Should you invest or pay off your mortgage?

In response to two articles I wrote on housing I received lots of queries on the wisdom of paying down a mortgage. Specifically, if it makes more sense to invest in the share market or make additional mortgage payments. This was a topic we covered in a recent podcast but there is an opportunity to expand on the topic. Unsurprisingly it is not cut and dry.

First some background on mortgages. A mortgage is an amortising loan. That means that each mortgage payment has a portion that goes to pay interest to the bank for loaning the money and a portion that goes to principal which pays back the outstanding balance on the loan.

Over the life of the loan the amount of each payment that goes to interest and principal changes. At the start of the mortgage term most goes to interest. At the end of the mortgage most goes to principal. In a 30-year mortgage it takes around 19 years for more than half of a payment to be directed towards principal. The proportions that go to principal and interest matter. Interest is just a cost for borrowing the money. Principal increases the amount of the house owned by borrower.

Making additional payments on a mortgage has the effect of accelerating the path along the amortisation schedule. Extra payments go to principal which shortens the length of the mortgage and ultimately reduces the amount of interest paid.

There is an undeniable benefit from additional mortgage payments. But there is an opportunity cost for that money. You could spend it in the pokie room at the local pub. Or you could invest it. You can assess your gambling prowess and I will stick to the investing side.

The wealth created by making additional mortgage payments

A baseline is required prior to evaluating the different choices available for homeowners. I’ve run a baseline scenario with current conditions and historical housing price appreciation.

I’ve ignored all other expenses associated with a house like stamp duty and maintenance and upkeep costs. These won’t change if pre-payments are made on a mortgage. The purpose of this article is to explore the impact of additional principal payments on a mortgage and not to figure out the return on a house. I’ve already done that in this article.

Below are the baseline inputs I'm using for this article. 

We can calculate a return on the house but taking a total wealth approach is an easier way to compare the impact of paying off a mortgage vs. investing. And that is what I’ve done using the inputs in the previous table.

After 11 years the house is now worth $2,104,851. Over that time period $628,328 of mortgage payments have been made. Of those payments $146,857 went to principal and $428,471 went to interest. Selling the home and paying off the remainder of the loan leaves the homeowner with $1,451,709.

Now that we have our baseline scenario we can explore the impact of making additional mortgage payments. I have assumed extra payments of $1,000 a month. Over 11 years a total of $132,000 of additional payments have been made. All of this goes to principal which saves interest costs and accelerates the amortisation schedule. That means that more of the regular monthly mortgage payments will go to principal.

Upon sale of the house total mortgage payments of $759,328 have been made. Of the total $331,258 have gone to principal and $428,070 to interest. The extra payments have resulted in a savings on interest of $53,401. After the remaining loan balance has been repaid this leaves the homeowner with $1,636,110. That is an increase in wealth of $184,401.

The impact of investing instead of paying off the mortgage

The question is if investing the $132,000 in extra payments would result in a higher level of total wealth. To make investing worthwhile requires a return of approximately 6% on $1,000 a month of investments. You will notice that the return needed is the same as the interest rate on the mortgage. And this makes sense as that represents the interest payments you are saving. The interest rate is the hurdle rate.

On first glance it seems reasonable that exceeding a 6% return is achievable. We can use ETFs as a proxy for the return that an investor would receive. The Vanguard Australian Shares ETF (ASX: VAS) has returned 8.45% a year over the last decade investing in the ASX 300. The iShares S&P 500 ETF (ASX: IVV) returned 16.30% a year over the same time period.

In the investment world we talk a lot about returns. But in the real world what matters is what you get to keep after taxes.

The impact of taxes on total wealth

Purchasing and selling a primary residence is exempt from capital gains taxes. However, we do need to consider taxes when investing the extra cash. Taxes are difficult to model because they are highly personal and vary widely based on different scenarios. I’ve made some assumptions but everyone should consider their own tax circumstances.

If you put the $1000 a month into VAS you would have a total of $212,413 after 11 years. Investing in IVV would give you $336,785. Prior to taxes both totals are higher than the wealth created by directing the extra money to paying off the mortgage.

Those returns come from capital gains and dividends. And long-term capital gains are discounted by 50%. I am going to apply a 25% discount to the total gains which provides the benefit from holding the ETF for more than a year but also accounts for the fact that there is no discount for dividends.

At a 32.5% marginal tax rate that reduces our gain on VAS to $192,813 and IVV to $286,869. At the top marginal tax rate of 45% the investment in VAS leads to a total of $185,274 and IVV to $267,671.

Even with taxes at the highest marginal tax all the scenarios exceed the wealth creation from paying off the mortgage. But barely. Franking credits on the investment in VAS adds a cushion but in the real world we also have to pay transaction costs which may be quite high if monthly investments are made.

What the future may look like

Looking at past scenarios is informative. But what matters is the future. When considering the future we need to evaluate the hurdle rate or the amount of return needed to exceed the benefit from paying off the mortgage. The hurdle rate will vary based on the marginal tax rate paid by each homeowner. The following chart shows the return needed to exceed the benefit of making additional mortgage payments.

These are high hurdle rates to overcome. Morningstar Investment Management projects future returns for 8 major asset classes. None of them exceed the 45% marginal tax bracket hurdle rates with Aussie equity returns project at 7.90% annual returns over the next 20 years.

What if the investments are made in super

The other option is directing the extra savings into super. If the contribution is non-concessional the homeowner would still pay the marginal tax rate on the income earned but would benefit from a 15% rate on capital gains and dividends with the same discount applied to long-term capital gains. This lowers the hurdle rate for investment returns. 

If concessional contributions are made to super there is the added benefit of lowering the tax on wages to 15% from the marginal tax rate. The same pre-tax earnings allow higher contributions to super. The pre-tax income needed to generate $1000 a month can support a $1,545 monthly concessional contribution to super at a 45% marginal tax rate. The following chart shows the hurdle rate of concessional contributions.

The return hurdle rates are meaningfully lower. In the case of the 45% marginal tax bracket the savings from a concessional contribution are so large that a negative return of .66% per year will match the wealth created by the additional mortgage payments. Given historic returns this scenario strongly supports investing the money. According to Katana Asset management the Aussie market has never had a rolling 8-year period of negative returns between 1875 and 2016.

There are several considerations beyond potential returns that should be taken into account when making a decision on what to do with extra cash. An offset account provides the benefit of saving on interest while also retraining access to cash in case of an emergency. Any interest earned on the offset account should be added to the hurdle rate.

Investing is an opportunity to diversify when so many Australians have the vast majority of their wealth tied to a primary residence. As always, the personal circumstances of each person should be the primary driver of any financial decision.

The upcoming second part of this article will explore different scenarios. If it matters where in the life of the loan the pre-payments are occurring and what happens when interest rates change. I would love to hear your thoughts at [email protected]

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