early mortgage pay off vs extra investment strategies
Hopefully we can spice things up a little and make it a bit interesting though, or at least introduce you to some 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 mortgage (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 this counts for a lot
- Investing is more exciting 🙂
- If you are in the US you can lock down the same low interest rate for 30 years (WTF!!! That’s so not fair! 🙁 )
For more thoughts on this see The Accumulator’s post on Why I’m not paying off my mortgage early
“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)
You have probably heard of cost averaging 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.
Personally I’m going to employ a value averaging 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 £1000 per month. Let’s say your current investments are worth £50,000.
Scenario 1 – The market goes up by 1% this month so your investment accounts are already at £50,500. Our target level is obviously £50,1000 so we would only make a £500 payment to the investments this month.
Scenario 2 – The market goes down by 0.5% this month and our portfolio is therefore at £49,750. We therefore make a payment of £1,250 to top it up.
This is where value averaging normally ends and we’d 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 that we’d actually use the rest of the surplus cash to pay down the mortgage instead. I know, genius is it not?!! No? Ok we’ll it’s a mildy good idea I think you’d have to admit 😉
So in Scenario 1 £1,500 would be for mortgage overpayments and scenario 2 it would be £750.
but what about the variations on my surplus cash?
If, like me, you don’t actually have a set amount 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 £1,762 to spare. We start with £50,000 we are splitting our variable cash 50/50 so our target would be £50,881 (£50,000 + £1,762 / 2). So we now only need to make a £381 investment and £1,381 goes to the mortgage pay off
Scenario 4 – As in scenario 2 above but with variable surplus cash. This month we’ve had a bumper savings month and have £2,408 to stash away somewhere. Our new target is therefore £51,204 so we need to make a payment to the portfolio of £1,454 (£51,204 – £49,750) and therefore £954 goes to the mortgage
Hopefully I haven’t lost anyone at this point… 🙂
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! 🙂
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 🙂
Scenario 5a – Portfolio had grown to £200,000 but we’re in a harsh bear market and it’s down 5% this month to £190,000. Our target for next month would be £201,000 so theoretically we need to fill it back up with the non-paltry sum of £11,000!!!! Imagine if the market then drops again 3% the next month and our portfolio is back down to £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 5b – With our alternative plan where we’ve stuffed all our spare cash into the mortgage, and therefore have a built in “stop loss” each month, our portfolio with the exact same scenario above would be at £192,000 after the first months drop and subsequent top up, and £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 AND 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 at 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 ETF 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 discussion 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!? 🙂