Should you make extra payments on a mortgage if you can earn a higher return than your interest rate?
If you’re new here, you may want to subscribe to my RSS feed. Thanks for visiting!
30 year mortgage at 4.5% interest. Over the long term, a diversified investment portfolio should be able to provide around a 5% annualized return. The 5% is not a guarantee, but past performance indicates that the probability of achieving this is good.
When you take on a mortgage, real estate become an aspect of your portfolio, so you need to take into account any other real estate holdings, whether physical or within a fund, REIT, etc. Real estate often occupies too large a portion of a family’s investment portfolio, especially the more that has been been put toward the downpayment – sometimes up to 20% in order to avoid a higher payment to cover mortgage interest insurance. The downpayment should be seen as a portfolio rebalance – one that shifts more of your assets into the segment that already takes up too large a portion of your portfolio.
Excepting housing bubbles, home prices typically rise at a 1% rate per year, more or less. If you buy a $500k home with 20% down, you’ve used $100k out of pocket, but you’re getting 1% on the 500k, which is an effective return of 5%. Any prepayment then reduces your leverage on the investment, and also shifts that money into an illiquid investment.
Additionally, net interest rate should be calculated after taxes. If your federal tax rate is 25% and state tax is 8%, then the effected rate of the 30-year fixed is closer to 3%. You also need to take inflation into account. Over the past 20 years inflation has averaged about 2.5%. If that continues, in another 20 years you will effectively be paying 40% less each month, since your payments don’t increase with inflation.
A simple analysis of your effective mortgage rate is AfterTaxRate-Inflation Rate. So roughly 3.2%-2.5% = .7%. Using this analysis, when you prepay your loan you’re saving 0.7%, while over the same period the diversified investment portfolio would give you 5%. If you could truly earn a higher rate of return by making early payments, then it would make sense to do so. However, the numbers here show that there are better investment strategies for your money.