I don’t know a lot of people in my personal life (outside of blogging) who are in a financially sound position. Most are spending, spending, spending. And that’s fine. There must be people that spend money in order for business to make profits so they can return those profits to me as an investor.
Anyway, like I said, I don’t meet a lot of people that are making the kind of good decisions that we as financial independence people tend to make.
But a while ago, I spoke to a colleague, who said he and his wife are trying to pay off their mortgage in 10 years. Quite impressive! Both are in their mid 30’s, so they’ll be mortgage free by 45. Not bad, not bad. But they both make quite good money, and maybe they can do better by investing the money?
This post is a case study in how my colleague lost 400,000 euros with this great financial decision. Really, it’s a good decision that will put him ahead of 95% of the population. Still, it will cost him nearly half a million!
My Colleague’s Mortgage
Because of our conversation about his mortgage I told him a little bit about my own path to freedom, how I save a lot and invest. That didn’t quite ring a bell with him. He does understand that saving is the way to go, but paying off his 2% mortgage is his priority. His reasoning: “There is no place you can get a 2% return anyways.”
Well, that’s not true, but if you don’t believe in investing, then it’s probably better that I don’t push too much. And after all, paying off your mortgage in 10 years is incredibly more beneficial than just blowing it all on cars, vacations, and dinners.
My colleague and his wife sold both their apartments when they married, and bought a single family home together. They paid around 300k for it, financed 275k. Of course, interest rates are super low, so they’re paying only 2% in gross interest. Factoring in tax deductions that’s about 1.5% net after tax.
The standard mortgage payment is about 950 euros per month, going with 1.5% interest and a 30 year amortisation. Because they’re trying to pay off the mortgage in ten years, they have to pay around 2,470 euros per month. This is an extra 1,520 euros per month.
In practice, this is not what they’re doing. My colleague is paying his mortgage on the regular payment plan, and then once every so often he sends a large payment to the bank, reducing the principal balance. This creates a negative effect, due to the time value of money. The sooner you pay, the less interest you pay. However, since the differences at these interest rates are so small, we’ll continue the case study as if they are paying extra on a monthly basis.
Let’s think a bit further. What if my colleague and his wife would invest their additional 1,520 euros per month, instead of paying off their mortgage? This is an uncertainty, since future investment returns are not guaranteed. However, over the course of 30 years or more the chance is very high that your investments will yield a positive return.
Let’s go with a 7% expected return. Some people say the stock market returns 9% on average, which is 7% after inflation, but we’ll just go with the more conservative 7% before inflation. I will not subtract inflation from this number, since we also do not subtract it from the mortgage interest rate. All the analyses here are before inflation.
If my colleague would have invested his money in the broad, world wide stock market using cheap ETFs or index funds, he could create a fortune. Not only has he then paid of his house after 30 years, but he’s also sitting on a load of money in his investment account. A quick compounding calculation with 18,240 per year, 7% interest, and 30 years, gives us slightly over 1.5 million in his investment accounts. That is after the Dutch wealth tax has been deducted every year! Without the wealth tax it would have been more than 1.8 million!
Comparing the Mortgage vs. Investing
In the two charts below you can see the differences between paying off their mortgage in ten years and paying it in 30 years and investing the difference. I used 1.50% net mortgage interest (after tax deductions) and an expected 7% rate of return on a broadly diversified index fund. I did not take into account inflation.
The first chart shows what happens when you pay off your mortgage, the second chart is the scenario where my colleague would invest aggressively and pay off his mortgage on the standard 30 year plan.
The conclusions is easy. Because the mortgage rate is so low, it pays more to just put all your additional money in the stock market, knowing that over a 30 year term there is a good likelihood that you will return somewhere in the 7% range.
The differences are enormous. This is a direct result of compounding interests over a 30 year term. Looking at the chart below, you’ll see the impact of the difference in mortgage interest and investment returns, compounded over 30 years.
In the beginning the gap isn’t that wide, but as the investor is generating returns well over what his mortgage rate is, he’s winning. You see a small hike in the blue line, that’s year 10 when the mortgage is paid off and all of the extra money of this person can go into investments. However, that extra capital that is now flowing into the investments is not enough to overtake the investor’s 10 years of investment returns working for him.
There is another thing at play here, uncertainty. Someone who’s paying off his house in ten years is not doing that to generate large returns, but to be exposed to less risk. That means that it is all but certain that my colleague will start investing after he has paid off the mortgage. If he doesn’t, the difference in net worth after 30 years will be even more.
Of course, there are also reasons to not invest everything but pay off your loans. It gives you more stability and potentially better peace of mind when you don’t have to worry about debt anymore. Your level of risk tolerance is important here. If you can handle a lot of risk, invest, if not, also pay off some loans.
For me personally I will not pay off my current mortgage, since I’m young and want to focus on growing my net worth. Also, my mortgage is super cheap at 1.40% before tax deductions. When I’m older, and closing in on early retirement, I might start paying off this loan. The you stop working it is probably worth to optimise for cash flow instead of growing your net worth.