In my last post I outlined why on average it’s better to invest your money than pay down your mortgage in an interest rate environment like the current one. However, since we only live once, we’re not so much concerned with average outcomes as we are with actual outcomes that affect our lives. This means we must consider worst case scenarios.
What if it happens to be a particularly bad year for the stock market?
There is no denying that stock markets have some very bad years. This means many people think of it a bit like a casino where you need luck in order to succeed and the odds are against you. The fact is that, unlike a casino, the odds are actually stacked towards you if you are a patient long term stock market investor. What you need to remember is that the goal of financial security and maybe independence is a long term one. This means year to year variations are not as important as building wealth over a longer period of time.
This may surprise you but the S&P500 has NEVER returned less than 5.9% per year compounded over any 25 year period. Not even if you were unlucky enough to start your investing in 1929 just prior to the great depression would you have made less than that. This means if you invested $10,000 in the worst case in the last 100 years you would have had $42,000 at the end of the 25 year investment period (1929 to 1954).
(See full list of returns here)
On average the S&P500 returns approx. 10% per year for any random 25 year period. This means that an investment of $10,000 is expected to be worth $108,347 after 25 years, which is significantly higher than the interest savings from paying down $10,000 of your mortgage.
Some of you at this point will be saying “I get it!” while others are probably saying “my head hurts from reading all these percentage! What does this mean??”. Let me give you a practical example of what happens to Jim and Amy over a time period of 17 years.
Jim prepays his mortgage instead of saving
Mortgage: $500,000
Term: 25 years
Mortgage Rate: 2.5%
Prepayment: $10,000 per year
Jim will be completely mortgage free in 17 years but will have no savings. His net worth will be exactly the value of his house and not a penny more. For the sake of easy calculation lets say the value of his house went up 50% and his net worth is $750,000, thought changing that assumptions makes absolutely no difference to the analysis. This is because paying down your mortgage makes no difference to the value of your house.
Amy does not prepay her mortgage but invests $10,000 per year in the S&P500
Mortgage: $500,000
Term: 25 years
Mortgage Rate: 2.5%
Prepayment: $0 per year
Amy will still owe $194,798.78 at the end of the same 17 years. However, she has invested $10,000 every year into the S&P500 and achieved the median 15 year annualized yearly return of 12.22%. (http://en.wikipedia.org/wiki/S%26P_500#Annual_returns).
Amy’s investing account after 17 years would be worth $560,085.80. This means she could now pay off her remaining mortgage of $194,798.78 and still be left with $365,287 worth of savings. Since the value of her house is exactly the same as Jims her net worth is $750,000 (house) + $365,287 (investments) = $1,115,287. This is 50% higher than Jims!
(You can verify all the mortgage calculations here)
What if Amy didn’t achieve the median return? Even in the worst case scenario of a 4.24% annualized return (the worst 15 year return in the last 40 years as per my previous post) she still comes out ahead of Jim (though by a smaller amount). Despite the complex calculations above the rule to determine whether to prepay a mortgage or to invest is very simple.
If your mortgage rate is higher than your expected investment return you should prepay
If your mortgage rate is lower than your expected investment return you should invest
Here is a chart of the results for your comparison:
Jim  Amy – average case 12.22% return 
Amy – worst case 4.24% return 
Amy – best case 18.93% return 

Starting Mortgage  $500,000  $500,000  $500,000  $500,000 
Yearly prepayment  $10,000  $0  $0  $0 
Mortgage after 17 yrs after its paid off from investments 
$0  $0  $0  $0 
Investment account after 17 yrs after paying off the mortgage in full 
$0  $365,287  $57,380  $939,377 
House Value after 17 yrs  $750,000  $750,000  $750,000  $750,000 
Total Net Worth (House + Investments)  $750,000  $1,115,287  $807,380  $1,689,377 
Amy’s worst case scenario is still better than Jim’s while her best case scenario makes her more than twice as well off.
So how do you get a 100% guaranteed return on your stock market investments? The answer, like most important truths in life, is simple and boring. If you invest your money in a well diversified portfolio over a period of at least 15 years, then based on history, you are guaranteed a positive return.
If after reading this you still feel like you’d rather just prepay your mortgage then you should go ahead and do that. In our society paying down your mortgage has evolved to be such a great and noble goal that many people feel a great sense of accomplishment and pride when they put down a large amount. I don’t want to play down the importance of that feeling, I just want to point out that it’s not a financially optimal decision. Also remember, if you invest your gratification may only be delayed, as one day you will have enough savings to put down that one gigantic payment and pay off the rest your mortgage in full.
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