If you have a mortgage it is probably the biggest debt you will ever have. In the hundreds of thousands of dollars. The amount of money you owe may even scare you. So like me, you are probably paying it off as fast as you can. And it seems logical.
Is it better to pay off the Mortgage as fast as you can?
Is this the most efficient use of your money?
The debate keeps coming up. I get comments and emails suggesting I re-evaluate my approach. Whether I should direct more to investments instead of paying down the mortgage. And they are right, it might be more beneficial to invest more instead. And I will show you some calculations towards the end to prove it.
Paying off the mortgage to me is a guaranteed return. A return on saving the extra cost of the interest accrued on the debt. This means that mortgage interest rates are key.
A 1% difference in mortgage rates from 4 to 5% on $200K over 20 years will cost you an extra $26,000 in interest.
The rate at which you are paying off your mortgage can also save you thousands. A 200k 4% 20-year mortgage will cost you $279 p.w. to service. If you increase this to $300 p.w. you will save $9,360 in interest.
That’s only $21 per week increase in payments- saving you $9,360 in interest.
And you will pay off the mortgage 2 years sooner.
It’s more than Just returns
There is great satisfaction from watching your mortgage balance reduce over time. And ultimately being free from the shackles of the bank.
And once you have paid off the mortgage you can invest the equivalent mortgage payment.
Paying the mortgage off faster is also a way of paying yourself first. You opted into paying the extra, and now the bank will hold you accountable. You have to make those payments. Definitely extra motivation to keep the payments up to date.
To pay off the mortgage faster, or to invest instead
In retirement, cash flow is key. So you might have a house that’s paid off- and that is awesome! Well done! But, you also need cash to survive. You can’t get cash from the house you live in. If like me, you want to retire early you need to build a passive income alongside paying off your house.
On the flip side, once you have paid your house off you can live rent-free. Rent or Mortgage payments are one of the largest expenses, followed by groceries. So when you have paid these off, you need less cash to get by.
But if you focus solely on paying the mortgage will it slow down the growth of your passive income stream? This question is what I will answer for you below.
The Truth, Investing vs. Paying the Mortgage
To truly answer the question “should you pay off your mortgage faster or invest instead” I decided to do some calculations.
- Use the current balance on my mortgage, which is currently fixed at 4.2%
- Assume a return on investment of 7.8% taxed at PIE rate of 28%
- Keep my payments constant at $1000 per week
The assumption that my mortgage will remain fixed at this rate is a bit hairy- Mortgage rates always change over time. But for the last 6 year, I have had a rate below 5%. And on the flip side, the assumption of a return on investment of 7.8% can also change.
The return of 7.8% comes from the average return for the NZX-50 for the last 69 years. Sure you could find better or worse returns. But I will use this average figure.
My payments to my mortgage and investment will most likely increase over time, as my income will hopefully increase over time.
So there are a few assumptions associated with these calculations, but no-one can predict the future.
By directing some of my mortgage payments to an investment instead, the length of the mortgage term will increase. The maximum term on Mortgages in NZ is 30 years- so I will work to that. This means that there is a maximum amount that you can divert to investing, in my situation the maximum is 56.7% to investing.
We will run three scenarios. The different scenarios will be different ratios of payment made towards investing and payments made to the mortgage. Once the mortgage has been paid, the entire $1000 weekly payment will be directed to investing.
Here are the scenarios
- Scenario one- diverting 0% to investing
- Scenario two- diverting 20% to investing
- Scenario three- diverting 40% to investing
- Scenario four- diverting the maximum to investing (56.7%)
|Scenario||% Diverted to Investing||Term of Mortgage||Interest Charged on Mortgage||Value of Total Investment after 30 Years|
|1||0 %||8.9 Years||$74,140||$2.69 Million|
|2||20 %||11.7 Years||$101,064||$2.81 Million|
|3||40%||17.3 Years||$155,221||$3.02 Million|
|4||57 %||30.0 Years||$289,004||$3.35 Million|
Below is a graph of the total equity in investment over 30 years for each scenario.
By paying off the mortgage as fast as I can I do stand to lose out on an extra $660,000!
There are many assumptions made to get to that number. And nobody can predict the future. The calculations do point to paying off the mortgage as not being the most efficient use of my money.
In the future, I think I will be directing more to investments rather than the mortgage. I can’t start now as I have just locked in at 2 year fixed rate with a fixed payment. When it comes to renewing this, if the interest rate environment is still low, it will definitely be more efficient for me to direct more money to invest.
Ultimately, you need to make a decision that you are comfortable with. This entails both maximise the returns on your investments and being able to sleep at night. I am comfortable with paying extra on the mortgage. I think it is more psychologically beneficial for me to pay down that large amount of debt.
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