A Fighting Chance Finance

How many times have you heard advice to pay of your mortgage by the time you retire? That having a paid off house is setting you up for success in retirement? The argument would be that when you retire, your income reduces substantially such that paying a mortgage payment each month could impact your ability to have the retirement lifestyle you want. The concept of having manageable expenses in retirement makes sense, but what if this strategy actually hampers your ability to set yourself up for a successful retirement? Hear me out!

Mortgage rates are about 2-3% right now. Right around the same level as inflation. This means that the interest rate you pay on your mortgage is the same amount that you “save” by the value of the loan going down over time. I’ll put in a simple example. Let’s say you have a $100,000 mortgage with a 2% interest rate. Let’s put principal payments aside for a moment. Each year, you’ll make interest payments of $2,000 (2% * 100,000). Additionally, the $100,000 at the end of the year will become worth 2% less than $100,000 in today’s dollars due to inflation. Accordingly, the mortgage is “free money” in real terms.

Making a mortgage payment is “investing in reduced mortgage interest”

When you make a mortgage payment, you reduce the principal balance on the loan little by little, until at the end of the amortization period of 25-30 years, the principal remaining is zero. But what do you get from an investment perspective by paying off your mortgage? You get a reduction in interest costs on the paid off principal. You pay off $10,000 of principal each year for the reward of $200 of less interest the following year.

If someone came along and said “would you rather invest $10,000 and earn a guaranteed 2% interest or invest $10,000 and earn a 8% return which might have some volatility during short term periods but on average has been iron clad over history”? When you look at principal payments as investments, rather than these abstract “necessary payments everyone makes just because”, you will realize the absolutely incredible opportunity cost of paying off your mortgage.

You might argue that “my house goes up in value, so it’s good to invest in my house”. But that house goes up in value and you get all of that appreciation whether or not a mortgage exists. Unless you default on the mortgage and the bank takes the house in foreclosure, all gains in the house price go to you. So don’t look at mortgage payments as additional investments in your house – you get that anyway – they are investments in reduced mortgage interest.

What is the opportunity cost of paying off my mortgage?

In my opinion, since not paying your mortgage principal does have a cost on a monthly basis (the interest rate on the unpaid balance), I like to take the equity and invest in something that produces a yield that at least covers the mortgage interest so that I am not out of pocket for interest costs, ever.

So what do I do? Instead of having my mortgage be locked in such that it is mandatory to make principal and interest payments, mine is structured as a re-advanceable Home Equity Line of Credit (HELOC). This means, when I make a payment on my mortgage, the principal balance repaid immediately becomes available to re-draw. Over many months, the amount available to re-draw becomes large enough to make investments with.

Let’s take a simple example of investing in a real estate investment trust (REIT) with the re-advanced equity instead of just paying down the mortgage. I like REITs, and real estate in general, for this strategy because they are not volatile, they are secured by a property and they produce cash flow regularly. You DO NOT want to under take this strategy of borrowing the equity on your home to invest in the stock market or anything speculative – that has the risk of both having your house leveraged and your investment declining to a value below what you borrowed. Stay conservative.

The REIT produces an annual yield of 5% income, and it is expected to appreciate in value by 3% each year. The total expected investment return is 8% between yield and appreciation. Our example mortgage is $500,000 to begin with, and carries a 3% interest rate over a 30 year amortization. Let’s assume we used this mortgage to purchase a $650,000 house that will go up by 3% each year.

This mortgage, if diligently paid each month over 30 years, comes with a total interest cost of $258,888. At the end of 30 years the house will be worth $1,577,720. The original investment was $150,000, so ending up with a paid off asset worth $1.6m, in exchange for a $258,888 interest cost isn’t a bad outcome. The net equity at retirement is $1.6m – the house.

Now, let’s see where we end up if instead of leaving the equity in the house, we use it to invest in the REIT. To keep things simple, we will assume that the REIT yields 5%, the reduction of 3% from the 8% noted above is used to pay the mortgage interest. In effect, the mortgage interest cost is now zero, and we have a 5% yield.

In the first year, the principal which can be re-drawn is $10,439. Invested at a 5% growth rate for 29 years, it grows to $42,968. In the second year, the principal which can be re-drawn is $10,756. Invested at 5% for 28 years, it grows to $42,166. This process is repeated for 30 years. The total ending value of the investments made using re-drawn principal totaling $500,000 is $994,165. At the end of the 30 years, the investor has the house worth $1.6m, a nearly $1m investment portfolio yielding 8% and a $500k mortgage. Net equity is $2.1m, and annual income is around $80,000 from the investment portfolio. Sure, some of this needs to pay for the interest on the mortgage which still exists of $15,000 per year ( 3% * $500,000) , but it sure beats zero income at all in scenario 1!

The investor has boosted their retirement net worth by $500,000 and created a $65k per year income stream. That is the opportunity cost of paying your mortgage down.

This analysis assumes that the $500,000 principal is all that can be pulled out and re-invested. The reality is that as the home appreciates, the bank will likely offer up to 80% of the value of the home as HELOC proceeds. So by the end of the 30 year period when the house is worth $1.6 million, the bank will probably offer a HELOC up to $1.3 million, allowing you to repeat the strategy with even more capital, thus further increasing your retirement income with the spread of income from investments you used the HELOC proceeds to buy and the interest cost of the HELOC.

By the way, since the entirety of the mortgage now exists to produce income, all of the interest is tax-deductible!

To learn more about this strategy, I highly recommend the book “Turn your Mortgage into a Pension” by Gord Johnson. Brilliant strategies around using your home equity to accelerate and improve your retirement.