Many Australians have a goal of paying off their mortgage to experience the amazing feeling of living in a home that is exclusively their own. While I can confirm that it brings a certain level of security as well as a huge sense of achievement, it is not a necessary pre-cursor to financial freedom.
The issue with debt
If you treat your entire financial situation like one large portfolio having a mortgage essentially means that you are long on a leveraged property position. As I have written about in the past, leverage increases investment risk and one of the ways that it does this is by exposing an investor to additional costs of finance as well as interest rate movements. This means that an investor can hold debt, in this case a mortgage, as long as they are comfortable with the residual risk once adequate controls have been put in place.
Financial freedom and mortgage debt
To have financial freedom a household needs to generate enough passive income to cover their cost of living. So, if a household’s total cost of living is $55,000 p.a. they will need a passive income of at least $55,000 p.a.; which equates to $55,000 x 25 = $1.375m portfolio according to the 4% rule. In the situation where a household has debt it introduces additional volatility to their overall cost of living, which means that a $1.375m portfolio may not be enough. In order to reduce the of risk not being able to meet expenses they will need to have a larger investment portfolio to reduce the risk associated with interest rate increases.
Let’s extend the previous example with the following conditions:
| Original loan amount | $200,000 |
| Current annual interest rate (principal + interest, owner occupier) | 2.59% (ING 2020) |
| Loan term | 30 years |
| Repayment period | Monthly |
This means that the $55,000 total cost of living is made up of $9,596 of principal and interest and $45,405 of other household expenses, so if they were mortgage free, they would require a portfolio of $45,405 x 25 = $1,135,111. If the household carries a mortgage in to retirement they will need to have a larger portfolio in order to protect them from the potential increased total cost of living that will accompany an increase in mortgage interest rate. The following table outlines the changes in the yearly repayments and portfolio size required for varying interest rates.
Here we can see how significantly larger amounts of capital are required as interest rates increase. For instance, at their current interest rate of 2.59% they will require an additional $239,890 of capital to meet repayments, at 5.09% this amount jumps to $325,401 and at 10.09% they require an additional $530,538. Now if 10.09% interest sounds unreasonable, we only need to look back to 1995 when the average mortgage rate was 10.5% (Whitten 2020), so it would not be unwise to consider controlling for this level of interest rate risk.
Other considerations to reduce risk
Changing the repayment loan terms
In the example provided the repayments for the household are what is required to be paid per year if the original mortgage amount of $200,000 was to be paid off over a 30-year period. Mathematically, if the interest rate remains the same the repayments will stay the same, it is only the ratio of principal and interest will change over time. If they have paid off a significant portion of the loan, then re-mortgaging the remaining balance for another 30 years would allow them to decrease the size of the required payments. For example, if they have $75,000 remaining, restarting the loan period would drop the yearly repayments from $9,596 to $3,598 at 2.59% Alternatively they can move to an interest only loan which would have a higher interest rate at 3.54% (ING 2020) with repayments of $2,655 p.a. The issue with both of these initiatives is that they will have an outstanding debt, and the risks that come with it, for a longer period of time.
Fixed rate mortgage
Fixed rate mortgages will often have a higher interest rate than variable rate mortgages which means that the household must accept a greater cost of finance. However, for the period that the rate is fixed the risk of interest rate increases is eliminated; something to keep in mind is that the benefits of a fall in interest rates will also be eliminated.
Supplementing income
If a household is willing to take on some work to supplement their income they can get by with a smaller sized portfolio. Technically, a household isn’t completely financially free if they need to work, however if their passive income covers most of their expenses and they are simply working to control the risk of increases in their interest rate, they are still in a strong position to pursue employment opportunities based on passion rather than salary.
Insurance
In the case where working to supplement passive income is required a household should consider insuring for losses of income. Because a household in this situation is close to financial freedom the level of insurance required will be low. In such cases insurance policies that payout immediately such as life, TPD and/or trauma insurance can be cheaper than income protection insurance. In the event of a loss of income, the payouts received, can be used to eliminate the debt and remove the risk for the remaining family members.
Concluding thoughts
Having a mortgage/debt and financial independence are not mutually exclusive goals. Further to this, it is even possible to retire safely with debt; a household simply needs the risk tolerance and the capacity to cope with the additional risk imposed on them by carrying debt.
At the FFE house we are not really comfortable with the risks of carrying debt whilst not having a reliable income so we intend to pay off our investment debt shortly before we cease full time work.
Engineer your freedom
References
ING, 2020, ING Home loan interest rates, ING, viewed 5/7/2020, <https://www.ing.com.au/rates-and-fees/home-loan-rates.html>
Whitten, R, 2020, Historical Australian Mortgage interest rates, Finder, viewed 10/5/2020 <https://www.finder.com.au/historical-home-loan-interest-rates>