Pay Down Mortgage Debt or Invest?
The other day I was listening to the latest podcast from the guys over at FIRE and Chill, and it was about “Should you Pay Down Debt or Invest?” – this seems to be a question that is asked a lot within the FIRE community. And the podcast listed a number of strategies that could be implemented.
This was particularly noteworthy for me because I am about 7 years away from reaching my FI, and I do not own a PPOR currently, but am planning on buying one at the end of 2021/start of 2022, where I intend for it to be my IP until I reach my FI and move in (it will not be close enough to where I work for me to be able to live in it until I reach FI).
After listening to their podcast, it gave me some inspiration to play around with the numbers and I thought I might share them so others can visualise the financial repercussions of such a decision.
Firstly, I must point out that for my own personal reasons I do not want to have any debt when I reach FI. I understand some people have no issue with making mortgage repayments once they do reach FI, but for me, personally, I want to have my PPOR completely paid off, so that does eliminate some of the available strategies they did list.
I decided to compare the following options:
Option 1: Pay off mortgage ASAP (calculate repayments for a 7-year repayment period)
Option 2: Pay minimum repayments on a P+I 30 Year Loan. After 7 years sell assets to pay off loan
Option 3: Pay minimum repayments on IO Loan. After 7 years sell assets to pay off loan
I also used the following variables:
Initial Home Loan Amount: $400,000
Interest Rate: 3.00% per annum
Net Rent Received: $300 per week (after all expenses are considered)
Capital Gains Tax Rate: 30.00% (used to calculate tax paid at the end of 7-year period)
Share Investment Return: 7.00% per annum
Option 1 was my base scenario for these calculations, and the total repayment was $5,285.32 per month (to pay down the loan over the 7-year period). This would leave $3,985.32 out of pocket after taking into consideration the $1,300 per month rent received.
Option 2 will have Monthly Repayments of $1,686.42 – so this will allow $3,598.90 to be invested each month instead of being used to pay down the loan as per Option 1.
Option 3 will have Interest Only Repayments of $1,000 per month – this will allow $4,285.32 to be invested each month instead of being used to pay down the loan as per Option 1.
Results
Option 1 – So at the end of this scenario, the value was $0.00 (this is the base scenario)
Option 2 – After 7 years, the principal remaining was $335,928.60, with the portfolio valued at $390,945.24. After taking into account CGT of $22,849.09, you will be left with $32,167.55.
Option 3 – After 7 years, the principal remaining will be $400,000 (obviously) with the portfolio valued at $465,509.92. After taking into account CGT of $27,207.08, you will be left with $38,302.84.
Changing Variables
I was then curious at what Interest Rate does it become a better alternative to pay down the debt instead of investing and the breakeven point appears to be around 5.40% per annum mark. I am confident that interest rates will not rise that high within the next 7 years so I imagine that Option 2/3 will be a better alternative compared to Option 1, at least from a financial perspective.
There is also volatility within the share market obviously, but I believe a 7-year period is long enough to be able to assume an average return of 7.00% per annum. But if Interest Rates remain at 3.00%, then the breakeven return is around 4.00% per annum over the next 7-year period. I believe, although it is a possibility, it would be unlikely to have such a poor return over that period.
Disclaimer
Also, I did not mention any tax benefits associated with paying more tax-deductible interest on the IP loan for the 7-year period.
Finally, I do understand that it is not a completely financial decision, and that if you were risk averse then you may have other reasons for choosing to pay down your debt. That is perfectly understandable and if that is your decision then go for it. I just think it is useful to at least have an idea of the financial implication of decisions you make.