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.
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.
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.
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