The most frequently asked question from our younger, higher-earning clients right now is whether they should use capital to pay down their mortgage. The answer? It depends but generally if the mortgage amount is not too high and the borrower has sufficient income and capital to live their life then it often makes sense to keep the mortgage and invest the money instead.
When It Can Make Sense To Pay Down a Mortgage
There are some obvious circumstances where paying down a mortgage is a good idea.
For one, if you need or want to spend the extra money that would result from a lower monthly mortgage payment then reducing your mortgage payment is clearly beneficial. In a similar vein, your mortgage payments may be about to (substantially) increase and you therefore might want to pay down the mortgage simply to maintain the household’s usual cashflow. Makes sense.
There is also the important concept of ‘peace of mind’. That is to say, even if you can easily afford your monthly mortgage payments, you may simply find it preferable, or ‘safer’ to have a smaller mortgage. And that’s totally fine and sensible. There is no point in feeling financially stressed unnecessarily.
It may also be entirely rational to reduce the loan-to-value (‘LTV) ratio of your mortgage even if you can afford the payments. Generally, we like to see people with a LTV of 25-75% for their primary residence and we like to see this decline as people get older. So if you went all out on the mortgage five years ago and want to get the LTV down to, say, 50% then this can also make objective financial sense.
But what if none of the above applies to you?
What if you are:
● Earning significantly more than you spend, even once the mortgage payment is accounted for, and
● Comfortable with the level of risk inherent in your mortgage amount, both its absolute value and the amount compared to the value of your property
Then you might consider not paying down your mortgage. Why?! Well, because it’s really quite likely that over a long period of time investing in the stock market will make more money than your mortgage will cost you.
How can we write the above with such certainty? For one, there’s a big caveat: ‘over a long period of time’. More fundamentally, the reason is that, in aggregate and over the long term, companies grow their profits at a rate that is higher than the government's interest rate*. Since your mortgage is heavily based on the interest rate offered by government bonds (and, in fact, is only marginally higher than that rate), it is extremely likely that the return on owning shares will be higher than the cost of your mortgage.
The challenge is determining whether you are one of the fortunate people that can truly afford both the ongoing cost of a mortgage and have the financial backup to afford that cost if your circumstances change. What does that mean in practice? Well, if your mortgage is 10x bigger than your investments then it’s probably a good idea to pay down your mortgage. But if your investments are larger than your mortgage (or are likely to be quite soon because of your high income / rate of savings), then you probably have enough financial cushion to harvest the greater return that is likely from investing in shares.
As an aside, there are also other benefits of having at least some mortgage including additional liquidity for costs like school fees and whatever else life might throw at you.
*Why? For lots of reasons. One is that companies, at least the big ones that make it to being listed on the stock market, are generally pretty good at optimising their productivity. This inherent 'survivorship bias' means that as an investor in the stock market you are not invested in your cousin's milkshake startup but rather you are invested in the likes of Google, Microsoft and other companies that have demonstrated they are pretty good at running a business. By owning hundreds of companies that have steadily grown their profits, you can be really quite sure that over the long term the returns will continue to exceed inflation by at least the few percentage points that is needed for the return to be greater than your mortgage rate.
Finding A Balance
As ever with financial planning, the answer is often found by meeting somewhere in between. The point of this article is not to convince you just to keep your mortgage and go all-in on the stock market, but it is to challenge the conventional view that paying down a mortgage should necessarily be your number one priority. If you can navigate yourself to a position where your mortgage is, say, 50% LTV, the payments are comfortably being covered and you have significant assets in reserve then you’re unlikely to need to pay down your mortgage further.