# What is the Optimum Amount of Equity in your Home?

The title question can actually also be combined with “should I pay of my house faster?”, which is a very popular topic that is debated endlessly on many personal finance blogs. Being in the process of buying a house, we did some calculations to find out what amount of down payment (and/or accelerated mortgage payments) would provide us with the best Return On Investment (ROI) for our available cash.

As per usual, we need to identify a few boundary conditions and assumptions to be able to assess the various scenarios, which are as follows:

• Assumed property value €200.000;
• Fixed term annuity mortgage (albeit this assessment also applies to linear mortgages and variable mortgages, as the principle is the same);
• Mortgage based on 5 year fixed rate, 30 year amortization period with the ING Bank;
• ROI assumed at 3%, 4% and 5% for funds invested (in whatever assets that rock your boat);
• The missed investment income or “Opportunity Costs” is defined as the lost ROI on the equity being locked in your property; and,
• Appreciation of the property is not taken into consideration, as you would need to sell your house to materialize the profit.

# Mortgage

Before we continue, a quick explanation on why we selected the ING Bank with regards to the mortgage provider for this assessment. The ING is the only banks that has 12 classes defined for its mortgage interest rates (most banks only have up to 3 classes). This means that your mortgage rate changes depending on what percentage (ratio) of your home value is mortgaged.

For example, if your current mortgage value is €150.000, and the value of the property is €200.000, your mortgage ratio is 75%, However, if you have just bought your house, with a down payment of say €10.000, your mortgage would be €190.000 and the mortgage ratio is 95%. As you can see in the table below, depending on what term your mortgage is defined, you are looking at about 0.35% difference in mortgage interest rate. That is considerable on a mortgage percentage around the 2% mark!

The point here is that you benefit from paying off your mortgage faster (or putting a down payment on the property at purchase) by paying less interest as well as getting lower monthly payments. That is a double win!

Team CF Top Tip (with a hat tip to one of our readers), if you have been living in the same house for a few years, doing a new price evaluation may help you lower your interest costs/monthly payment as, due to the price increase the newly calculated mortgage ratio may drop you into a lower interest rate class.

# The Assessment

As noted earlier, a smaller mortgage means lower monthly payments and less paid interest. But on the other hand you are also losing the opportunity to invest your money into assets that generate you (cash-flow) income or create capital gains (i.e. the “Opportunity Costs”). As you can imagine, there must be a sweet spot in the amount of equity in your home, but as you would expect, it depends on the interest rate paid and the assumed ROI.

In the figure below we have tried to show, for three assumed ROI’s, at what Mortgage Ratio your will find the tipping point between benefitting from paying off your mortgage faster or better invest into assets (stock, bonds, ETF’s, rental property, etc.).

## So how should you interpret this graph?

The orange, green and red lines indicate the theoretical ROI (being 3%, 4% and 5% respectively) on the funds that are “locked” into your home (i.e. the “Opportunity Costs”). For example, if you have a Mortgage ratio of 90%, 10% of the property (in this case €20.000), could have been generating income. At 5% ROI this would have been €1.000 a year.

The blue line is showing the reduction in the amount of interest  (expenses) you are paying, on a yearly basis for this scenario and the ING interest rates shown above. As you can see this is not a linear line, which is caused due to the reduced interest rates you get for owing an increasingly larger portion of your house.

At the tipping points (as shown at ~44%, ~78% and ~90% for the 3%, 4% and 5% Opportunity Costs options respectively) the return you make on your investments become larger than the reduced (or saved) interest costs. Beyond these points, you are better off investing the funds than using them to pay off your mortgage faster. Another benefit is that you maintain the mortgage interest tax deduction (aka “Hypotheekrenteaftrek”) as large as possible for as long as possible.

# What Does This Mean In Reality of You?

This completely depends on your situation, firstly you would need to know (or at least assume) an ROI that is applicable to your assets. Next, check your mortgage interest rates and classes to see how additional down payments affect your monthly payments (or reduction in interest).

The next step is just doing the math, depending on the results you can start to evaluate your options. For some of you it might be worth paying down the house, for others it may mean that you should start to divert as much cash as you can towards investments/assets.

# What Does This Mean In Reality of Us?

Considering our current portfolio is generating about 4% per year (after taxes/inflation), and we still can decide what to do with our available cash, it seems most logical to put the available cash into the mortgage (which currently sits at 102%). Simply because the reduction in interest expenses at this stage is far larger than the potential income from the funds when invested (we would need a ROI of about 27% on the available cash to compensate the increased interest expenses…). Theoretically, when we get to about 85-75% of our mortgage, we should really start diverting every available € towards investments rather than putting it into our house.

In reality however, we would continuously reducing our mortgage amount by our monthly payments. Based on our preferences and the shown interest rate drops per mortgage ratio class, we will aim to initially reduce our mortgage ratio to 95%. After that, as it takes time and considerable amounts of cash to drop to the next (lower) mortgage ratio class. So it is likely better to invest in the means time, try to make some dividends and capital gains, and cash at a point where we would be able to drop a large cash amount into the mortgage to force the amount into the next interest rate class (which is generating the largest impact on cash flow and interest expenses).

Another point of consideration here is that the property we are buying is a four-plex, of which we will use the largest unit for us and the other 3 units will be rented out. This means that every € that we put into the mortgage is factually an investment, as it reduces the mortgage cost and thus increases the cash flow and profit on the property.

1. Sam says:

Hoi, ik sta op het punt om mijn eerste huis te kopen en vraag me ook af wat slim is: een lagere hypotheek afsluiten of mijn geld belegd laten. Volgens mijn berekeningen, het laatste.

Eerst even de uitgangspunten.

1)Ik reken op 6% rendement op mijn aandelen. Ik zie 6 tot 7% rendement vaker terug als lange termijn prognose. Wat wel goed is om te weten is dat mijn (beoogde) hypotheek 50% annuitair is en 50% aflossingsvrij. Over het aflossingsvrije gedeelte krijg ik geen hypotheekrenteaftrek, maar kan ik het wel opvoeren als schuld in box 3. Gezien deze schuld een stuk groter is dan de waarde van mijn aandelen, heb ik geen belastbaar vermogen :-). Ik zit alleen nog met inflatiecorrectie. Jullie hebben in jullie berekening deze verdisconteert in de ROI. Waarom? Ik vraag me af of ik dat ook moet doen.

2) ik zou 10% van de woning kunnen aanbetalen

3) bij 101% financiering betaal ik 2,28% rente als ik het 10 jaar vast zet. Als ik 90% financier betaal ik 2,08% rente

Zoals ik het nu zie: of ik betaal 2,28% rente over 101% van de woningwaarde (=hypotheeklasten) minus 6% rendement over 10% van de woningwaarde (=rendement over aandelen) versus 2,08% rente over 90% van de woningwaarde (=hypotheeklasten zonder rendement van belegd vermogen).

Dan levert belegggen duidelijk toch meer op dan afslossen? Zelfs als ik met een ROI van 5% reken. Zeker als ik de hypotheekrenteaftrek buiten beschouwing laat (die wordt in de loop der tijd steeds minder).

Of zie ik iets over het hoofd / maak ik een denkfout?

1. hey Sam,
Dank je wel voor je essay 😉 Hierbij wat reacties:
1) of je inflatie mee wilt nemen is puur aan jezelf. Wij hebben het gedaan om een beter beeld te krijgen van hoeveel we er werkelijk op vooruit/achteruit gaan. Het gaat hier voor ons dus echt om de koopkracht.
2) Kan je doen
3) Voorbeeld: €100.000 koopwoning = 101% hypotheek = €2302.8 rente (zonder tussentijdse aflossing/HRA). Voor 90% hypotheek is het €1872 rente per jaar + 11.000 @ 6% ‘lost opportunity cost” = €2532 total “kosten” (je geld zit vast in je huis en levert geen redement, het “kost” je dus 6% per jaar). Kortom, je kan het dus idd beter beleggen ipv in je huis stoppen. Het kantel punt voor jou ligt zo rond de 3.9%. Meer rendement = beter beleggen; minder rendement = beter in je huis stoppen.

2. Thanks for the nice post. We have paid of ±50% of our mortgage and put the rest into investments. That generates most ROI for us, as mortgage interest level will not go down at paying down more of our current mortgage.

1. It is almost unique calculation for each situation, as there were so many different mortgage types, rates and limitations. It got a lot simpler these since there are now only two options annuity and lineair mortgages (e.g. no more savings/investment mortgages, etc.).
Good for you that you found you sweet spot.

3. Hey CF, these are great considerations and if we had a mortgage, I’d also struggle to decide which is better. I’d want to direct money towards both, but I’m not sure what the appropriate amounts would be.

I’d heavily skew towards investing though, I’d rather have the (probably) guaranteed income, allowing us to have more income to pay for bills. Having \$0 debt doesn’t pay for FIRE (I know it helps a lot though). 🙂

Tristan

1. Fair point Tristan on the \$0 debt *(which is what we have now). But in this case leveraging the paycheck to make an investment seems the right way for us. We just needed to know what the optimum was from an investment perspective.
Cheers.

4. Interesting assessment. We did a revaluation February this year, and when looking at the lower interest rate including the fee paid for the taxation, the pay back time of this investment was only around 3 months. Our LTV is currently around 90%, which seems fine when assuming a 5% ROI on our assets.

1. Hey FV, the hat tip was in fact for you guys. We thought it was a very smart thing to do the re-evaluation on the property value.
Good for you that you found your tipping point. Guess you guys will go into full investment mode now?

1. Our emergency cash fund was a bit low so we did some cash hoarding lately…. And we would like to have some liquidity for our future home. But we will definetively start investing again soon!

5. Seems like a solid plan. There are other cash flow considerations to consider as well. Real Estate has poor liquidity, so when opportunities arise, it’s harder to move cash out.

Do you guys have sufficient alternate cash flow that if the other 3 units were vacant you could still pay the mortgage?

1. Oh yes, plenty. We selected the mortgage based on the worst case scenario of 1 income (we now have two) and no rental income. Even in that scenario we would still be ok.

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