early mortgage pay off vs extra investment strategies
Some prime real estate I will never be able to afford š
Well that’s a sobering title on a Friday morning isn’t it folks!? Yes I’m actually writing a post about boring old personal finance for once rather than cooking or my garden. š
Hopefully we can spice things up a little and make it a bit interesting though, or at least introduce you to someĀ new(ish) ideas you may not have heard of before.
paying off your mortgage or investing more money…?
… is an age old question that is hotly debated in PF circles. The basic arguments for each case are as follows.
Pay Off Mortgage Man might say:
- Getting rid of all debt makes me happier than any potential increase in monetary terms
- Stock markets are volatile, I like the guaranteed pay off of my mortgage interest rate
- Interest rates may (will) rise at some point in the future so pay off now while the going is good
For more arguments on this line of thinking see In Source Life’s excellent post on why he aggressively paid down his mortgageĀ (which nudged me into writing this post as well. Cheers ISL!)
I *heart* Investing Individual may retort:
- Long term stock market gains blow away current mortgage rates. I’m playing the long game!
- Inflation is eating away at my principle owed – over 25-30 years thisĀ counts for a lot
- Investing is more exciting š
- If you are in the US you can lock down the same low interest rate for 30 years (WTF!!! That’s so not fair! š )
For more thoughts on this see The Accumulator’s post on Why I’m not paying off my mortgage early
arguments schmarguments
“So what should we do oh great and wise one Mr Starter of FIRE’s?” I hear you ask?
Well my personal opinion is of course you can do both. I can see both points of the argument and I don’t believe they are mutually exclusive. Paying down your mortgage earlier is a great option, and so is investing in the market!
However this does leave us with another hard question to answer which is “How do I split my surplus cash into each option?”
The way I see it there are two options
- Cost averaging (Perhaps better known as Dollar Cost Averaging – DCA – or Pound Cost Averaging)
- Value averaging (Again, known as Dollar Value Averaging or Pound Cost Averaging)
cost averaging
You have probably heard ofĀ cost averagingĀ before and it is simple to explain. This is where you just invest a set amount each month and have done with it. So combining this with a mortgage payoff plan, you might just split your surplus cash 50/50, invest half and pay off the mortgage with the other half.
Pretty much job done there!
You could even mix things up slightly by setting a target allocation of each, say 40% mortgage and 60% investing if you so wished.
But that’s pretty much as complicated as this method is going to get. I’m all for keeping things simple but I think the second option could work out better over the long run.
value averaging
Personally I’m going to employ aĀ value averagingĀ system. This is where you decide on a value amount you would like to increase your investment account by each month and make an investment that would make it equal to that increase. It’s probably easier to explain with an example so let’s start by assuming you want your investment account to increase by Ā£1000 per month. Let’s say your current investments are worth Ā£50,000.
Scenario 1 – The market goes up by 1% this month so your investment accounts are already at Ā£50,500. Our target level is obviously Ā£50,1000 so weĀ would only make a Ā£500 payment to the investments this month.
Scenario 2 – The market goes down by 0.5% this month and our portfolio is therefore at Ā£49,750. We therefore make a payment of Ā£1,250 to top it up.
This is where value averaging normally ends and we’dĀ keep the rest of the money in cash, waiting for a potential market downturn. As you can probably tell the benefits of this over cost averaging are that you invest more at lower prices and less at higher prices, which should in theory boost your returns.
But the twist for our mortgage pay down strategy is thatĀ we’d actually use the rest of the surplus cash to pay down the mortgage instead.Ā I know,Ā geniusĀ is it not?!! No? Ok we’ll it’s a mildy good idea I think you’d have to admit š
So in Scenario 1 Ā£1,500 would be for mortgage overpayments and scenario 2 it would be Ā£750.
butĀ what about the variations on my surplus cash?
If, like me, you don’t actually have a set amountĀ of surplus cash each month you will need to do something similar to the following:
Scenario 3 – As in scenario 1 above but with variable surplus cash, first month we have Ā£1,762 to spare. We start with Ā£50,000Ā we are splitting our variable cash 50/50 so our target would be Ā£50,881 (Ā£50,000 + Ā£1,762 / 2). So we now only need to make a Ā£381 investment and Ā£1,381 goes to the mortgage pay off
Scenario 4Ā – As in scenario 2 above but with variable surplus cash. This month we’ve had a bumper savings month and have Ā£2,408 to stash away somewhere. Our new target is therefore Ā£51,204 so we need to make a payment to the portfolio of Ā£1,454 (Ā£51,204 – Ā£49,750) and therefore Ā£954 goes to the mortgage
Hopefully I haven’t lost anyone at this point… š
From the above examples it would seem that as your potential contributions get smaller in comparison to your portfolio size, the amount you end up contributing as a percentage to each becomes more volatile. It may therefore make sense further complicate this by fiddling with the starting allocation of each. For example my starting point might be 40% to the mortgage and 60% to investments. I think this would smooth out the curves somewhat (although obviously you may end up with a longer mortgage payoff).
It would be interesting to do some long term simulations on this to see how it worked out and what the optimum strategy is depending on your monthly surplus, mortgage and portfolio sizes. If there are any spreadsheet boffins out there who have some time to spare please do get in touch! š
possible drawbacks of value averaging combined with early mortgage pay down
As we have ascertained from the small number of examples above, if you have a large investment portfolio even small swings in the market could eclipse the surplus cash you have to invest/pay down so it may end up being very binary in what you do each month. Is this necessarily a bad thing though, I’m not so sure?
A bigger issue is that the whole point of value averaging is that you are building up a cash buffer when markets are frothy so that if/when the next downturn appears you are fully equipped to stock your portfolio back up to the desired value. If you are redirecting your payments straight into the extremely illiquid mortgage pay off plan then when that downturn comes, if you are losing more each month than what you have surplus cash to pump in, then you cannot keep your portfolio up to that desired value. Again I am not sure this is necessarily a bad thing either, it’s kind of a stop loss each month on what you put in. I’m not sure if I could handle the following extreme example, for example š
Scenario 5aĀ – Portfolio had grown to Ā£200,000 but we’re in a harshĀ bear market and it’s down 5% this month to Ā£190,000. Our target for next month would be Ā£201,000 so theoretically we need to fill it back up with the non-paltry sum of Ā£11,000!!!!Ā Imagine if the market then drops again 3% the next month and our portfolio is back down to Ā£194,970, before topping it up again. That would be hard to take even though I know in the long run keeping filling it up on every drop is the optimum strategy.
Scenario 5bĀ – With our alternative plan where we’ve stuffed all our spare cash into the mortgage, and therefore have a built inĀ “stop loss” each month, our portfolio with the exact same scenario above would be at Ā£192,000 after the first months drop and subsequent top up, and Ā£186,240 after the second drop before topping it up again. I don’t know why but that feels less stressful to me!
paying off ANDĀ a cash buffer with an offset mortgage
The solution to the second issue above would obviously be to get an offset mortgage and store the excess money in the offset account. You would then get the benefit of “paying off your mortgage” while also having a massively liquid chunk of money to invest should there be a large market downturn.
I think this sounds like the best strategy for those with large portfolio’s already and/or limited funds each month, but for me with a much smaller one (oh dear god, I can just see #theFirestarterHasGotASmallerOne trending on twitter right now!) and a decent amount of surplus cash each month I feel like it’s not really needed right now. Maybe one for the future when the portfolio grows and/or the income shrinks!
A second option would be store up the excess cash for a year actually in a decent paying cash account like the Santander 123 and then pay a big chunk off the mortgage each year depending on how well the markets have done and how much you have in there, obviously leaving behind some of it for any potential downturns the next year.
my plan going forward
So as you can probably guess by now I will definitely be using the value averaging method. However I do still need to build up some cash or cash like reserves before chucking any extra money atĀ my currently illiquid (i.e. I don’t have an offset) mortgage principal. I also want to look at some alternative investments like P2P lending, so I will most probably just use the portion that is not going to “the markets” – a.k.a the Vanguard LifeStrategy 80/20 or FTSE All-World ETFĀ in my case – to do whatever I think is best for it that month, be that P2P lending, stocking up cash reserves, or paying down some extra mortgage principal. I will be getting a big windfall in October when I cash in my share save scheme which will bolster cash reserves anyway so it will be nice to have the problem of deciding exactly where all of that gets directed to as well. I will most probably value average it using the above strategy and then split the non markets portion as I see fit.
over to you…
I’ve really enjoyed writing this one and there is a lot to talk about here so it would be great to continue the discussionĀ in the comments!
Your starters for 10…
Do you favour paying down your mortgage vs investing more money in the stock market or vice versa?
Have you used cost averaging or value averaging? If so which one did you prefer and why?
Do you think my methods are getting far too complicated for my own good and I need to go back to basics!? š
Discussion (22) ¬
Another benefit of the mortgage paydown (and potentially influencing the calculations) would be if you originally bought at a low LTV as most young buyers tend to do. This limits your mortgage choice and usually results in an above-average mortgage interest rate for the initial period.
Overpaying the mortgage allows you to reach a higher LTV quicker which then means you can remortgage to lock in for a lower rate next time.
Personally I’m split about 70-30 between mortgage – ISA investments, however may readjust this when we remortgage next year at a better LTV.
Hi ERG,
Great point! 70/30 sounds like a good split while initially trying to get down to a better LTV.
I’ve never really had to think about this because my first mortgage was a really strange one where we got shafted for 2 years but then it dropped to a 2% tracker rate, which obviously wasn’t worth remortgaging for, and by the time we ended up moving house we had enough equity to get a decent rate anyway.
Cheers!
Great minds….i’m drafting a post on this very topic. I’ll spare you the details but I’m firmly in the camp of getting rid of the mortgage quickly. Sure you might make more in the market but you may also lose more.
For the me the freedom that being mortgage free will bring far outweighs the potentially better returns I can achieve in the market.
Nice… I’ll keep an eye out for the post UTMT! š
That is a genuinely fascinating idea. I have not encountered Value Averaging before. There are–as you note–a couple of rather major niggles with it. However, as a policy in general it seems a great idea.
Plenty to think about from this one with regards investing strategy. Thanks a lot!
Cheers DD, glad to hear it’s new info to some then and I’m not just preaching to the choir. š
Earlier this year, We decided to make a lump sum mortgage repayment in order to lower the monthly amount we need to pay.
The difference will be used to invest each month in the markets, euro cost averaging.
Why did we do this: I value a lower debt more than the potential market gains. One of my options is to go freelance. Having less obligations on the mortgage at that time makes me feel good.
You have some nice frameworks to choose between invest/repay. the value option is quite refreshing… The big downside is a big market drop… not enough cash to invest. How about: in principle a 50/50 split, but if there is a correction in the market of more than 3 pct compared to last month, then do 40 mortage/60 invest, and if the drop is more than 5 pct, then do 30/70
Hi Amber Tree,
Yes the great thing as with any financial plan really is you can just tailor it to however you feel comfortable with.
As I mentioned in the last section I won’t be following exactly rigid rules but deciding what to do with the “cash” part of the split. I might also follow a different allocation than 50/50 as well, your suggestion sounds like it could work well.
Cheers!
But Mr. Firestarter, what if you have a lot more than that invested, the value drops Ā£5,000, and you have to scrounge up that much to replace it. I don’t, but I’m just saying…
You really only have variable rate mortgages in the UK? You’re right, that isn’t fair. We had been pouring money into our 3.375% mortgage, but starting next year I am going to start by maxing out one retirement fund at a time, and we’ll see if there’s more left at the end of the year to put into debts.
Hi Norm,
Yep that is one of the drawbacks of Value Averaging but as mentioned in the post the general idea is that you save up cash reserves when the markets rise so you have it spare when there is a drop. It must take a cool head to be able to keep the reserves there and then lump it all in when it happens… I’m not sure I have the stomach for it to be honest but we’ll find out someday I guess š
You can fix but the longest fix I’ve seen is for 10 years and the rates are much worse the longer the fix. For example a 2 year fix may be 2% and a 10 year one 5%, so most people just go for the shorter term fixes to get the best rate and have to keep remortgaging every few years, or go for a middle ground of 3 or 5 year fixes and take a middle ground rate as well.
Sounds like a great strategy you have, especially if you’ve already made a lot of overpayments in the past. Good luck! š
ERG has a point. Think about LTV and when/if your fixed/variable mortgage ends.
Dat Der Under the money may be verbose on his blog but I can guarantee what he/she says will challenge your thinking
Norm has a point but i’d be wary of maxing out retirement pots before ISAs unless there is the usual financial advantages of doing so.
I would say plot all your assumptions in excel and then use the log function of the graph and you can see the exponential.
I’d imagine once you get to 60% LTV your graph would show you over the long term it is much of a muchness.
Good luck either way.
The most important fact is you save shedloads, it’s the % saving rate that really counts over the long term. Both strategies are decent.
Not saying value averaging isn’t a valid idea it’s just sounds like a fancy pants label for something that works only in 2D. wait til you have 100k in the market and you have a Greek crisis or similar. I.E volatility will make your namby pamby self cry
Hi Dick,
Thanks for the comments!
I think an Excel graph is the order of the day, if I get time I’ll knock one up and do another post on it.
Haha… I fully appreciate that this isn’t for the faint of heart. I think having the “stop loss” of a max amount you can put in each month would hopefully make it an easier task to stick with the plan. But I dare not say there wouldn’t be tears in your given situation. I’ve never invested through a bear market so far and I guess some day (soon!?) I’ll find out how that feels. Eeep! š
Cheers again for the comment and well wishes and all the best to you as well good sir.
You are on an amazing journey and there is more than one way to get there. You pretty much can’t go wrong.
Thanks again Dick, inspiring words!
I struggled with this when setting up my asset allocation, coming at it from the other direction: is my investment in property the value of the property or the value less the outstanding mortgage?
My insight is that the mortgage is leverage on the entire portfolio, not the property. This helps reveal both how horribly exposed most of us with modest liquid portfolios are to large illiquid investments in property, but also allows you to allocate your spare cash into the various assets according to a fixed asset allocation (helping to do value averaging), and denying your inner chimp from sabotaging your performance.
To do this properly you then need to figure out what the notional rent is on your property (Zoopla? 4% of value?) so that you can decide whether your long term goal of retirement is better met by reducing this rental figure or increasing your investments.
My view is that the leverage a property adds to your portfolio can produce an amazing increase in performance but the additional risk (of default) that it creates is not worth it with your main residence (as the return is swallowed up by the notional rent). It does, however, highlight the advantage of having a heavy chunk of BTL in your portfolio — it is almost unique as an asset class in being a source of leverage, independent of whether the net returns are strong. Try asking your bank manager for a 20 year loan at 2% against your pension!
Both cases are good and as a number of people have flagged up, there are key points around LTV values. For me, we have a (relatively!) low LTV (sub 60%) so have access to all the good rates, so we will be filling up our ISAs first, and then any left over cash (!) will come off the mortgage. Id prefer to have no mortgage, but if we dont top up our ISA, when the mortgage is gone, we will have too much spare cash as our mortgage is higher than our ISA limits…
Most important thing? Make sure you do at least one of the two options!
I think the idea of value averaging would make a ton more sense if you had $50K laying around idly, so I guess technically I’m a candidate, but that money is for the house!
Technically, I don’t do either strategy. I do the if I have money its going in, and if I don’t then it’s not strategy.
Hi TFS,
The way I think about this is to look at the interest rate on my mortgage (in our case it’s 3.3%), and say, do I think a post-tax rate of return of that rate (guaranteed to be realised – not a volatile, risky estimate of future returns) is attractive?
In our case, the answer to that is that a guaranteed post-tax return of 3.3% is clearly very attractive, so we overpay the maximum. (In fairness, we are in the lucky position of also being able to fund our ISAs fully. If we couldn’t do that, it would be a tougher decision, for sure.) Even if you are in difficult-decision-territory (say you can’t make material overpayments and fully fund you and your spouse’s ISAs), I do think that the guaranteed nature of the return on overpayment is highly valuable, and that’s in addition to the psychological benefits of paying down debt.
The flipside to this is, clearly, that overpaying the mortgage, when compared to other options (e.g. investing in financial assets – let’s say shares and bonds – or other property, whether BTLs, REITs or whatever) clearly increases your exposure to UK residential property, and in particular to your own house, relative to gross assets. So you are increasing your exposure to property (though you should always have a need to “consume” housing, so there is a natural asset:liability match there) and also your idiosyncratic risk (you can’t really “diversify” your house!). On the other hand, you’re decreasing leverage, and so decreasing risk overall.
Overall, to me, the arguments favour making overpaying an important part of your strategy. A 50:50 split could work well as a rule of thumb; I don’t think I’d bother with complicated “value cost averaging” strategies. Maybe adjust your weightings if equity values got really extreme (in either direction).
Phil
P.s. I think the equation is perhaps slightly different for people with very large portfolios. Once you’ve got (financial) investments of say Ā£600k – Ā£1m+, I think it could make sense to draw down a low LTV mortgage to add some gearing to your portfolio. This seems to me to be the optimum way to add some modest gearing to a private investor’s investment portfolio in a controlled and low-risk manner, without having to post collateral, face margin calls or any of the other horrid risks that mean leverage and quoted equities generally just don’t go hand in hand. Once I’m at that happy stage, I may well seek to do just that. But that is very different to having a 75%+ LTV style mortgage that one uses to buy the property.
For us, there is no way we would pay extra towards our mortgage. We have a tracker giving BoE BR +1.49% (so currently 1.99%). If I can make ca. 7.5% p.a. on investments (which I have been doing since 2006), why would I give extra money to the bank instead? All our spare money therefore goes to investments. If (when) the rates rise, we will analyse every time this happens to make sure that we’re still doing the most beneficial thing for our long-term finances. Of course, as noted above the inflation is eating away at our mortgage, but the high rates of returns on investments are several % above inflation, so the answer is super clear right now.
If interest rates went up to 4, 5, 6% or something – we’d probably be paying the mortgage instead.
Came here from MMM. I’ve found this site and community comments, particularly on this thread really helpful as I’m the only one of my friends doing this.
I’ve only just started out on the journey to FIRE, although my mortgage rates are cheap (1.24% – took out a tracker just at the BoE base rate peak) I’m saving hard and paying mortgage:investments at a 75:25 ratio. This is while I experiment with investments. Opened my first account ever only 2 weeks ago. Once I feel happy that I know what I’m doing I’ll shift the ratio to 50:50. I just didn’t want to put a huge sum into something until I had some experience of it and had some personal data to test some hypotheses. I have a lot of Excel spreadsheets too!