Spin on an old question - borrowing to invest

[kiwichick]

Hi all,

I've asked a similar question to this before (http://forum.mrmoneymustache.com/investor-alley/new-zealand-investing/), but I wonder what the answer would be if the situation changed a bit.

Consider this hypothetical situation. Say you have a house with a decent amount of equity (say 50%). A house that you KNEW you would be selling in a few years, without repurchasing another (say you're moving overseas, moving cities, have short-term work contracts, won't have a permanent abode anytime soon etc). Mortgage interest rates are low (5% or less). You have $1000-$2000 a month extra once all bills are paid. When you sell, you expect to put most of the proceeds from the sale into investments with some short term savings and emergency cash.

Given this situation, would you put the money towards aggressively paying down the mortgage, or would you invest it instead?

The former offers guaranteed returns while you're in the house (the mortgage interest rate), and when you sell you have a large lump-sum of money. If you invest it all at once, you could be investing just before a correction. Or there could be a slump in house prices, meaning you either have to sell at a much lower price than you want or rent the house out but have all your money tied up in one asset. You could take out another mortgage to release equity, but you are relying on the bank to allow this and there could be a high interest rate then or high fees involved etc.

If you invest instead, you'll be making regular payments, taking advantage of dollar-cost-averaging for a hopefully decent return. Your money is diversified and not tied up in one asset. When you move, if house prices have slumped you can more easily keep the house as a rental and not feel like you need to sell at a loss. If house prices are high, you still get to keep the same amount of profit as if you had aggressively paid down the mortgage, but get the returns from the stock market as well. On the other hand, your investment could return less than your mortgage interest rate. Meaning you're paying a premium for diversification.

Personally I lean towards the latter these days, as I feel more comfortable with money sitting in various 'pots', rather than it all being tied up in one place. It does of course depend on the prevailing interest rates at the time though.

Conventional advice is always to repay the mortgage first, but I don't think this is really a one-size-fits-all solution and am keen to see if mustachians think differently.

What would you do?

[Left]

unless I misunderstood you, you aren't borrowing against the house to invest but just asking if you should pay down the mortgage or invest?

I'd invest it, the house already has a short "time" frame, no point putting more than needed money into it, it just won't generate a big return in just a few years anyways. Even if you only make 4% on the investments instead of the 5% over 5 years, you are only down 5%... but you'll make it back in 10-20 years... Unless you think the market will return 0% for 5 years or negative returns. In which case, your house would be worth less and all that extra payment that went into mortgage just made someone else rich while you end up with a "cheaper" house to sell

If you are asking to borrow against the house, then I would say no. You don't know what the economy might be in just a few short years, if it tanks, you may not be moving (not sure if you are moving for family/job/retirement, but they all take money...). If you borrowed against a house, you may not have a roof either.

[johnny847]

As eyem, I am also confused as to whether you really mean borrowing against the house or paying down the mortgage in lieu of investing. Your post says one thing but your title says another.

If you do mean borrowing against the house to invest, anytime somebody brings that up I like to bring up this thread: https://www.bogleheads.org/forum/viewtopic.php?t=5934
Now in that thread market timer used callable debt, whereas a mortgage isn't callable. So it's not quite a fair comparison. But still, I would be very cautious about borrowing to invest.

[Telecaster]

Conventional advice is always to repay the mortgage first, but I don't think this is really a one-size-fits-all solution and am keen to see if mustachians think differently.

What would you do?

I'm fairly new here, but from what I've read on the board recently, that is not the conventional wisdom, at least not around here.  Two important things to keep in mind.

1) The length of a typical single-family home loan is 30 years. So that's most likely the time horizon we are looking at.

2)  A house is a very slowly appreciating, illiquid asset.   The conventional wisdom says a very slowly appreciating, illiquid asset is NOT where you want to put your money.   But in the case of a house, the conventional wisdom kinda gets thrown out and people think it is a good idea for some reason.

[FiveSigmas]

I would check out this thread for more material on whether to pay down the mortgage:

http://forum.mrmoneymustache.com/investor-alley/paying-off-mortgage-early-how-bad-is-it-for-your-fi-date/.

It’s a long thread, but there are lots of good insights (particularly the points about viewing a mortgage as a negative bond). I think it’s worth reading even if, as in your case, you’ll be selling the house in a relatively short time frame.

2)  A house is a very slowly appreciating, illiquid asset.   The conventional wisdom says a very slowly appreciating, illiquid asset is NOT where you want to put your money.   But in the case of a house, the conventional wisdom kinda gets thrown out and people think it is a good idea for some reason.

I wouldn’t confuse the issue by considering what might happen to house prices. It’s an important variable when choosing between buying and renting, but it shouldn’t enter the equation when deciding whether to pay down a mortgage.

If you pay down the mortgage, you’re not tilting your portfolio towards or away from real estate, because you already own a 100% stake in your house. If the value of your house goes up, you get to keep all of that added wealth – the bank doesn’t get a penny of it. And when prices go down… well, you still owe the bank the same amount of money. The house only becomes the bank's if you default, and from the sound of the original post, it doesn’t sound like that’s a concern.

All you’re doing by paying down a mortgage is decreasing the size of a loan – a loan just happens to be backed by your home. To put it another way, the choice you're considering isn't between increasing your exposure to real estate vs. stocks. Rather, it's a choice between bonds vs. stocks.

Edit: "equities" -> "stocks".

[kiwichick]

unless I misunderstood you, you aren't borrowing against the house to invest but just asking if you should pay down the mortgage or invest?

TBH, I don't see the difference between redirecting money that would have gone towards repaying a mortgage to investments, and outright drawing down against the mortgage for investments (unless there are extra fees involved with the latter). If you invest $10,000 income that you would have otherwise put on the mortgage, that's $500 interest after 1 year at 5%. If you borrow $10,000 from the mortgage at 5% to invest, that's still $500 interest. Same net result. Though perhaps my viewpoint is skewed a little as I personally use a revolving credit account for all income and expenses, so any money I invest is coming from the mortgage account.

(Not sure what you mean by callable debt?)

[FiveSigmas]

If you do mean borrowing against the house to invest, anytime somebody brings that up I like to bring up this thread: https://www.bogleheads.org/forum/viewtopic.php?t=5934
Now in that thread market timer used callable debt, whereas a mortgage isn't callable. So it's not quite a fair comparison. But still, I would be very cautious about borrowing to invest.

That's another good thread. Thanks for the link!

[kiwichick]

Does it make a difference if the mortgage in question is for a rental property rather than your own home? Obviously taxes on a home vs a rental differ, but these vary by country. I personally would never throw all my savings into a rental property as that's putting all my eggs in one basket. I'll admit that I'm biased towards shares, as shares are more flexible (if you need to free up some cash in a hurry, it's often easier to sell a few shares, than it is to apply for a mortgage or sell the whole house) - perhaps this is colouring my opinion.

[K-ice]

I do not really see the "new spin" on this question. Is it the short time line to sell your home?

I found an interesting discussion on this here:

http://forum.mrmoneymustache.com/real-estate-and-landlording/the-great-'pay-off-mortage'-vs-'invest-in-stocks'-debate-possible-solution

The long term math says investing is better, provided you are following stocks (ETFs) and not just sitting on a savings account. The emotional safe choice is to pay the mtg faster.

After I crunched some numbers looking at long term net worth I decided it is not about the mortgage but more about how much in other funds you have to invest.


If you have very little extra to put at the mtg or invest, investing is better.
If your mortgage is just a small part of your expenses and you are saving lots anyway the difference between the two doesn't really matter.  Over a short period of time the difference is even less since you cannot take advantage of the investments compounding. Normally I would say evaluate your risk / gut feeling and do either.

But considering the short term nature of your mortgage (~2y then sell), and markets can fall and not recover within 2y,  I would lean towards paying it off more than investing.

Disclosure: I do not feel I am a confident investor, so I paid off my mtg on my house asap. I am learning more about investing and plan to pay the mtg on a rental more slowly. 

[K-ice]

I didn't see your rental comment until after my previous post.

I am going through the same thought process with a rental.  I have made a list of questions based on some of the things I have read. I hope they help:

Q1) Do you expect a greater than 2% spread on your investments vs. mtg rate?  YES   Invest (without a 2% spread I would lean towards paying the mortgage faster.)  In your example 5% mortgage rate is quite high compared to the NorthAmerican rates.

Q2) Are you confident investing?  YES Invest  (Have you been investing in stocks or ETF for at least 2y? If you just let your “investments” sit in savings accounts I would not risk low yield investing over mortgage payment. )

Q3) Do you plan to own the home for more than 2y?  YES  Invest  (If you plan on selling soon, because the market can fall and not recover within a short period, I would recommend paying the mortgage since that is a sure thing over the next 2y.)

Q4) Is the house a rental property?  YES Invest   (If the property is your primary residence it feels better to pay the mortgage & I don’t think there are mtg tax breaks in CAN or AUS, unsure NZ. If it is a rental, let the tenants pay the bills, write off that interest and you are best to put the extra cash somewhere else.)

Q5) Are you short on other cash to invest?  YES Invest  (If you are short on cash to invest it is better to get started sooner rather than later.  If you have lots of other cash to invest (ie 1-3x your mtg pmt) , it makes very little difference one way or the other. )

Maybe these 5 questions can help you decide. Only you can make the choice as to how many you answer Yes or No to in order to help with your decision.   

Other MMM, I would be happy to hear the questions you asked yourselves and your opinions too.

[kiwichick]

From http://forum.mrmoneymustache.com/investor-alley/paying-off-mortgage-early-how-bad-is-it-for-your-fi-date/:

And if your income dries up, I'd much rather have that amount liquid, able to pay your mortgage (or not), rather than not have a mortgage and have lower expenses, but be unable to pay them because so much of your money is locked up in an inaccessible form of home equity.

This is a very good point and something I agree with. If you're made redundant, a bank is highly unlikely to let you borrow against your house to cover expenses. You might have an emergency fund to cover a situation like this, but what if it takes a lot longer to find a job than you expected? If you have share investments you can sell them to free up cash to pay your bills. If all you have is your house.... shit outta luck. Gotta sell.

[NZBubble]

That is just the question I have been posing to myself over the weekend.

Well, at least I think it is. Perhaps you are my twin :0)

Are you asking whether, in a situation where you have $1000-$2000 per month, and a rental mortgage, whether it is better to pay down the mortgage or invest?

I wish I had the answer.
It depends on what rate your shares are increasing, vs your mortgage interest rate.

Sorted.co.nz has a great calculator which tells you the actual value of a lump sum put on a mortgage, and also the same for increasing repayments. If you only have a short term left it's not much.

It would also depend where the house was. If it's in Auckland, I'd be inclined to invest. That way you have ridiculous valuation increases and as long as your shares are gaining more than 6% I think that is what I would opt for.

A rental in a regional area with not so much price movement? I'd probably chip away at the mortgage.

Did you see we Kiwis can now buy Vanguard shares? Through Smartshares and through ASB Securities. Too bad they are mostly $66 each and one is $150.

You can buy 8-12 shares with your extra funds :0

[kiwichick]

I didn't see your rental comment until after my previous post.

I am going through the same thought process with a rental.  I have made a list of questions based on some of the things I have read. I hope they help:

Q1) Do you expect a greater than 2% spread on your investments vs. mtg rate?  YES   Invest (without a 2% spread I would lean towards paying the mortgage faster.)  In your example 5% mortgage rate is quite high compared to the NorthAmerican rates.

Q2) Are you confident investing?  YES Invest  (Have you been investing in stocks or ETF for at least 2y? If you just let your “investments” sit in savings accounts I would not risk low yield investing over mortgage payment. )

Q3) Do you plan to own the home for more than 2y?  YES  Invest  (If you plan on selling soon, because the market can fall and not recover within a short period, I would recommend paying the mortgage since that is a sure thing over the next 2y.)

Q4) Is the house a rental property?  YES Invest   (If the property is your primary residence it feels better to pay the mortgage & I don’t think there are mtg tax breaks in CAN or AUS, unsure NZ. If it is a rental, let the tenants pay the bills, write off that interest and you are best to put the extra cash somewhere else.)

Q5) Are you short on other cash to invest?  YES Invest  (If you are short on cash to invest it is better to get started sooner rather than later.  If you have lots of other cash to invest (ie 1-3x your mtg pmt) , it makes very little difference one way or the other. )

Maybe these 5 questions can help you decide. Only you can make the choice as to how many you answer Yes or No to in order to help with your decision.   

Other MMM, I would be happy to hear the questions you asked yourselves and your opinions too.

Good questions. Is the 2% spread in Q1 to account for tax paid on dividends/capital gains?

For me personally, I can answer yes to 4 of the 5. Even though 5% is high compared to American standards, it's low in NZ. And I would expect over a longer timeframe (I'm expecting to sell in 5 years) that the investment would make significantly more than that. Even when the world's stock markets dropped in 2008, they had rebounded within a year or two.

[kiwichick]

That is just the question I have been posing to myself over the weekend.

Well, at least I think it is. Perhaps you are my twin :0)

Are you asking whether, in a situation where you have $1000-$2000 per month, and a rental mortgage, whether it is better to pay down the mortgage or invest?

I wish I had the answer.
It depends on what rate your shares are increasing, vs your mortgage interest rate.

Sorted.co.nz has a great calculator which tells you the actual value of a lump sum put on a mortgage, and also the same for increasing repayments. If you only have a short term left it's not much.

It would also depend where the house was. If it's in Auckland, I'd be inclined to invest. That way you have ridiculous valuation increases and as long as your shares are gaining more than 6% I think that is what I would opt for.

A rental in a regional area with not so much price movement? I'd probably chip away at the mortgage.

Did you see we Kiwis can now buy Vanguard shares? Through Smartshares and through ASB Securities. Too bad they are mostly $66 each and one is $150.

You can buy 8-12 shares with your extra funds :0

Why does it matter where the house is? I would be more inclined to pay off an Auckland mortgage quickly, purely because house prices are so ridiculous there that the mortgage amount would probably be astronomical and I'd be fretting about a correction! :-) But a dollar on an Auckland house mortgage is the same as a dollar on a mortgage for a house in Timaru. Curious to see your line of thought.

I was very happy to see Smarshares offering the vanguard shares. Doesn't matter about the share price though, as all investor money pooled together anyway. From what I understand, you're buying units in the smartshares fund, which then invests in the vanguard fund. The unit price of the Smartshares USF (VOO - S&P500) is $5.935 currently.

[K-ice]

]

Good questions. Is the 2% spread in Q1 to account for tax paid on dividends/capital gains?

For me personally, I can answer yes to 4 of the 5. Even though 5% is high compared to American standards, it's low in NZ. And I would expect over a longer timeframe (I'm expecting to sell in 5 years) that the investment would make significantly more than that. Even when the world's stock markets dropped in 2008, they had rebounded within a year or two.

The 2% is just the spread I think I would need to feel comfortable. I have the hardest time answering Q1 and Q2.

I hadn't considered the taxes much since if we buy and hold you don't pay tax except a small amount on dividends. I know the US and CDN are different here. I also invest in mostly registered tax free or tax defered accounts.


So another question may be.

Q6) Do you still have room to invest in tax free (or differed) accounts? YES Invest.

[Wadiman]

My 2 cents worth:

Why not make an 'each-way' bet?  It doesn't necessarily have to be a 100%/0% proposition.

I decided to allocate 50% of my income surplus to extra mortgage repayments and 50% to investments after mulling over this question for a fair while.  It's been working well for me as I get to see progress towards my FIRE account and debt reduction at the same time which has been helping me stay motivated and on-track.

[NZBubble]

That is interesting info about the vanguard shares, I have only looked briefly and really through ASB where the shares themselves are bought. I must have a proper look at Smartshares now it doesn't just offer sucky expensive options.

My thoughts on the mortgage, regional values vs Auckland. I suppose I think this because regional prices tend to be fairly stable, so the benefit you get out of extra mortgage repayments in 5 years is really pretty much limited to the reduction of interest on capital. Paying an extra $250 per week over a 20 year term will save a lot in interest, but over 5 years, not so much.

Whereas, and I have no qualitative data here, only observations on the share values of what I own, that by and large share values (my few, anyway) have increased far more than 6%.
About 2 months ago I bought a few shares in 2 different companies. While the one I put the lions share of the funds in has risen only 2%, the other has increased in value by 25%.

Over a whole year drawing down an extra $20k on an LOC will cost $1200 in interest.

If you buy $20k of shares, and they gain even 10% in value you are still $800 ahead. Less tax.

Feel free to critique away here because I am searching for the same answer I think.

I want the best possible return for the little bit of extra money and I am in completely in 2 minds about it.

[forummm]

Investing with leverage (what you're proposing) is not for everyone. And as your time horizon gets shorter, it's more risky. I have done it with low interest loans (like a cash-out refi and a 0% car loan). But that was also when the market was at lower valuations. And I have 2 very reliable income streams and very low expenses, and the total amounts borrowed are a very small amount of my NW. Each of those things significantly limits my risk.

[kiwichick]

Investing with leverage (what you're proposing) is not for everyone.

Yep, very true. Especially that Bogleheads example - that was extreme. In my case, when I sell that money (equity) is going to be invested in shares anyway as I a) won't be buying a home to live in for a while and b) am not a fan of property investment. Purely because of the human side of the equation (I'd worry the tenants would be a nightmare). So I figure, if all my money is going into shares eventually anyway, why not get a head start so by the time I have a large amount to invest I'll have a decent amount of experience in share trading and be less likely to dump it all into the market right before a collapse. I'm comfortable with the risk of investing income into shares now, because it's still a small amount when compared to the money I'll be looking to invest 5 years down the line. And if house prices crash right before I'm due to sell, I'll feel more secure hanging on to the house and renting it out, waiting for prices to rise again, if I have money invested elsewhere that I can call upon. I personally would be unlikely to take out an additional mortgage if shit hit the fan as by that point I'll be a full time student with a very low income - the bank would be unlikely to lend to me.

But it's great to see different perspectives as everyone's situations change throughout their lives. It's good to look back on these sorts of posts and see different sides of the argument when trying to decide what to do.

[NZBubble]

Investing with leverage (what you're proposing) is not for everyone.

Yep, very true. Especially that Bogleheads example - that was extreme. In my case, when I sell that money (equity) is going to be invested in shares anyway as I a) won't be buying a home to live in for a while and b) am not a fan of property investment. Purely because of the human side of the equation (I'd worry the tenants would be a nightmare). So I figure, if all my money is going into shares eventually anyway, why not get a head start so by the time I have a large amount to invest I'll have a decent amount of experience in share trading and be less likely to dump it all into the market right before a collapse. I'm comfortable with the risk of investing income into shares now, because it's still a small amount when compared to the money I'll be looking to invest 5 years down the line. And if house prices crash right before I'm due to sell, I'll feel more secure hanging on to the house and renting it out, waiting for prices to rise again, if I have money invested elsewhere that I can call upon. I personally would be unlikely to take out an additional mortgage if shit hit the fan as by that point I'll be a full time student with a very low income - the bank would be unlikely to lend to me.

But it's great to see different perspectives as everyone's situations change throughout their lives. It's good to look back on these sorts of posts and see different sides of the argument when trying to decide what to do.

I should clarify first that I have never borrowed to buy shares, and have paid off two houses and a business on a low income using a LOC ( I'm quite risk averse), but if, God forbid, the housing market crashes right when you are going to sell and you end up keeping it as a rental and starting full time study, I would suggest while you are still working, getting a valuation and applying to extend your mortgage as far as possible, then parking the funds in a LOC/ offset account.

This way you will incur no interest, however should the (rental) roof suddenly need replacing (for example) you have access to funds which you would not be granted once no longer working.

I have kept my original variable loan open so now have the funds available to completely renovate rental should I decide to flick it. I worked full time when I got the loan but only work very part time now and would be less likely to be able to extend the mortgage.

[zb3]

Borrowing to invest makes perfect sense provided you have a long timeframe, don't over leverage and your expected return exceeds the cost to borrow.  Borrowing actually reduces long term risk as it allows you to spread your investment more evenly over time in nominal terms.  If you are interested in leverage you should read lifecycle investing.  The evidence is compelling.

[NZBubble]

Borrowing to invest makes perfect sense provided you have a long timeframe, don't over leverage and your expected return exceeds the cost to borrow.  Borrowing actually reduces long term risk as it allows you to spread your investment more evenly over time in nominal terms.  If you are interested in leverage you should read lifecycle investing.  The evidence is compelling.

It's the 'expected return' part I have a problem with :0)

What you say makes perfect sense. I do know one person who borrowed $400k against their house to buy shares. I bought $1000 myself. Those shares have gained 51% in the 3 years I've held them.

However, this was a second time around for my friend. They did the same thing 10 years prior and lost all their money. A lot. Fortunately parents helped out which is why they had a house to borrow against 10 years later.

[zb3]

Surprised your friend had the guts to do it again after losing everything.  Expected return isn't great right now I'm only slightly leveraged at moment, although once stock drops and the pe10 becomes more reasonable I will up my leverage a lot.  Do you leverage individual stocks or index funds? Id be too cautious to leverage individual stocks, much prefer etfs.

[Bbqmustache]

It's the 'expected return' part I have a problem with :0)

What you say makes perfect sense. I do know one person who borrowed $400k against their house to buy shares. I bought $1000 myself. Those shares have gained 51% in the 3 years I've held them.

However, this was a second time around for my friend. They did the same thing 10 years prior and lost all their money. A lot. Fortunately parents helped out which is why they had a house to borrow against 10 years later.

Perfect three sentence story of why you should not borrow to invest.  Negative things can happen on either side of that transaction when you use other people's money.  Highly recommend you do not do it.

On another note, I recall from your initial post that you would use proceeds from the house sale to fund an emergency fund.  If you have $1,000 to $2000 extra every month now, how long would it be before you had 12 months of expenses in a savings account using that extra money?  Emergencies are not going to kindly wait until you sell, and if you have to sell because you have an emergency, better start practicing bending over low now.  Build up a fat cash buffer against the storms of life, then invest.  The house proceeds will come in time, when you decide to sell.  Please don't dig a debt hole.

[kiwichick]

Right now, the "emergency fund" is a revolving credit portion of my mortgage. However, if I lost my job today I would have $25,000 paid out immediately from a workplace savings/retirement scheme - it's locked up while I'm still working at my current employer but gets paid out in cash as soon as I leave. Plus a few grand in current investments. If I don't leave until Feb 2017 to go to Uni, this will grow and I expect to have a total of $40,000 savings when I start Uni, plus whatever I put into investments between now and then, plus the revolving credit account (which will have a nil balance). No kids, so I can rent out a room or two (I should be doing that now actually, but this is the first time I've ever lived alone and I'm not quite ready to give that up just yet!). Mortgage payments + rates + insurance will be below market rent, so I feel pretty confident about my situation and don't feel the need to put any cash aside, earning a paltry amount of interest.

That being said, when people on this thread talk about leveraging, they seem to think of borrowing 100s of thousands against the house to place into shares. While many may be comfortable with this amount of risk, I'm still very much 'small potatoes' and would never be comfortable with that kind of risk. A few 10s of thousands over time, yeah, as even if that investment were wiped out, I could rebuild it without too much worry even while studying (part time job, renting out rooms). But 400K?? Nup, far too much risk.

[NZBubble]

I hear you. And am nodding so hard it's likely my head will fall off.

Renting out rooms, while annoying, might be a really good money spinner and a source of untaxed income while you're at uni? Just checked the IRD website and you are allowed 2x boarders at $254 each, if you charge more tax kicks in. But $500 of untaxed income a week, maybe that's worth keeping the house for?

Unless of course uni is in a different place. 

[kiwichick]

Uni is in the same place thankfully, so renting out rooms is definitely something I'll do while studying, though I'm very picky about who I share my living space with. I thought about renting the place out or selling and renting a smaller place on my own, but it works out better financially to stay put.