Key Post After-Tax Investing in Equities vs. Early Mortgage Repayment

[RedOnion]

For it to be the sensible option, you'd really want your equity fund returning +5% before tax and expenses over the long term.

That's exactly my question though.

Assuming you can fund mortgage, long term, and an effective rate of 2% (which itself is a massive assumption), you need an investment return of 5% + per annum to break even. To keep an effective mortgage rate of 2%, risk free rates need to stay around 0%, long term. Do you really believe over 20+ years you can achieve a 5% return over risk free rates? Given that the market has already priced in rates staying below Zero for the next 10 years.

 

[Ent319]

That's exactly my question though.

Assuming you can fund mortgage, long term, and an effective rate of 2% (which itself is a massive assumption), you need an investment return of 5% + per annum to break even. To keep an effective mortgage rate of 2%, risk free rates need to stay around 0%, long term. Do you really believe over 20+ years you can achieve a 5% return over risk free rates? Given that the market has already priced in rates staying below Zero for the next 10 years.

I've no idea! Is there any time over the past 40/50 years where investing in an equity index fund over a period of 25 years would not have yielded returns greater than 5% YOY before tax / expenses?

Edit to add: Isn't the break even rate (Mortgage Interest Rate/59 * 100) ? So for 2% effective you'd need your fund to be producing 2/59 * 100 = 3.39%. For 3% effective your fund would need to produce 3/59 * 100 = 5.08%

 

[NoRegretsCoyote]

but I've always thought it odd why people would want to tie up most of their net worth in a dwelling when they could happily live in a smaller one and free up money to invest into actual productive assets.

We spend a little over 40% of net income on housing (inc insurance, utilities, etc) on a relatively large house.

It suits us at this stage of life. We have three young kids and spend a lot of time at home.

I don't see what "productive investments" I should be investing in. Am comfortable with pension and don't have an own business that needs cash.

 

[RedOnion]

I've no idea! Is there any time over the past 40/50 years where investing in an equity index fund over a period of 25 years would not have yielded returns greater than 5% YOY before tax / expenses?

You're missing a major point though. You're looking at total return, which is almost irrelevant. You need to look at that return, adjusted for interest rates.
There's no point looking at historical data from the 80's when stocks were returning 10%+ per annum while ignoring that mortgage interest rates were over 10%.

You'll easily find charts showing the real rate of return, adjusted for inflation which isn't a bad starting point, and there have been extended periods with a real return.

 

[Ent319]

You're missing a major point though. You're looking at total return, which is almost irrelevant. You need to look at that return, adjusted for interest rates.
There's no point looking at historical data from the 80's when stocks were returning 10%+ per annum while ignoring that mortgage interest rates were over 10%.

You'll easily find charts showing the real rate of return, adjusted for inflation which isn't a bad starting point, and there have been extended periods with a real return.

It'd be really helpful for you to explain this a bit more as I don't quite get what you're saying. Haven't interest rates been low for a good while now while the stock market has been producing good returns?

 

[RedOnion]

Haven't interest rates been low for a good while now while the stock market has been producing good returns?

Not really, since we're talking about a 25+ year time frame.
It was really only in 2015 that rates went negative, but more importantly it was only in the last 12 months that the market has priced in an expectation that rates will remain low for a very long period.

The interaction between risk free rates and investment values is a cornerstone of economic theory.

 

[Ent319]

OK - that's helpful. I'll try and read up on it. But if the market has priced in an expectation that interest rates are going to remain low for the foreseeable future, intuitively that would seem to backup what I'm saying somewhat?

I mean, I would like to unequivocally state that what I've suggested in this thread makes very little sense if:

(a) Interests rates rise
(b) Cashback offers fall to the way side

I fully appreciate that over the next twenty / twenty five years, these will likely happen.

But isn't the right thing to do to invest in the thing that's likely to lead to the most return at the time?

 

[zephyro]

I've no idea! Is there any time over the past 40/50 years where investing in an equity index fund over a period of 25 years would not have yielded returns greater than 5% YOY before tax / expenses?

Do you not understand the equity risk premium and that basing equity return expectations in the current zero-rate environment to the last 40/50 years when the risk-free rate was far higher is totally inappropriate?

 

[cremeegg]

Eh, no. You get the full benefit from day 1 of overpaying your mortgage. You pay less mortgage interest immediately.

Brendan

From an accounting point of view Brendan is correct, but from a cashflow point of view, the OP is correct. Surely the cash flow view is more relevant.

If I overpay my mortgage by €x per month, I will have €x less spending money each month. My mortgage will end some number of months earlier, Yipee! but until then I have less free cash.

 

[cremeegg]

"dollar cost averaging" and "euro cost averaging" sounds like some clever investment technique which maximises gains and minimises risk. But it's nothing of the sort.

5 Myths About Dollar-Cost Averaging (DCA) - Stash Learn

There are misconceptions about dollar-cost averaging. We took a look at some myths to help you understand how to implement it and what it’s intended to achieve.

learn.stash.com

.

Many people invest €x per month, not because they believe in 'dollar cost averaging' but because they have money available to invest on a €x per month basis.

 

[Gordon Gekko]

It’s pretty simple really. If I invest in equities and things go pretty well, I might make 7% a year. I’ll probably pay around 1% for the privilege. Then I’ll suffer a mixture of CGT and income tax on the upside, let’s call it 40% on average. So 2.8% in tax and 1% in costs: which leaves me with around 3% for myself.

Or I could just pay off mortgage debt which is typically around 3%.

So if things go well, I might make 3% versus saving a guaranteed 3% by repaying the debt.

 

[Ent319]

Do you not understand the equity risk premium and that basing equity return expectations in the current zero-rate environment to the last 40/50 years when the risk-free rate was far higher is totally inappropriate?

This is my understanding and where I'm coming from:

- Asset allocation is one of the few ways investors' choices can have positive effects on their portfolio.
- Anyone who has tried to predict or time the equity market has normally ended up with egg on their face.
- In recent history, the equity market has consistently produced the highest returns out of most asset classes at a macro level. Taking a passive approach to investing through an index fund over a long period of time would have likely ensured you'd gotten the best returns in equities.
- For an investment to break even vs. early repayment of a debt, the investment's return after taxes and expenses must be greater than the average interest rate of the debt. For it to be an option worth entertaining, you'd want to be fairly sure it was going to be 1% to 1.5% higher.
- At the moment, through maximising switching incentives, you can achieve an effective mortgage interest rate of between 1% to 2% without a great deal of complications. This is maintained by retaining a high principal.
- For an investment to beat this, after tax and expenses, it would need to give you you more than roughly 3% after all taxes and expenses are taken into consideration. For it to be sensible, you'd want it to be at least 4% after tax, depending on your risk tolerance.
- It wouldn't seem to be a huge stretch of the imagination to assume that the equity market might return greater than 4% returns after tax.
- It would be madness to invest in equities in Ireland if you had an effective mortgage interest rate of 3% to 3.5% or more, or at higher rates as the case may have been historically.
- It is unlikely that interest rates are likely to arise for the foreseeable future.
- Were interest rates to rise in the future, you could always rebalance how you invest, or sell your equities to make an overpayment.
- Notwithstanding reductions in monthly payments which would provide you with greater cashflow, tying up a lot of your principal in the early repayment of a debt that is likely to only be realised when you sell your house seems to be putting your eggs in one basket?

To go back to my original question: what have I missed? I am absolutely coming at this with an open mind. If anyone can save me from making a stupid financial decision - please do!

- Am I stupid to think interest rates might remain at the level they're at?
- Am I stupid to think that I might be able to make more money investing in equities while effective interest rates on mortgages are low. If so, why?
- If effective interests rates are likely to be higher later into the mortgage, does it make more sense for me to allocate my assets to early repayments now or wait til later if investing in other assets might make more money?
- Is it stupid to think that I might be able to liquidate my assets invested in equities in the event that interest rates do start going up? How much time would have to pass for this to be a "safe" option?
- Am I being too optimistic about potential returns from the equity market? Is the tax situation and potential returns much worse than I'm making out?
- Might investing in equities and investing in overpayments provide diversity benefits?

 

[RedOnion]

- It wouldn't seem to be a huge stretch of the imagination to assume that the equity market might return greater than 4% returns after tax.

That's a massive assumption.

For it to be an option worth entertaining, you'd want to be fairly sure it was going to be 1% to 1.5% higher

No. Not 1%, or 1.5%. At least double.
So if interest rates are 5%, you need an investment return of 10%, etc.

- Is it stupid to think that I might be able to liquidate my assets invested in equities in the event that interest rates do start going up? What time period would interest rates have to remain low for this to be a "safe" option?

All other things being equal, as soon as there's an expectation that interest rates will go up, then asset values will go down, since asset values should be the present value of future cash flows. So you're hit with a fall in the value of your investment, and an increase cost of servicing your mortgage at the same time.

Think about it logically. Very clever people 'invest' to lend the money for your mortgage. They're currently happy to lend that money to the bank at 0%, or less. In turn the bank is happy to lend it to you for 2%. Do you think if there was an 'almost certain' 5% available in equities they wouldn't be investing there instead? There's a risk in equities, which is why the returns should be higher.

 

[Ent319]

That's a massive assumption.

OK - could you illustrate this for me? From what I understood the market generally returns 8% PA. After tax (41%) and expenses (1% AMC), this would be around 4%.

No. Not 1%, or 1.5%. At least double.
So if interest rates are 5%, you need an investment return of 10%, etc.

Would this be regarded as quite a conservative position?

All other things being equal, as soon as there's an expectation that interest rates will go up, then asset values will go down, since asset values should be the present value of future cash flows. So you're hit with a fall in the value of your investment, and an increase cost of servicing your mortgage at the same time.

Think about it logically. Very clever people 'invest' to lend the money for your mortgage. They're currently happy to lend that money to the bank at 0%, or less. In turn the bank is happy to lend it to you for 2%. Do you think if there was an 'almost certain' 5% available in equities they wouldn't be investing there instead? There's a risk in equities, which is why the returns should be higher.

OK this is really helpful. So cashflow wise if everything went to pot it would likely be a double whammy.

 

[Ent319]

One other thing that just sprung to mind is deemed disposal's dragging effect on compound interest over time. I guess if you repay your mortgage early you get "true" compounding benefits for the outstanding term.

 

[RedOnion]

So cashflow wise if everything went to pot it would likely be a double whammy.

Not just cashflow wise. It's a double whammy. Full stop.

OK - could you illustrate this for me? From what I understood the market generally returns 8% PA.

Past performance, etc. etc...

What were average interest rates over the period that the market returned 8%? The question you have ignored is how much has the market returned over risk free interest over any extended time period?

 

[Ent319]

What were average interest rates over the period that the market returned 8%? The question you have ignored is how much has the market returned over risk free interest over any extended time period?

I have to be honest mate, I wouldn’t really know where to start to solve this. I presume you already know the answer?

 

[RedOnion]

I presume you already know the answer

No, I haven't got to that YouTube video yet.

But it's not worth working out. As you already know the total rate of return in stocks has averaged around 8% over the long term. Find me any 20 year period in history where you could have funded a mortgage at an average under 4% to make that worthwhile.

To think that markets will continue producing returns of 8% plus, while also being able to finance a mortgage at around 2% is just pure fantasy.

You should research the history of endowment mortgages in Ireland to open your eyes on how people can over estimate returns Vs paying mortgage.

 

[Ent319]

OK so this thread has been really helpful for me. Thank you to all those who contributed. To draw a line under it, and for posterity sake, I thought I might summarise what I've taken away from it / some of my further thoughts. If any mod wants to link this post in the OP so they don't get the wrong impression from the thread that's fine.

- I was probably way too optimistic about returns from the equity market after tax and after expenses. Even if investing in an index fund returned 8% PA, you're probably only going to end up with 4% of that after tax and after expenses in Ireland. This is under a positive scenario, which is by no means guaranteed, and assumes you won't need to pull your money out of the market at an inconvenient time. Deemed disposal's negative effect on compounding will lag your investments even more over the long term.

- Despite the fact you might have a lower effective mortgage interest rate after cashback / switching incentives are taken into account, mortgage overpayments will still benefit you at the average, up-front interest rate of the remainder of the mortgage term. Overpayments also benefit from true compounding, unlike after tax investment in equities subject to deemed disposal.

- Switching Incentives might not always be available. If they're available on the mortgage market, it probably makes sense to try and benefit from them as much as possible to reduce the effective interest rate of your mortgage. The fact that overpayments will reduce your principal and might lessen the benefit of these incentives probably shouldn't sway you off from making overpayments. There's a dearth of other easy after-tax investment options available in Ireland and switching incentives might not always be available.

- Mortgage Overpayments reduce risk, reduce leverage, provide big cashflow benefits (in the long-term), offer the opportunity to access lower LTV interest rates and provide a guaranteed return that's ultimately likely to be better than any after-tax investment in equities at the moment. This really shouldn't be overlooked. I think it's pretty easy for me as a young person, in a couple and without kids to forget that life might throw a big turd in my direction that would make these benefits much more valuable than the extra 1% I might make sticking money into the equity market. This extra 1% is unlikely to make a big difference to my life anyway.

- For practical purposes, mortgages seem to best be conceptualised as unattached debt. You'll ultimately lose your house if you don't pay your mortgage, but the debt itself has to be paid irrespective of the ups and downs in the value of your house. The benefit of paying off this debt is realised irrespective of what you do with your house, whether you trade up, trade down etc ... although there are specific benefits to making overpayments if you decide to trade up.

- Inflation's reduction of the real impact of your debt doesn't matter. Any investment you make will likely be similarly reduced by inflation.

- Equities still rock for pension investments. It always makes sense to have a plan in place for your pension before considering after-tax investments. I thought I should drop this in.

- Some after-tax equity investing would seem to be appropriate if you have a mortgage and you anticipate you'll encounter large expenses during the term of your mortgage. Having this money aside might mean you don't have to go into debt to pay the expenses (although, if you've overpaid a lot, your improved cashflow might be sufficient to meet the cost of the expense). This could include: a house extension, becoming unemployed, going back to college, buying stuff for your kids, etc ... It shouldn't be the focus of your investments though if you have a mortgage that you can overpay. After-tax equity investing would also seem to be sensible if you've paid off / are close to paying off your mortgage, have a strategy for maximising pension benefits and you don't want to become a landlord.

Again, big thanks to everyone who contributed to the thread.

 

[Brendan Burgess]

10/10 An mhaith!