Thursday, May 11, 2017

Should You Invest or Pay Down Your Mortgage?

“It is better to be vaguely right than exactly wrong.” ― Carveth Read.
In a good example of how you should be careful where you go for financial advice on the internet, the blog Money After Graduation attempted to tackle a reader question about whether to save money or pay down a mortgage. The analysis and conclusion are not useful.

Ordinarily I applaud those who pull out their math skills to answer questions, but in this case, crucial factors were missed. The article simplified the reader’s question by assuming that TFSA investments would provide a tax-free return of exactly 5% each year, that the mortgage interest rate would stay less than 3%, and that nothing bad would happen in the reader’s life.

With these assumptions, there is no need for the article’s detailed calculations. We can see that 5% is more than 3%, so investing will beat paying down the mortgage. No need for any further analysis, unless there are problems with the assumptions, like the possibility of stock market crashes, poor health, and lost jobs.

I would hope that most people already know that investing in stocks and bonds is likely to give higher returns than a mortgage interest rate. The other factors to consider have to do with risk. Mortgage debt is a form of leverage. There are limits to how much leverage it makes sense to take on.

If there were no uncertainty in life, we could all get rich borrowing as much as possible at a modest interest rate and earning a higher return in the stock market. Market returns would cover the interest on the debt and more. But the stock market is volatile, and people get sick and lose their jobs.

If you have too much leverage, losing your job during a stock market crash could ultimately lead to losing your house too. This may sound unlikely, but losing your home would be so devastating that it’s a more important consideration than whether investments usually earn higher returns than mortgage interest rates.

The exact amount of leverage that makes sense for you depends on several factors including your age, health, income, job security, and how easily you could find another job. Unfortunately, people often overestimate their job security. One reason seems to be that the thought of losing our jobs is so scary that the only way to get through the day is to believe that our jobs are secure.

Most people understand these things to some degree. Big debts make people nervous, and they feel better when they can pay down their debts. We may not be able to figure out our optimum leverage level, but we often recognize too much leverage when we see it.

Not to pile on, but the Mortgage After Graduation article also contains the following quote: “Even at 1%, cash in the bank is better for your net worth than mortgage pre-payments simply because cash will earn a compounding return and mortgage pre-payments won’t.” This is wrong. Pre-payments on your mortgage have a compounding effect on your net worth. Cash earning 1% interest will not outperform a mortgage pre-payment. Of course, this doesn’t mean we shouldn’t hold some cash. The purpose of holding cash is to prepare for an emergency or other cash needs that arise, not to act as a better investment than paying down your mortgage.

Getting back to the question of what to do with some savings, I see 4 main possibilities: invest, add to an emergency fund, pay down the mortgage, or pay down some other debt. Which one is correct depends on the details of the person’s financial life. The general order is to eliminate high interest debt, build an emergency fund, pay down the mortgage until you get to a sensible level of leverage, and finally invest. Deciding what to do can be difficult, but thinking in this way offers a chance to be vaguely right instead of exactly wrong.

7 comments:

  1. And to make it more complicated, if you are worried about job security, you can't pay the mortgage down too aggressively, as you still need liquid savings/investments to pay the monthly mortgage payments if you do lose your job.

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    1. @Potato: That's why I put building an emergency fund ahead of paying down the mortgage.

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  2. "Unfortunately, people often overestimate their job security. One reason seems to be that the thought of losing our jobs is so scary that the only way to get through the day is to believe that our jobs are secure."

    Ouch .. truth hurts.

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    1. @aB: While at work I often like to joke that I come into work every day knowing that this day could be the last based on management whims. I usually get stunned looks in response.

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  3. Not to pile on, but the Mortgage After Graduation article also contains the following quote: “Even at 1%, cash in the bank is better for your net worth than mortgage pre-payments simply because cash will earn a compounding return and mortgage pre-payments won’t.” This is wrong. Pre-payments on your mortgage have a compounding effect on your net worth.

    Yes. The other things she gets wrong are a matter of opinion but this one is a fact.

    In general, the referenced post demonstrates that lots of numbers nice style and pretty pictures don't equate accuracy or common sense.

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    1. @BHCh: In general, I find that younger people tend to do analyses that assume life will continue without variation. Older people make this mistake too, but they seem more likely to factor in the possibility of calamity. Perhaps this is because older people have experienced or watched others experience more calamity.

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    2. Agreed. I like the initiative and she is obviously making a different type of person think and plan, which has to be good. Still, it makes me smile when she is selling a course for "experienced investors". She couldn't have been an investor during the last 2 crashes, so it's like eggs teaching a chicken.

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