It’s time to check in with an old friend. The debate between paying off your mortgage or investing.
I’ve written about this before, about a year ago. So why am I writing this post?
Well, because some of the numbers have now changed. The trade-off looks different than it did before, and I’ve been thinking about this recently.
On top of the mortgage vs investing debate, we’ll also consider ridiculously cheap mortgage rates, renting vs owning, and 6 mortgage strategies for optimising cashflow in retirement.
Lots to cover, so let’s get started!
The Current Environment
In my view, recent developments have changed things. Here’s why.
Because of the economic fallout from the coronavirus, the Reserve Bank (RBA) cut interest rates effectively to zero. Given the sluggish economy, rates were almost at zero anyway.
On top of that, the RBA is providing very low-cost funding to banks (for 3 years) and targeting bond yields to keep the cost of debt down and encourage the flow of credit.
So in the last few weeks, many banks have come out with unbelievably cheap mortgage rates. Funnily enough, many of these loans are fixed rates for 1-3 years.
Here are some examples of the latest mortgage offerings from Aussie banks and lenders…
AMP – 2.39% fixed for 2 years.
Bankwest – 2.33% fixed for 3 years.
Macquarie – 2.39% fixed for 1-3 years.
ANZ – 2.19% fixed for 2 years.
Virgin Money – 2.29% fixed for 2 years.
Commonwealth – 2.29% fixed for 1-3 years.
Ubank – 2.29% fixed for 3 years.
HSBC – 2.25% fixed for 1-3 years.
I’m sure there are many more, these are just a few that I’ve come across.
Note: some rates are only for existing customers, while others are only for new loans. It varies between lenders, so best to check around. Fees apply in some cases.
The point is, however you slice it, these interest rates are incredible!
Buying vs Renting
How does this change my thoughts on home ownership?
Well, with mortgage rates in the low 2s, buying a house looks much better than before!
Even adding 1% per year ownership costs (council, water rates, insurance, maintenance), plus allowing for buying/selling every 10 years, this brings the annual cost to around 4%, roughly in line with rental yields in most cities.
So for those who have the desire, and are in the position to, buying a home at current rates seems like a great deal.
The outcome is you’ll have a similar level of monthly cashflow as if you were renting, yet you have the security/stability of ownership.
That doesn’t mean everyone should buy. It’s still a matter of preference and everyone’s situation is different.
But depending on your location, renting may no longer allow a higher savings rate compared to owning.
As an aside, these mortgage rates have some real potential to help get things going again on the other side of this economic shutdown.
Stimulating home-buying and building usually has huge flow-on effects for the economy, so the RBA may keep this funding option open for the banks if required.
Paying Off the Mortgage vs Investing
Because of the change in mortgage rates, this equation has also changed.
Just as before, any chunk of money used to pay down debt has a return equal to the interest rate. It saves you from paying interest on that chunk of debt.
At the moment, that return might be in the region of 2-3%. Whereas, investing in shares could give us a long term return of around 7%.
That’s a pretty decent margin – larger than before when mortgage rates were 4%. The upside of paying off debt is, the return is tax-free. Not only that, but it’s guaranteed.
On the other hand, the upside of investing is, a potentially much stronger long-term return.
Remember, only a small portion of the shares return is taxable. The gains aren’t taxable until sale, and only a modest amount of tax on dividends is payable, thanks to franking credits on Aussie shares and lower dividends on global shares.
Some say that ultra-low mortgage rates mean you should take advantage by paying off your house and getting rid of your debt.
Others see it as the best time to NOT pay off your house, and instead, invest elsewhere for higher returns.
But whatever you felt when rates were 4% is probably still how you feel about the trade-off now. Or maybe not… maybe your view has changed?
Get A Better Rate, For F*$# Sake!
I’ve said this numerous times. One of the best things any of us can do is nail down the best possible rate on any debt we have.
Even if you have zero borrowing power and no ability to switch lenders (that’s us), your bank doesn’t know that! So get on the phone, tell them what rates are on offer elsewhere and kindly ask them what they can do for you.
We’ve done this recently and have managed to get some great discounts despite being in no position to refinance to another lender.
In fact, we’re in the process of breaking a couple of fixed rate loans right now with much higher rates. We’re being charged an arm-and-a-leg in break fees. But that’s okay, because we’re immediately re-fixing at much lower interest rates.
In many cases, paying break fees to get out of your current fixed rate loan could still be worth it. For example, we’re paying $12k in costs to save $14k of interest over the next 12 months.
In principle, it’s obscene to pay so much in fees. But in practice, that’s actually a solid return.
On another loan, we simply took a few minutes to ask for their best rate, and 0.10% discount was applied to our loan with no changes required.
I know, that doesn’t sound like much. But on $450k of debt, that’s $450 per year for 10 minutes work!
Even if your variable rate is relatively attractive at 3% right now, and your loan balance is $400k. Getting one of these fixed rates at 2.3% will still save you a massive $2,800 interest per year.
So make this your one and only job for the next week. Most of us now have more free time to chase down deals like this. And chances are, you’ll be well compensated for your time!
The All-or-Nothing Approach
Back to the main question of paying off your mortgage or investing…
Both are good options, so there is a natural urge to do a bit of each. But I’m not really a fan of that approach.
As mentioned in my last article, paying off half your house and investing half as much can work against you when it comes to retiring early.
You have extra equity in your house, yes. But in most cases, your mortgage payments are still just as much as before.
So I think to enter retirement with an optimised level of cashflow, an all-or-nothing approach makes sense.
In simple terms, this means maximising investments or eliminating the mortgage. Both are possible though, as you’ll see below. Anyway, here are 6 approaches that I can think of for achieving this.
6 Mortgage Strategies for Optimising Cashflow in Retirement
Option 1. Pay off your mortgage ASAP. Focus every dollar towards your mortgage, then start building your investments. As an example, maybe you spend 5-7 years smashing the mortgage, then 5-7 years building your share portfolio.
Option 2. Pay off your mortgage a bit quicker than normal, but invest regularly too. Earlier, I said I don’t like this half-half approach. BUT, if you time it so your mortgage is gone when you’re ready to retire, then that’s a big thumbs up. Use an extra repayments calculator to work this out with your own timeframe.
Option 3. Pay the bare minimum on your mortgage and direct every spare dollar towards investing. Retire early with a mortgage which will continue to be paid off slowly over 30 years.
Option 4. Same as above – bare minimum repayments, invest as much as possible. Then, as you leave work, sell some investments to pay off the mortgage.
This way you benefit from your money working harder during your FI journey and then move into retirement debt-free.
Option 5. Pay interest-only on your mortgage, and put savings into a linked offset account, while also investing.
This means less cash invested than the above options, but putting savings into the offset account will reduce future repayments, thereby improving your cashflow. This option means you’ll need to refinance every 5 years to a new interest-only term.
After leaving work, this probably won’t be feasible, at which point you’ll need to start paying principal & interest, or pay the loan off completely with your offset account/investments. (Thanks to reader ‘Hugo’ for reminding me of this strategy!)
Now it’s time for the sixth option, which almost feels like a magic trick!
Option 6 – The Magic Mortgage Solution for Maximum Cashflow
The idea here is, you make bare minimum repayments – whether interest-only or P&I, plus you refinance to a longer loan term every couple of years to minimise repayments and maximise cashflow.
Then, do this one final time just before leaving work. Here’s why…
Take a 30 year loan of $400,000 at 3% interest rate. Your repayments are $1,686 per month, or $20,232 per year. (By the way, for this example I’m using this loan calculator).
Say you’ve been making regular repayments while building your investments. Now, after 10 years of hardcore saving, you’re ready to leave work. Your loan balance is now around $300,000.
Your repayments are still $1,686 per month assuming the same interest rate, and your loan will have 20 years to go. But let’s say you refinance to a fresh 30 year loan.
Now, your repayments on the remaining $300,000 loan will be $1,265 per month, or $15,180 per year.
You just lowered your housing costs by a whopping $5,000 per year! Your house is still being paid off over time, but now your cashflow is much improved as you move into early retirement.
To be clear, this is the same as having an extra $125,000 of investments paying you 4% per year.
You haven’t bought anything, sold anything, nor is there any tax to pay or anything complex to manage. All you’ve done is stretched out your loan.
Not only do the above strategies maximise your cashflow, but it also gives you more flexibility. Just because you set up your loan to have the smallest repayment possible, doesn’t mean you can’t decide to pay extra or pay it off much sooner than planned.
As you can see, there is no shortage of options. So it’s really about choosing which one suits you best.
Higher income earners might opt to pay off their house sooner. Mortgage interest savings are tax-free, yet their investments are likely to be taxed at a high rate.
Lower income earners may lean more towards investing, as the higher potential returns may be more valuable to them and investments won’t be taxed much (they may even receive tax refunds due to franking credits).
Of course, it’s also nice that mortgage savings are guaranteed. In recent months, it’s become abundantly clear to many new investors that market gains are far from certain!
What the market giveth, the market can taketh away lol.
What Would I Do?
Just as before, I lean towards investing rather than paying down debt. I’d also refinance to a super-low rate and a longer loan term if possible.
If I was just starting out, I’d probably buy a place at current ultra-low interest rates. But only if it was clear we’d like to stay there for ten years. The costs of buying and selling are just too high otherwise.
Considering the above options, the goal would be to minimise repayments to create more available cash for investing, while retaining the benefits of home ownership. We’d also consider debt recycling, of course.
It doesn’t matter how you choose to approach the mortgage vs investing trade-off. But right now is an incredible time to re-examine your housing costs, nail down a crazy cheap interest rate, and maximise your cashflow.
And if you’re heading towards the end of your FI journey, make sure you don’t get stuck in no-man’s-land with a half-paid off house.
Either pay it off by the time you retire, or refinance and make those repayments as low as possible. Both methods go a long way to optimising your cashflow and flexibility for early retirement.
What do you think about renting vs buying in the current interest rate environment? And does this change your view on paying down debt vs investing? Share your thoughts in the comments below…