How do you put a price on security?
Well, in this post I’m going to try and do exactly that but, first MoneyMonk asks the question that all people have at the back of their minds:
As a woman, I just want to say that “to each it’s own” Women love security.
If you are not a person that love investing, and you have the cash to pay off your mortgage (considering that you plan to live their forever)
Adrian- not everyone is business oriented. Some just don’t have the business acumen to run a business. Therefore, that group SHOULD pay off the mortgage
This is the dream of home ownership: own your home outright and you have nothing to worry about.
But, do you?
Let’s say that you own a $150,000 home today … what will it be worth in 30 year’s time?
About the same as a $150,000 home today, but in future dollars!
So, let me ask you; when your kids grow up, move out, and you retire, what are you going to move into?
Probably the same, or another $150,000 home … a smaller condo or newer townhouse that will probably not give you too much change, if any, from $150,000, a retirement home that (with fees) will cost you far more than $150,000.
Your home is not your financial security; your realizable net worth is. Put it another way: you can’t live off your home, but you can live off your cash and investments.
True security comes from knowing that you can pay your monthly bills for the rest of your life, without needing to work or get handouts from friends, relatives, or the government, through up markets and down (war, pestilence, and other Acts of God aside).
I hope that you see my point …
So, let’s look at two scenarios for a $150,000 house that you just bought and locked in a 30 year fixed rate loan at 6% (a bit higher than today’s actual rates, which are still between 5% and 5.5%):
1. You pay off your mortgage early
Note: We will assume that you are allowed to pay off as little / much as you like on your loan (not the case with some fixed rate loans in the USA, and certainly not the case with most fixed rate loans in most other countries!) because it makes the math simpler.
This is great, because you ‘earn’ 6% on your money [AJC: remember, a dollar saved – in interest – is the same as a dollar earned], better yet:
– The amount you ‘earn’ is guaranteed; every year that you are no longer paying that 6% loan, you are in effect earning 6% … simple and guaranteed!
– Unlike an investment that pays you 6%, there is no tax to be paid on the 6% mortgage that you save (although, there can be a negative benefit of losing the tax deduction on your home loan interest … but, I’m trying to keep this simple), so it’s more like earning 7.5% – 8.5% (depending on your tax rate) in any other investment.
– Let’s say that you plonk the entire $150k down in one hit, you save the entire $175k INTEREST (yes, a house that you buy for $150k in 2010 will have cost you $325k, just in principal and interest, by the time you have paid off the 30 year loan in 2040).
2. You do not pay off your mortgage early
Note: Paying the loan off slower will, naturally, save you something greater than $0 and less than $175,000 … but, is too hard to calculate, here, so we will continue to use the assumption that somehow, you were able to pay that entire $150k loan off in one hit.
Well, it’s a fairly simple calculation then, isn’t it: what can you invest $150,000 in that will return more than $175,000? Let’s run some numbers and see:
Business: If Michael Masterson is right, and we gain 50% (or more) from our own business, then after 30 years you would have earned $29 Billion on your $150k ‘seed capital’.
But, MoneyMonk is right: there is extreme risk and skill involved in being successful in business … just a shame the potential reward is so low 😉
[AJC: just a tad more than the $175k interest that you would have saved if you used the money to pay off your mortgage instead of starting a business]
Real-Estate and Stocks: Again, if Michael Masterson is right, and we gain 30% by investing in a mixture of buy/hold real-estate and stocks (naturally, continually reinvesting the rents and dividends), then after 30 years you would have $392 million …
… if that sounds a lot, remember that Warren Buffett built up a $40 Billion+ fortune over 40 years at not much more than 21% compounded.
Stocks: I agree with Michael Masterson, that if you buy stock in just a few good businesses when they are are going cheap (as the market does from time to time) and wait 30 years, you should have no trouble getting a 15% compounded (pre-tax) return so, after 30 years you would have nearly 10 million.
But, all of this has some risk / skill associated with it … so, maybe paying off the mortgage and snaffling that $175k is still the way to go for all of those risk averse people [AJC: Like me. True!] out there?
But, wait, what if we just do the ‘no brainer’ thing and plonk that entire $150k in a set-and-forget-low-cost-Index-Fund?
Here’s the good news: paying off your mortgage is a 30 year investment (you have forgone 30 years of being locked in to a loan and paying 6% interest year in, year out), so it’s only fair that we buy $150k of Index Fund units and don’t even look at our portfolio for 30 years, right?
Well, that’s an ideal strategy – THE ideal strategy – for Boglehead set-and-forget investors! So …
Index Funds: Over 30 years, the markets (hence the lowest cost Index Funds) have averaged something more than 12% – set and forget (!) – so, after 30 years you would still gain close to $3.5 million!
But, wait … we’re all about security here: you can’t live off averages, right? What happens if there’s another crash like 1929 and 2008 the day after I plonk my entire $150k into an Index Fund?
Well, you lose half your money immediately 🙁
But, we don’t care what happens immediately, this is a 30 year set-and-forget plan … and, there has been NO 30 year period where the stock market hasn’t returned AT LEAST 8%.
Now, isn’t 8% (since we have to pay tax on it) exactly the same as the equivalent after-tax 6% mortgage (give or take 0.5%)?
Yes!
The lowest possible return that we can get with any reasonable investment strategy that we can come up with is exactly the same as the best possible return that we can get by paying off our mortgage early.
Now, isn’t that interesting?
>The lowest possible return that we can get >with any reasonable investment strategy >that we can come up with is exactly the >same as the best possible return that we >can get by paying off our mortgage early.
Adrian,
I’m not in favor of paying off the mortgage early- I agree that other investments are almost certainly better… however the mortgage is 100% certain. Other investments have a historical range of returns but there is no lowest possible return. It is possible that stocks could stagnate for the next 30 years and return only a 4% annual growth rate. I don’t think that is too likely- but it is certainly possible.
-Rick Francis
Adrian,
Good post. I’ve read Masterson’s books and sometimes he glazes over the complexity of building a big, successful business. I’m entrepreneurial myself (own a few businesses) but I’d love to hear a case study of buying a business to generate returns like he says (50%). Don’t know if you have any experience with that but it could make a fun topic.
I have this discussion with my wife all the time. She gets that we shouldn’t be paying down our mortgage intellectually, but not emotionally.
Now, we did recently put down an extra $30K when we last we refinanced our mortgage, but that allowed us to lower our interest rate on the entire principle by 2%, cut and our mortgage payment by 1/3, and pay back the refi costs in 4 months so that was money well spent.
Of course, I did set up an automatic withdrawl for the mortgage savings to ensure that the money isn’t suddenly getting spent.
@ Brandon – I liked the first 42 pages of his “7 years to 7 figures” (if that’s what his book was called), the rest was fluff case-study stuff.
But, I went from two B/E businesses to over $14 mill. in sale value (plus the $5 mill. in stock/RE/other investments that I had built up over 7 years, using the business cashflow), so I guess that is a 50%+ compounded case study right there! 🙂
For average market returns the money has to be put into the whole market, i.e. an ETF, and dollar cost averaged both In and Out. It is not possible to simply withdraw a large chunk of invested cash without skewing the returns in one direction or the other. Also, since no ETF is truly “the whole market” this reduces the safety net somewhat, as companies come and companies go (that money you invested in Nortel through your ETF is gone). Might as well try and hold a whole beach in your hands. With a house, the mortgage can be paid off a little bit here with the odd big chunk (pay raise?) without the threat of “buying” your mortgage at a market peak. Once the house is paid, the equity is in the property. This to me makes the house payments look better than the “investing for dummies” option. Jost people want piece of mind. Of course, we’re not most people, are we?
I agree with Rick,
Paying off a mortage is 100% certain. For those people uninterested in the stock market, this gives them a piece of mind.
It’s not about gaing an extra 4% someplace else. No one seems to factor in market crashes.
How long is normal to keep a mortage? at somepoint you need to pay for it or move and rent for life
Everyone has different priorities
@ MoneyMonk – If you’re prepared to ‘invest’ your money in your mortgage for the 15 – 30 years life of a typical mortgage, then you have to compare that to how the alternate investment (could be stocks, RE, business, etc.) might perform over that same period.
4% (if that’s what the difference works out to be, after tax) compounded for 15 – 30 years is a lot to give up – assuming that you need the extra return in order to reach your Number 😉
“Now, isn’t 8% (since we have to pay tax on it) exactly the same as the equivalent after-tax 6% mortgage (give or take 0.5%)?”
Actually, No.
The 6% that you save by paying off your mortgage gives you shrinking returns since your principal keeps reducing.
The 8% that you gain by investing on the other hand gives you growing returns since your returns are re-invested. So by putting 150K in an 8% yield investment, you don’t gain a mere 175K in 30 years. You actually gain 1.36 Million.
If you wanted to just match the savings you would have made by paying the mortgage off, all you need to do is find an investment that returns a measly 0.5%
That is a big motivation to not pay off your mortgage early.
@ Saif – I plugged the numbers into a mortgage calculator to find out how much interest you can save … the max. you can save is the $175k interest. But, ONLY if you pay it all up front.
So, any way that you analyze it, it’s MUCH better to invest than pay your mortgage off early, unless you’re a terrible investor.
You are not comparing apples to apples here.
Mortgage debt is a debt, plain and simple. The advantage that comes from paying it down early is measurable, and fixed. When comparing it against investment opportunities, you should only compare to those with similar risk characteristics (for example, CDs or Treasuries).
A 30-year investment in stocks, real estate, or index funds could result in a loss of 100% of the investment. There is not a similar level of risk associated with paying off mortgage debt (for example, the lender would not suddenly ask you to repay twice the original principal amount).
Think of it this way…if an investor decided to allocate 35% of his/her portfolio to debt instruments, it would not make sense for the investor to select stocks and REITs for that 35% portion, because stocks and REITs don’t fit the allocation model (even though there is greater potential for capital appreciation over the long term). That investor would be taking on additional risk, which may defeat the original purpose of the fixed income allocation.
If you can find fixed income opportunities which offer a better yield than paying down a mortgage, then I agree investing makes more sense than debt reduction. But in normal market conditions this scenario wouldn’t exist.
Hypothetical scenario…if I own a home with no mortgage, and a financial advisor tells me to open a home equity loan so that I can invest the proceeds in the stock market, I am not walking, but RUNNING for the nearest exit.
“A 30-year investment in stocks, real estate, or index funds could result in a loss of 100% of the investment.”
@ Executioner – What’s the greatest 30 year loss in any of these instruments that you’ve ever seen?
BTW: I presume we’re talking about any sensible stock, RE, or index fund investing strategy … we’re not talking about putting 100% of our portfolio into Enron are we?!
“Past performance is not an indication of future results.”
Just because it hasn’t happened before, doesn’t mean it can’t happen in the future. And although I’ll concede that it is unlikely that a broad index fund would ever drop to zero, it’s not outside the realm of possibility (I do, however, think it is much more likely that we will see 30-year returns of less than 8% in the future).
This is the whole point of asset allocation. If you don’t think asset allocation is important, then we are obviously using different underlying assumptions, which makes further debate difficult or meaningless.
“we are obviously using different underlying assumptions, which makes further debate difficult or meaningless”
@ Executioner – the underlying assumption that I am using is that most of my readers want to reach a large Number by a soon Date e.g. $7 million in 7 years … even $2 million in 10 years will do it (otherwise they would be reading another blog).
Working backwards, this usually implies going for a (much) larger compounded growth rate than either strategy (paying down your mortgage; diversification / asset allocation) that you name can provide.
Their choice: trade-off absolute protection of their capital for larger returns. It’s a difficult choice, I’ll admit 🙂
I think mortaged house purchases and stock market investments are pretty well the same. Getting a house with a mortgage is exactly the same as borrowing money to buy a stock on margin and then repaying that loan over time. The timeline is different and people tend to sells their stocks faster, but the leveraged practice is still there.
House appreciation used to be a sure bet, but it isn’t any more. And you could to be able to refi if your income changed.
The risk/reward balance is different now. Learning how to mitigate the risk and get high rewards is every wanna-be-millionaire’s goal (well mine).
“The risk/reward balance is different now.”
@ Neil – Do you mean NOW = TODAY or PERMANENTLY?
If NOW = TODAY, isn’t this a GOOD time to buy?
If NOW = PERMANENTLY, shouldn’t we be loading up on baked beans and heading for the hills?
Forever man! Run for the hills!
… or at least until we reach some level of equilibrium again (whatever that level is). Stocks are faster responding and tend to balance out sooner than the housing market.
I think it is a good time to buy in some areas, but you really need to run the numbers and get the right deal. In my local region, cash flowing rentals are still a challenge and there seem to be a gut of commercial properties out there.
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I loved Saif’s comment, which I think really gets to the heart of the matter. 8% returns in the stock market vs 6% return by paying down mortgage would seem to suggest that the returns are the same, but they aren’t. The stock market continues to compound on itself. Once a house is paid off, there’s no investment base to build off of. On the other hand, stocks now have a large basis to continue to grow at 8+%.
@ Chris – I, of course, agree. But, to give the ‘other side’ (pro-paying down their mortgage) its due, the assumption is that they will THEN use the no-longer-required debt/principle repayments to START investing.
The real issue is that paying down your mortgage is de-leveraging (is that even a word?), when you should be doing the exact opposite!
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