Monthly Archives: October 2013

The investment advice a financial adviser will probably never give you

This investment advice is a simple one that many people in many countries do naturally but that, for whatever reason, is very undeveloped here in the US: the early mortgage repayment.

Let’s imagine that you have a mortgage with a 5% interest rate and that your income puts you into the 25% tax bracket (marginal). Let’s assume you have $1,000 of extra cash you would like to invest: What is the risk free investment you can find that can guarantee me a 5% gross return over the remaining length of my mortgage?

None!

(note: if you know of one you should start a financial investment advisor business Smile)

When you reimburse your mortgage in advance, you are reducing how much you still owe and therefore you are reducing the number of years you will have to reimburse it by having less capital to reimburse. Less capital owed equals less interests which leads to more capital repaid each month with your mortgage payment which eventually leads to shorter mortgage. However, you will not reduce your immediate monthly payment.

In essence, you are making a risk free 5% investment (under the above assumptions). This is $1,000 from your mortgage you will never have to pay 5% interest on. You’re saving 5% yearly for the duration of the mortgage = you are having a 5% return on your money.

This return is a gross return though. For your mortgage, you would actually deduct these interest from your taxes, so instead of 5% saving you are actually saving 4%. However, if you were to find an investment that returned 5% yearly, you would also have to pay the same 25% taxes on these returns (e.g. interests on a saving accounts) so it washes out.

Before drilling into the nitty-gritty of the actual cash flow analysis one important point: how does inflation impact this? In short: it does not. The core assumption is that I am comparing Apples to Apples, i.e. risk-free vs. risk-free investments. What will count here is the return you can get. The final result remains unchanged, in absolute value, regardless of the inflation. In 10 years from now, regardless of whether the inflation is 2% or 15%, $100 will be the same $100. They will just buy you much less in a 15% inflation scenario than in a 2% one but the logic remains unchanged.

The only genuine key variable is cash availability. When you repay your mortgage in advance, its value is tied in the house until you’re done repaying it fully. So if you need the money in 5 years but your mortgage still has 10 years to go this is definitely not something you want to do.

Let’s now look at the numbers. I posted on my SkyDrive an Excel spreadsheet. Feel free to poke at it, play with it (all the blue cells are variables to play with).

I took the following assumptions:

  • You still have 10 years worth of mortgage payment (but the spreadsheet allows you to play with values form 1 to 10 years) 
  • Then all the other variables are here for you to play with: remaining principal, amount you can invest back in your mortgage (think: Bonus, stock…), marginal tax rate, savings account return and mortgage APR
  • I did not factor inflation simply because it does not matter in this calculation
  • I assume you don’t need the money before the end of the mortgage (hence don’t need to take an expensive home equity loan during this period)

With a 100k mortgage, 5% APR, 25% marginal tax rate, a savings account at 2.5% (which, currently does not exists! Current ones are more in the 0.5-1.5%), and $10k to invest, the calculation gives you that, after 10 years, you are about 12.5% better off with putting the $10k into your mortgage than in your saving account.

Total savings after 10 years:

  • Put the $10k in a bank saving account: $ 19,671

  • Invest in Mortgage: $ 22,967

  • Gain From early mortgage reimbursement:

    12.6%

The second tab of the spreadsheet also shows that this gain benefit drops by +/1% per year. For instance if you only have 5 years left in your mortgage, the gain of reimbursing it early vs. putting your money in a savings account is down to 7%.

Finally, if you only have $1,000 to put in your mortgage of $100k, then, over 10 years, the gain will only be of 4%. Probably not worth it on its own unless you can repeat this multiple times as one of the advantages of this approach is that, unless you take a home line of credit, the money is “locked” in virtual savings, and can’t be used to by a new TV Smile

I know that most people would argue that this money can be put to better use through the stock market, etc. This is true. However, you must also remember that this is a risk-free investment at a guaranteed fairly high rate (vs. a savings account). You can’t compare this with regular portfolio investments. In this case it becomes then a personal portfolio allocation choice and this is a completely different story.

For the full calculation the spreadsheet can be found there on my SkyDrive.