This post is part 5 of 7 in a series entitled “When not to pay down your mortgage,” which outlines many scenarios where paying extra on your mortgage isn’t necessarily the best financial strategy.
The previous articles in this series have dealt with considerations that should be important to every home buyer: preparing for emergencies, saving responsibly, and making informed decisions about how to prioritize debt payment.
What we haven’t yet considered, though, is the role of real estate as an investment. For many people, the goal of getting a mortgage is ultimately to own that home. If that is your goal, this article may not be as relevant to you. But if you don’t necessarily plan on staying in the same area for the long term, or you plan on upgrading to a larger home at some point, your goal is NOT owning the home you are currently paying a mortgage on.
Instead, you need to consider payments on your mortgage as part of a larger investment strategy.
Seeing the investment return when you sell
If you plan to sell your home before your 30-year or 15-year mortgage (or whatever length) has come to term, your goal should be to maximize the return on your investment. If you purchase a home with a 30-year mortgage, and you plan to sell in 10 years, it doesn’t really matter if you own 30% or 70% of the house after 10 years. What matters most from your overall financial picture is whether you come out with a strong return on your investment.
For the moment, let’s consider a very simple case where you have a “magic” loan that requires you to pay no interest. (This might actually happen in real life: maybe you made a deal with some family members to pay them back within 10 years.) Also, we’re not going to consider the other costs of owning a home: taxes, home insurance, maintenance costs, etc. Those will stay the same regardless of your mortgage payment strategy, so they’re not going to change the present analysis. (However, they do play a role in deciding whether you should even buy a home in the first place. In cases where you plan to own a home for only a few years, you might be better off renting rather than buying. That’s a separate issue from what you do once you already have a mortgage, so it’s not particularly relevant here.)
We’re also going to assume, as we have in previous posts, that you have enough equity in your home so you don’t have to pay PMI (generally at least 20%). PMI is an additional complication that can really cut into your rate of return, so often it’s best to try to achieve that level of equity as quickly as is reasonable.
Okay, so let’s take some extreme cases. Say you buy a house that’s worth $100,000. You put a 20% down payment on the house, i.e., $20,000. You owe some “magic bank” or family member $80,000. Again, we’re going to first take a really simple case where you don’t have to pay interest and don’t even make payments. (We’ll get into the details later.)
Let’s say that over 10 years, the value of your house increases to $150,000. You sell the home. $80,000 of that $150,000 goes to pay off the loan. You’re left with $70,000.
If you wanted to think of this as a return on an investment, you put in $20,000 at the beginning of the 10 years, and you walked away with $70,000 at the end. Your money effectively was increased 3.5 times, or an overall return of 250%. That’s an effective annual return of 13.3% on your investment for 10 years — a rather high number.
Now, let’s say that instead of making a 20% down payment, say you made a 50% down payment. After 10 years, the home is worth $150,000. You sell it and pay off the other $50,000 remaining on the loan. You walk away with $100,000.
At first this may sound better: you walk away with more money. But you also put more money into the house to begin with. For a $50,000 initial investment, you came away with $100,000. You doubled your money, so your overall return is 100%, or about 7.2% annually. That’s still a good return, but it’s significantly less than you had with a smaller initial investment.
The lower investment in your home can (under some circumstances) result in a higher effective return. Note that in both cases the amount of money that goes in and comes out is exactly the same overall: in both cases, you eventually pay the $100,000 purchase price, and you eventually sell the house for $150,000. Your net profit in both cases is thus $50,000.
The difference is that you put in varying amounts to get that profit. If someone gave you a choice: (1) invest $20,000 and net $50,000 profit in 10 years or (2) invest $50,000 and net $50,000 profit in 10 years, which would you choose (assuming there was equal risk)? You’d obviously go for the first case.
And that’s an important consideration for short-term owners. Your goal is not to have a high percentage of equity at the end of 10 years: it’s to get away with the best return with the smallest amount of investment.
Now, of course, we made a lot of assumptions here. In many cases, what I’ve just described may not be a great strategy. Let’s think about some other scenarios.
Depreciating home value
The most important assumption we made above is that your house actually went up in value after 10 years. For a well-maintained property in a desirable area to live, property values generally do gradually trend upward. How much upward is highly variable, but I’ve seen averages over the past 50-60 years fall in the 4% annual return per year for residential property on average. In desirable areas, it might be more like 5-8%, while in many areas it will be lower than 4%. Only in the cases of real estate bubbles, speculation (often in previously undeveloped areas), or property neglect, do you tend to see significant decreases in value for the long term.
Nevertheless, many people have seen home values drop significantly since around 2006, so it’s important to consider the case of a depreciating home value in our calculations.
Let’s again take an extreme scenario. Before we had a home that gained $50,000 in value; now let’s consider a loss of that magnitude.
Suppose again you buy a home that costs $100,000. Suppose you make the $20,000 down payment. And now suppose that after 10 years, the home has lost $50,000 in value, so it is only worth half of what it was before.
When you go to sell the home, you only get $50,000 back, but you need to pay off an $80,000 loan. So you need to come up with $30,000 just to sell your home. In common language these days, you were “under water” in your home loan.
Your return on your investment isn’t just zero. It isn’t even negative 100%, because you clearly lost more than your $20,000 investment. In this case, it’s as if you doubled-down at a casino and need to cough up even more money just to get out of the game.
Instead, suppose you initially put down a $50,000 payment, as we considered before. In that case, when you sell the home, you get $50,000 from the sale, which you need to immediately use to pay off the remainder of the loan. You walk away with exactly $0.
Again, in both cases, you lost $50,000. That was your net loss. But the lower down payment magnifies the effect of that loss, requiring you to come up with more money just to get out of your investment (obviously the least desirable situation).
What we know so far
When a home value goes up, you get a greater return per amount invested by having lower equity. What a home value goes down, you get a greater loss per amount invested by having lower equity.
Having lower equity will, in some sense, magnify the effects on your investment. Therefore, it generally only makes sense to deliberately keep your equity down to reap a higher investment if you’re fairly confident of an increase of property value.
This may sound a bit like gambling, and all investments are gambling to some extent. But do remember that in these simplified cases, the NET gain or loss is the same in all cases. You’re still gaining $50,000 at the end or losing $50,000 at the end OVERALL, regardless of the strategy. It comes down to a question of where the best place is to put your money. So, if your home value is going up, and if you haven’t achieved some of the goals discussed in previous posts like having an emergency fund, insurance, and retirement savings, it’s perhaps a better bet to invest more in those things before worrying about an increase in equity.
Of course, that’s not the whole story. We haven’t factored in the interest yet.
Returns in real mortgages
When we consider the amount paid in interest to hold a mortgage, most of the returns we saw previously don’t look so good. Nevertheless, under normal circumstances (i.e., not in a real estate bubble) with low interest rates (as we have now), lower equity still may not be a bad thing for investments.
Suppose, for example, that you have a 4% rate on a 30-year mortgage. Suppose that you get a reasonably good (but not stellar) 5% increase in property value annually. Suppose that you start out with a 20% down payment (to avoid PMI).
The calculations now are rather complex, but in the end, you would still see a higher effective return for a short-term sale by making the standard mortgage payments each month, rather than by overpaying.
Suppose you plan to sell your home after 10 years.
If you pay your standard payment, you would end up with a 51.7% return on the money invested over 10 years (about 4.25% annual return).
Now, suppose you overpaid your mortgage by increasing your payments by 20%. (For example, if you had a $500 standard payment, you paid $600 every month instead.) In that case, your effective return on your money when you sell after 10 years would be 48.2% (or about a 4.01% annual return).
If you increased your payments even further to build equity and paid double your standard mortgage payment, in this scenario you’d end up with a 39.8% return over 10 years (about 3.41% annual return).
It’s important to note again that this advice applies only to short-term ownership. If you overpay your mortgage each month, you will eventually pay it off early. And once you’ve paid off your mortgage, the interest no longer cuts into your returns, while your home value may continue to appreciate. That means that eventually the overall return will in fact be better when you overpay, since you end up paying less interest overall.
For the scenarios discussed here, your return for a 20% overpayment will surpass your return for a normal payment around 24 years into your mortgage. If you double your mortgage payment every month, the break-even point is about 15 years: after 15 years of ownership, your overall return on investment will be greater with the doubled payment versus the standard one.
This is confirmation that this the strategy we’re discussing here is only relevant when you plan to sell early. The longer you own your home, the less relevant these ideas are.
Also, let’s emphasize the assumptions here: this was for a 4% rate on a 30-year mortgage, with a 5% gain in property value. The returns will obviously be quite different depending on individual circumstances. As a rule of thumb, this strategy is strongest when your expected gain in property value is at least the percentage of interest you’re paying on your loan. You’ll still get higher effective returns on your money invested by not overpaying with your 4% interest rate if your property only gains 4% every year in value, instead of 5%. You’ll still barely get it if your home only gains 3.75% annually. This should be common sense, but if your house is gaining value at at significantly less than your interest rate, the additional interest you’re paying in will trump any additional returns by keeping equity lower.
If you plan to sell your house in the short term (5 to 10 years), building up equity is often not that beneficial just for the sake of equity. If you are fairly confident that your home value is rising annually, there may also be good investment reasons why lower equity can actually help your overall portfolio. Whether this is a good decision in your particular case will depend on the rising value of your real estate investment when balanced against the losses in interest that you pay on the loan.
With all of that said, keep in mind that inflation already can make the long-term difference in interest payments between payment strategies less relevant, as discussed in the first post of this series. In the end, it comes down to a comparison among three different rates: your mortgage interest rate, the inflation rate, and the rate at which you house gains (or loses) value. If your interest rate is below or around the inflation rate, overpayment may not be a good strategy. As discussed here, if your interest rate is below or around your home’s appreciation rate — and you plan to sell soon — overpayment may not be a good strategy. Making the exact call for a particular situation is difficult and requires some more complex mathematical analysis, but these overall trends are important.
Ultimately, what matters when considering an overpayment strategy is what you do with the money if you don’t use it to pay down the mortgage. The previous posts in this series discussed some critical financial needs that may need to be addressed before paying down a mortgage. If you have all those needs covered, though, you still need to figure out what to do with the rest of the money if you don’t put it into your mortgage. A comprehensive investment strategy needs to take that into account, and this topic will be considered in the next post of the series.
Disclaimer: This is not intended to be professional financial advice, nor does it apply to all people in all situations. It’s a good idea to consult a professional financial advisor before making any major changes in your finance management, because individual circumstances will often affect the choice of strategy.