I teach my financial investing clients to manage costs in their portfolio – it’s my second Rule of Financial Gravity. Usually that effort focuses on avoiding financial products that have steep fees, but sometimes the conversation drifts to the role of the client’s mortgage in their financial picture. Are there costs associated with a mortgage? Of course there are, you’re thinking. There’s an interest rate tied to the payments on the house. But have you really analyzed the impact of that payment on your finances?
A client recently in my office wanted to cut costs in her financial investing portfolio, but never looked at her mortgage as a place to do it. She had a 30-year fixed mortgage at 5 ¼ percent. Her monthly payment was $1400 – four hundred in principal, and a thousand dollars in interest. My first question to her was, “so where’s the 5 ¼ percent?” If you look at one thousand in interest she was paying in her fourteen-hundred dollar payment, that’s not five percent she was paying, it was seventy percent! That’s a great place to try to cut costs. Look at your mortgage amortization schedule, and you’ll see that the only payment you will ever make where the interest is actually at the rate you agreed to will be payment number 360. That’s the scary side of compound interest. Mortgage payments are front-loaded with interest in the first several years to make the payments come out the same amount every month. That’s why mortgage companies celebrate when someone pays off 10 years of a mortgage and then refinances – those 10 years of payments were mostly interest! So the question we need to ask is this: is it financially wise to pay off my mortgage early?
Too many people think this way: “I’m making 9% in the market, and I’m only paying 5% on my house – so if I put financial investing money in the market instead of paying off my mortgage, I’m gaining 4% I would have lost”. These people are fooling themselves. Let’s see why, and we’ll learn about a principle I call Cash Flow Equivalent Return.
Financial Investing can get complicated, so let’s simplify our math. Let’s imagine a mortgage with $100,000 in principal, and a $1000 monthly payment. If I won $100,000 in the lottery, and paid off the house, I’d save $1000 each month. The big question is this – if I put that $100,000 in the market instead of paying off the mortgage, what kind of rate of return would I need in order to get that same $1000 per month benefit in my cash flow? Said another way, what’s the Cash Flow Equivalent Return that I need to break even? I’d need to make $12,000 a year from my $100,000, a 12% return. That’s my Cash Flow Equivalent Return, relative to paying off my mortgage early with that same money.
Whoa! I’d need to make a 12% return in the market to match the benefit of putting that same financial investing money toward my mortgage? Yep – and that’s just the net return. Don’t forget that taxes and insurance get added to a mortgage payment, and don’t forget the money I’d have to make in the market would be subject to capital gains taxes. Put that together, and I’d need to be pulling a 14-18 percent return from the market to match the cost savings of just paying off my mortgage with the money.
Do you have some cash to put in financial investing? If you put it in the market, you’ll need to have some spectacular luck to compare with the benefit of just paying off your own mortgage. Did your financial advisor tell you that? No? How does he get paid? Is it by helping your financial picture, or by selling you his favorite financial product? Think about it.