What Comes First — Your Mortgage (the Chicken) or Investing (the Egg)?

Some detailed guidance on this common and perplexing question.

At some stage in their financial journey, all homeowners who still have a mortgage will face the question: Should we increase our mortgage repayments or use the extra funds to invest?

This is a difficult question to answer as the answer is “It depends” at many levels. The good news is that you will win either way. You’ll either get rid of that mortgage quicker and then start to invest, or the mortgage goes full term, and you start investing earlier.

But the outcomes can vary significantly.

This article provides some valuable guidelines for those facing this dilemma. We also address the choices of those who have not taken the plunge into a mortgage and are assessing their options.

Let’s deal with the chicken option first.

A simple example may help.

If you have a typical $450,000 fixed interest mortgage at 5% over 30 years, the total interest you pay will be approximately $420,000.

Now, if we assume that after 5 years, you have an extra $500 per month to pay off the mortgage. This will pay the mortgage off 7 years early and save $148,000 in interest.

For the remaining 7 years, you invest the total monthly payments in an S&P500 index fund at 10%. At the end of the 7 years (the original termination date of the mortgage), you could expect to have an investment fund totaling approximately $337,000 after paying tax on the earnings.

As you can see, paying your spare cash into your mortgage as extra payments has the following results -

1. The loan term is significantly reduced, particularly during times of low-interest rates.
2. You will save mortgage interest because of the shortened loan term. The amount saved will depend on the reduction in the term and the prevailing interest rate.
3. At the end of the 30-year mortgage term, you will own your home and have a good investment fund.
4. You will have peace of mind knowing that your home is all yours after 23 years.

Now we’ll consider the (nest) egg option.

We’ll vary the simple example above.

You have the same $450,000 fixed interest mortgage at 5% over 30 years. You will not make any extra payments, so the total interest you pay will be approximately $420,000.

Again, we assume that after 5 years, you have an extra $500 per month, and you invest the $500 in an S&P500 index fund every month at 10%.

At the end of the 30-year mortgage term, you could expect to have an investment fund totaling approximately $475,000 after paying tax on the earnings.

Using the available cash to invest has the following results -

1. The mortgage will proceed as initially planned.
2. You will own your home at the end of the 30-year mortgage term and have a more significant investment fund.
3. You will have peace of mind knowing that your home is all yours after 30 years.

So, what’s the answer?

As you can see, the answer will depend on your preferences. Whether the additional size of the investment fund is enough to offset having peace of mind earlier is a question only you can answer.

You’d also need to have confidence in the long-term performance of the S&P500, as that will affect your view of the investment fund differential.

Of course, my example is simplistic as incorporating all life’s vagaries is difficult. In real life, you would expect that the $500 excess would be able to increase over time. Maybe you need to move, so the original mortgage is paid out, and you start another (probably larger) mortgage.

Whatever the changes, the basic outcomes I have explained above will hold. It is a decision about early repayment of the mortgage Vs a larger investment at the end.

I can’t be more specific than that.

And what if you don’t have a mortgage now?

I did promise to address that situation (and thanks for being so patient while I got to it!)

To be totally consistent, I have to say the answer for you is also “It depends”.

In this situation, the comparison calculates the cash flow required to buy and own your home and the cash flow needed as a renter of a similar property.

In the homeowner calculation, you need to include repayments and the costs of maintaining the property, factoring in painting and replacing floor coverings, etc., which a renter can ignore. Depending on the property being considered, these can be large.

Usually, the rental option requires less cash flow than the homeowner option, and the difference is the amount the renter has to invest.

As we did above, you need to calculate the future value of an investment in an S&P500 index fund for 30 years at 10% if you add that amount per month.

If the final amount is greater than the expected value of the home in 30 years, staying as a renter is the best option.

But . . .

The renter also needs to consider the possible lack of stability or continuity of being a renter. Moving when a landlord decides to sell or wants to rent to another tenant will be disruptive for your family. Also, relying on a landlord to keep the property well-maintained can be frustrating.

The investment fund needs to be significantly larger than the expected home value in 30 years to compensate for those considerations.

Anecdotally, many astute finance gurus have deliberately remained as renter/investors maintaining that homeownership provides an inferior return on investment.

So, what should you do?

Whichever situation you are in, calculating the relative benefits of each option available to you is the obvious starting point. Knowing the value of each option will provide you with the information to assess whether enduring the downsides is worthwhile.

If you are not sufficiently confident to complete the calculations yourself, ask a financial advisor, but a word of warning — if the answer isn’t “It depends”, there may be some bias in the thought process.