Embarking on the journey of homeownership often prompts a pivotal question: Should you direct your resources towards paying down your mortgage or invest? In this article, we dissect the crucial factors that guide this decision-making process, shedding light on interest rates, risk tolerance, and time horizon.
Interest Rates and Returns
At the heart of the dilemma lies the balance between the interest rate on your mortgage and the potential returns from investments. Understanding this interplay becomes paramount, as it directly influences the allocation of your financial resources.
Risk Tolerance
Consideration of your risk tolerance forms the backbone in this decision-making process. Mortgage payments assure a guaranteed return by chipping away at your debt, while investments introduce risks.
Time Horizon
Investing often thrives as a long-term strategy, reaping benefits over an extended period, while paying down a mortgage yields immediate advantages. We guide you through the evaluation of your time horizon, urging alignment with your unique financial goals and timeframe.
Case Study
Let’s look at a real-world scenario. Imagine you as a homeowner with a S$1 million mortgage, a 25-year loan period, and a 3% per annum interest rate. It would work out to something like this:
Payment # | Monthly Payment | Interest | Principal | Loan Balance |
1 (First payment) | $4,742.11 | $2,500.00 | S2,242.11 | $997,757.89 |
61 (5 years) | $4,742.11 | $2,137.64 | $2,604.48 | $852,450.28 |
181 (15 years) | $4,742.11 | $1,227.75 | $3,514.36 | $487,587.19 |
300 (Last payment) | $4,742.11 | $11.83 | $4,730.29 | $0 |
In the initial years, a significant chunk of the fixed monthly payment is allocated to covering interest expenses. However, the percentage of the monthly payment that goes toward interest decreases over time.
At the end of 25 years, your total cash outlay (incl. interest) is estimated at $1,422,633.94, meaning your total estimated interest paid is $422,633.94.
What if you were to make an additional $500/month principal repayment?
Monthly Payment # | Total Capital | Total Returns | Total Portfolio Value | Loan Balance |
1 (First payment)1 | $5,242.11 | $2,500.00 | $2,742.11 | $997,257.89 |
61 (5 years) | $5,242.11 | $2,056.83 | $3,185.28 | $819,546.12 |
181 (15 years) | $5,242.11 | $994.04 | $4,298.08 | $373,317.13 |
260 (Last payment) | $3,239.07 | $6.83 | $3,232.24 | $0 |
By doing so, you would finish paying off your mortgage around 3 years earlier with a total cash outlay of $1,360,445.13 with interest paid at $360,445.13. That means you would have saved $62,188.82 in interest payments.
Now, let’s look at what happens if you invested the $500/month instead.
Assuming you get an annualised return of 7%, this is what it will look like:
Monthly Investment # | Total Capital | Total Returns | Total Portfolio Value |
1 (First payment) | $500.00 | $2.92 | $502.92 |
61 (5 years) | $30,500.00 | $6,218.21 | $36,718.21 |
181 (15 years) | $90,500.00 | $70,388.40 | $160,838.40 |
260 (21.7 years) | $130,000.00 | $174,937.65 | $304,937.65 |
300 (25 years) | $150,000.00 | $257,398.56 | $407,398.56 |
If you were to invest, you would have a total portfolio value of $304,937.65 with $174,937.65 in total returns. Your investment returns would be worth more than double compared to your interest savings of $62,188.82.
And if you were to continue investing $500/month until the end of 25 years, you would have a portfolio value of $407,398.56 with $257,398.56 in total returns.
As the numbers are laid out, the choice becomes clear. However, remember that the challenge lies not in making the choice but in creating and managing a portfolio capable of delivering an annualised return of 7%.
Whether you opt for the stability of reducing mortgage debt or the potential growth offered by investments, the key lies in aligning these decisions with your unique financial goals.
This is an article by InvestAble.
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