Finding optimal balance between unscheduled mortgage loan replayments and financial market investments

Question

Imagine the following situation.

• You have a mortgage loan, it has a quite low fixed interest but runs over a couple of decades
• You have positive experiences over a couple of year with the financial market
• You have some annual savings

Then,

• It's possible to reduce the mortgage loan's compound interest by unscheduled payments
• But maybe it could be a better plan to find some well-educated decision to balance investments between the financial market and loan's unscheduled repayments, but not having too high risk by trying for example finance the repayments from the financial market income.

Is this actually something you could compute in a formula using according some variables as assumptions? Additional consideration is also the inflation rate - with high inflation it might not make sense at all to make the unscheduled repayment.

Answer 1

Extra payments on your mortgage, ignoring taxes, are identical to investing in bonds that pay whatever your mortgage loan rate is. If you're in the US, most homeowners these days can't itemize to deduct their mortgage interest so you can usually ignore taxes but you could account for the additional tax benefit as well if you're in the minority.

While your mortgage rate is undoubtedly low historically, it is almost certainly higher than what you'll get for investing in bonds of a similar level of risk. And almost certainly less than what you'd expect to gain investing in stocks.

Assuming you have an asset allocation that puts some of your money in bonds and some in stocks, you'd likely get a higher yield by putting your bond money toward your mortgage. So if your intention would be to hold, say, 20% bonds and 80% stocks, it would be reasonable to use the 80% for stocks and the 20% for mortgage payments.

Answer 2

Is this actually something you could compute in a formula using according some variables as assumptions?

This is an age old question, and isn't new.

If you get a 30 year mortgage, and keep that mortgage until the loan is paid off, then due to the nature of the declining loan amount less and less of the payment is interest. Also over those decades as your income grows, and the kids move out of the house, the loan becomes easier to pay for. That leads to the dilemma: should I pay it off faster, or use the extra cash I have each month to invest in my retirement funds, or travel, or get a new expensive car?

There is a related question that sparks debate: do you want to still want to have a mortgage in retirement, or is the goal to payoff the mortgage before you retire?

These issue spark articles, blog posts, chapters of books, even whole movements and books.

Determining what to do is a personal decision. The formulas and spreadsheets can help put some of this into focus. But they can't answer it fully due to uncertainty: how will the market act over the next X years? You also have to make assumptions regarding future income, and future expenses.

The biggest issue is that it can't measure your personal goals, or what will make it easier to sleep at night. Some people need to pay the mortgage off as quickly as possible. Others have no problem keeping it well past retirement.

Investing that extra cash does have risks. But if you are behind on your retirement savings then putting the extra money into your retirement accounts could make sense. Paying extra on the mortgage locks that extra cash away, but if next year you lose your job it didn't lower your monthly expenses unless your refinance. Of course getting money out of your retirement accounts isn't easy either.

Answer 3

Is this actually something you could compute in a formula using according some variables as assumptions?

Yes.

It's called "volatility" which is a quantitative metric of the "risk" of a specific investment. Your mortgage has basically 0% volatility but a low rate of return. The S&P 500 has a much higher average rate of return but also a much higher volatility The long term average has been 15.2% but there have also been times of much high volatility.

High volatility basically means that the rate of return fluctuates a lot over relatively short time frames. This includes going negative, i.e. loosing money and sometimes significantly so.

One way to manage your investment is to set yourself a target volatility. This target is basically based on your time frame on when you think you will need the money. High volatility investments will tank occasionally and you need to be able to wait it out until it has recovered. After the drop in 2000 it took the S&P500 over 8 years just to recover (i.e. 0% rate of return).

If you have a time frame of 15+ years, you can target a higher volatility and over time rebalance to a lower volatility in small gradual steps.

Example: if you want a volatility of, say 10%, you can put 2/3 of your investment in an S&P 500 fund (or equivalent) and 1/3 into your mortgage (or bonds, etc)

This all assumes that you have no other debts, sufficient emergency savings and have already maxed out all tax advantaged saving vehicles (401k, IRA, Roth, HSA, etc.)