financial independence faster the question now shifts to:
Does someone that invests less (because they are making mortgage payments) but starts earlier achieve financial independence faster than someone that starts later but invests more?
Having financial independence and a mortgage
Contrary to popular belief you do not need to pay off your mortgage to retire. You simply need to produce enough passive income to be able to cover your repayments as well as the situation where interest rates rise considerably. This adds a further consideration to whether or not a household should eliminate their mortgage completely.
Minimum repayments vs pay-off mortgage first (max repayments)
To answer the question above I created a simulation looking at 2 scenarios using the assumptions below:
| Take home income | $90,000 |
| Cost of living ex mortgage repayments | $50,000 |
| Mortgage | $300,000 |
| Mortgage term | 30 years |
| Interest rate | 2.54% (ING 2021) Note 1 |
| Repayment frequency | Monthly |
| Mortgage repayments per month | $1,191.61 (ING 2021) |
| Annual total cost of living inc mortgage repayments | $64,299.33 |
| Portfolio growth rate | 7% |
| There are no fees or taxes |
Scenario 1: The household pays the minimum principle + interest amount ($14,299.33) towards their mortgage and invests the remainder of their excess cash ($25,700.67) at a 7% return. Financial independence is reached once their portfolio exceeds 25 times their annual expenses (25 x $50,000 = $1.25M) plus their outstanding mortgage value. The idea here is that once this point is reached, they can sell a portion of the portfolio and pay off their mortgage whilst living off their portfolio distributions as per the 4% rule.
Scenario 2: The household pays off their mortgage first before they start investing. To do this, they will use 100% of their excess cash ($40,000) to pay off their mortgage. Financial independence is reached once their mortgage is paid off and their portfolio exceeds 25 times their annual expenses (25 x $50,000 = $1.25M).
Results
The results of the financial journeys for making minimum repayments (scenarios 1) and maximum repayments (scenario 2) are shown in the graphs below:
Observations
By making the minimum repayments, the household in scenario 1 achieves financial independence in 23 years (Note 2). If they chose to pay off their mortgage first it would have taken them 25 years (Note 2). So, even though making the minimum payments requires a larger portfolio ($1.345M vs $1.250M) it still allows the household to reach financial independence faster. This is due to the fact that investment growth is higher than the mortgage interest rate and scenario 1 allows more time for returns to be compounded
The required portfolio size (green line) in scenario 1 decreases more gradually when compared with scenario 2. This correlates directly with needing to allow for additional funds to pay off the remaining mortgage value (blue line).
Even though the money invested each year is less in scenario 1 when compared with scenario 2 ($25,701 vs $40,000) the portfolio value in scenario 1 is always higher than in scenario 2. This highlights the effect of an additional 7 years of exponential growth.
Key considerations when choosing a strategy
In this simulation making minimum repayments provides the household with an additional 7 years to take advantage of compound growth. This means they can reach financial independence 2 years faster than if they were to pay off their mortgage first. However, it exposes them to the risk of upward interest rate movements and a higher cost of living for an additional 15 years. Being able to cope with these risks should form the basis for considering which option better suits your own household.
Interest rate movements and portfolio returns
Interest rate increases will cause mortgage repayments to increase. This reduces the amount that can be invested in scenario 1 and extends the mortgage pay off period in scenario 2. In terms of reaching financial independence this situation affects a household under scenario 1 more severely than a household in scenario 2. To demonstrate this, I ran both scenarios again, with differing interest rates and portfolio returns. The years required to achieve financial independence for Scenario 1 and Scenario 2 are shown in the table below.
| Interest rate -> | 2% | 4% | 6% | 8% |
| Portfolio return | ||||
| 3% | 30,30 | 33,31 | NA,32 | NA,34 |
| 5% | 26,27 | 28,28 | 31,29 | 34,31 |
| 7% | 23,25 | 25,26 | 27,27 | 30,28 |
| 9% | 21,23 | 22,24 | 24,25 | 27,27 |
| 11% | 19,22 | 20,23 | 22,24 | 25,26 |
| 13% | 17,21 | 19,22 | 20,23 | 22,25 |
The table above shows that if the interest rate moved from 2% to 4% and portfolio returns remained at 7% it would now take 25 years as opposed to 23 years for the household making the minimum repayments to achieve financial independence. Whereas the household making the maximum repayments will extend their time by only 1 year.
Further to this, the table above indicates that for a household making minimum repayments to achieve financial independence faster than one making the maximum repayments their portfolio growth rate needs to be at least ~3% higher overall than their mortgage interest rate.
Cash flow
In the world of personal finance, excess cash flow represents financial security. Holding a mortgage, or any sort of debt, means repayments need to be made. This reduces a household’s excess cashflow which increases risk. Something to note is that mortgage payments do not decrease as the outstanding mortgage value decreases, so the additional cost imposed on a household’s annual expenses remains the same throughout the life of the loan.
While both scenarios require a steady source of incoming cashflow, making the minimum mortgage payments requires a higher level of income for a longer period of time. Using the original example, a household in scenario 1 will have a total annual cost of living, including repayments, of $64,299.33 for 23 years. For the household in scenario 2, once they pay off their mortgage after 8 years, this figure falls to $50,000. This allows them to have more leeway during periods of unemployment such as career breaks or job losses.
Discipline and consistency
The 7% return that I often cite is based on long run market returns of dollar cost averaged portfolios. When deciding which strategy to pursue, it is critical to invest in a way that is similar to the simulations presented here. If you have the tendency to try to move in and out of positions to try to time the market it is likely that you will produce a lower return and experience worse results than the simulations. Additionally, if you do not invest your excess cash you can also experience sub-par results.
Personal goals
If your personal goal is to own your own home in as short a time as possible and this ranks higher in importance than reaching financial independence, then go for it. The length of your financial journey may be extended, but being mortgage free is still a very solid position to be in. Never underestimate how much the psychological benefits can outweigh the financial.
On the contrary, if you have the objective of accruing as large a portfolio as possible, then making the minimum mortgage repayments produces better results. This is because the rate of return on investments tends to be higher than the mortgage interest rate.
Ability to leverage against your home equity
If you are looking to take on additional leverage for investment purposes then it can sometimes make sense to take out a loan against the equity in your property. In this case putting more money into your mortgage will give you more home equity than simply paying the minimum – regardless of whether or not the property value appreciates. This is due to the fact that as the mortgage outstanding decreases the proportion of each payment that goes towards the principal increases. As a result, this will give you more equity with which to borrow against.
Concluding thoughts
At the FFE house we chose to pay down our mortgage as quickly as possible (scenario 2). Admittedly, I did not do this level of analysis prior to choosing this course of action. However, the rationale behind our decision was wanting to be in a position where we did not need to make mortgage repayments. We would then be free to focus all of our excess cashflow on investing.
After looking at the simulations I personally feel that the possibility of achieving financial independence about 2-3 years earlier is not worth the additional risk shouldered by making the minimum repayments. Although, this could be a case of confirmation bias. The reason being is that having a mortgage (and added expenses) can reduce freedom to do things like work a lower paying job prior to reaching full financial independence; or take time off due to redundancy or re-training. Both of which were important to me at the time, as the risk of job losses in my industry is fairly high.
I want to finish by saying that while both strategies are financially sensible, the optimal choice will depend highly on your goals; household’s situation; and outlook for future portfolio returns relative to interest rates. In either case, you need to be investing excess cash flow. Remember that you will only be doing a disservice to yourself by not using your excess cash for investing or paying down debt.
Engineer your freedom
Notes
- Home loan is for owner occupier, principal + interest, LVR is 80% or less
- Years to retirement are rounded up to the nearest whole year
References
ING, 2021, Home loan interest rates, ING, available from <https://www.ing.com.au/rates-and-fees/home-loan-rates.html>
ING, 2021, Home loan repayments calculator, ING, available from <https://www.ing.com.au/home-loans/calculators/repayments.html>