Should you be making money on your mortgage?

09 February 2021

Written by Sarah Kelsey

With record low-interest rates, the traditional adage of pay down your mortgage before you start thinking about investing needs some serious consideration.

 

You can now secure a fixed-rate mortgage below 3%, whereas investing could generate a net return (after fees and taxes) of 5-6% over the medium term. This could give you an annual profit of 2-3% per annum - if you invested $100,000, this could give you a profit of $10,000 - 15,000 over a 5 year period.

This is not for everyone and if you are going to go down this route. Markets can be scary, individual companies can go bankrupt, and markets can drop up to 50% in a single year (even the largest companies!), so make sure you are prepared for these events and have the ability to remain invested through a full market cycle. 

If you are going to go down this route, you must follow some of the golden rules of investing which we have laid out below.

 

The rules of investing if using your mortgage

Whenever you invest using debt you are taking on more risk than if you invest without using debt.  The reason being that you will need to repay the debt plus interest which means you could lose more than your initial investment.  Therefore you need to be very careful about how you invest and ensure you are doing so in a low-risk way.

Make sure you are committed for the long term – investing is a long term activity, and markets are volatile. It would be best if you were committed to investing for the long term (at least 5 years) to ensure that you can remain invested through the ups and downs of the market. 

Make sure you have enough money saved away for an emergency –you need to be prepared to be a long term investor; therefore you need to make sure you have the capacity to remain invested and won’t need to take money out for an emergency or an unexpected cost. 

Make sure you are properly diversified – one of the biggest errors investors make is not having their investments spread wide enough. You should be invested in several different companies and across a variety of markets. Putting all of your money into a small group of companies exposes you to a significant amount of risk as issues with a single company can cause your portfolio to perform terribly. To achieve appropriate diversification, managed / index funds are often the best way.

Fix the cost of your debt for a long period – interest rates are currently at all-time lows and who knows how long they will stay this low.  To mitigate the risk that interest rates might rise to make sure you can afford a higher weekly mortgage cost or fix your mortgage for the longer term.

 

The maths of using your mortgage to fund your investments

Investing is like any business decision; the most important job in business is to understand your costs and your income. If you run a bakery, your main inputs (and therefore costs) are flour, labour and electricity; you generate income by selling bread or other baked products. Your bakery makes a profit when the cost of the inputs is lower than the income you generate.  With investing, you have costs (the cost of money plus other costs), and you generate income through investment returns.

The cost of money

The cost of money is either the interest rate you pay to borrow the money or the return you could have had by investing the money elsewhere.

Average debt costs

average debt cost

Source: 

1.       Mortgage rates taken from interest.co.nz as at 8/1/2020.

2.       Personal Loan and Credit Card rates taken from previous research.

 

As you can see from the chart above, there are very different borrowing costs dependent on debt type. Credit card debt is typically the most expensive debt and can be as high as 10-15%, whereas you can get a mortgage for as low as 2.7%. It is essential to note that mortgage rates are at historical lows and might rise in the future, so don’t expect to bank on a 2.7% mortgage forever. 

It will rarely make sense to use a personal loan/overdraft or credit card to invest as the interest rates are too high to generate appropriate returns.

Investment returns

Forecasting returns can be notoriously difficult, particularly given the very abnormal interest rate environment we are currently in – historical returns are not as relevant as they were achieved in a higher interest rate environment. 

The expected return from investing

 Expected return from investing

Source: 

1.        Academic returns use 10-year historical Damodaran Equity Risk Premium at the end of 2020 plus US 10 Year Treasury.

2.       Historical market returns taken since 1992 as this is the only period from when consistent data can be taken.

 

With interest rates at all-time lows, using historical returns is not a great tool to forecast future returns.  Academic forecasters break down a return into the interest rate component and the risk component, allowing us to normalise for historical interest rates.  Using this metric gives a forecasted return of 7.1%. 

It is important to note that these are all long term returns. In a given year, the market can be up or down by up to 50%, so the returns can only be generated over a longer-term basis.

The other hidden costs

Like many businesses, investing has some hidden costs that you also need to consider when thinking about investing.  Some of the bigger ones to think about are:

A. Transaction costs

Every time you trade you will be charged a fee, you will be surprised at how quickly these costs can add up, so number one rule is to minimise your trading to minimise your transaction costs.

B. Management fees

If you invest in a managed fund (which I believe is the best option), make sure you are clear on the fees charged.  Fund managers can charge up to 1.5% which is a significant chunk of your 7.1% so be careful on the management fees; you will typically be better off over the long term to choose a low-cost fund.

C. Taxes

While we don't have a comprehensive capital gains tax in New Zealand, taxes on gains made from selling shares may apply to NZ investors depending on your intentions when you purchase those shares.  Furthermore, you will be taxed on dividends and international shares. Calculating your tax obligations can be complicated, so consult a registered accountant if necessary. 

Your investing profit & loss


Your investing profit loss

 

The risks of investing

Investing can be scary, and there are lots of ups and downs. Too many New Zealanders believe that investing in the share market is highly risky and that you can lose all of your money by investing through the share market.  In my opinion, this is due to a few factors:

  • The 1987 crash in New Zealand was far more spectacular than in other parts of the world and was followed by a lengthy recession which meant that the NZ stock market did not recover for almost 10 years. This effectively “burned” a generation of investors who came out of that experience vowing to stay away from the stock market forever.
  • Far too often, we employ a DIY approach to investing. New Zealand has one of the highest rates of retail participation in the stock market in the world. Everyday investors often hold a small selection of investments, that is a hazardous approach, an individual company can go to zero, though it is doubtful that an entire market will. To deal with this, you need to ensure you have an exposure to lots of companies across lots of different markets. A managed fund is often the best way to deal with this as they will manage your money across a vast number of investments.
  • People do not realise that investing is a long term activity and are searching for short term gains. If you invest in the stock market, you should be looking at it with a 5-10 year horizon. In this article published in March 2020, we show the recovery period for previous market downturns. You can see that it can take up to 5 years for markets to recover, though invariably they do. The quickest way to destroy value for an investor is to sell investments ahead of the market recovering. This article talks about the value destruction caused by people shifting from growth to conservative KiwiSaver funds at the height of Covid-19 in 2020. 

Markets will go up and down, though invariably they do recover, the key is to ensure you have a timeframe that allows you to remain invested for long enough for them to recover and that you have a wide enough exposure to ensure that you are not exposed to any single company or sector.

The most important risk mitigation is to have access to emergency funds. If the unexpected happens (job loss, health issues, car breakdown or urgent house repairs required), you must have access to cash to cover these expenses. If you do not have sufficient cash available, you will need to sell your investments, and you might be selling them at a very negative point in the market cycle.

 

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