Why NOT-Paying-Off Your Mortage is Better For Investing

When it comes to home loan or mortgage, especially mortgage of your own home, we often get carried away by old & classic understanding to payoff your mortgage as soon as possible. While it is probably true for some people, if you’re into investing and actively planning your wealth creation, then this article will show you exactly the opposite. You will find out that by not paying off the mortgage, you will be significantly better off.

This will involve a very important concept of wealth creation: Control vs Ownership. By not paying off the mortgage you are not after ownership. But even without the ownership, you will realize that you have full control as if you own it. So, isn’t it better: still have the same power, but you pay less and even have more profit for your investing.

Before we go, I have to warn you that this topic is quite advanced. To benefit you have to have investor mindset and you need to be comfortable having debt. But to tell you the truth, if you’re not comfortable with debt and don’t have investing mindset, then you will have more hurdle to overcome in your journey achieving your financial freedom.

To Own or To Control

If you own “something”, what can you do with it ? Well, practically you can do almost anything(with certain restriction as allowed by law, of course). You may use it, modify it, you may sell it, you may gift it to someone else, etc. And of course, your name will be on the title of ownership.

For example: you own a house. Then you can stay in it, extend it, paint it, sell it, rent it out, renovate it, etc. And your name will be registered as the owner. If you buy the house outright then you will see the “Title of Ownership” straightaway, but most of us would see that title after we pay off the loan, say in 25 years.

But how about if you still have all the power as if you own it (only with a bit restriction) and the only real different is that your name is not in the “Title of Ownership” or that you will never see that ownership certificate ? This is what we refer as “controlling” instead of owning.

For example: let’s go back to the house on above example. You can still stay in it, paint it, extend it, sell it, rent it out, renovate it, etc (although you cannot just give it to somebody else). The only real different is just you never see the “Title of Ownership” in your hand as it will be held by the lender. Will you choose just control the house if you pay less money and give you better profit as investor ? Of course!

How do you control a property as such ? Rent it ? Although rent a property can give you certain control in using it as place of residence, it doesn’t give you the power as if you own it. The answer is by taking “Interest Only” loan.

“Principal & Interest” Loan vs. “Interest Only” Loan

Normally, when you apply a home loan for your own home, you will get what so called “Principal and Interest” loan. Say you take 25 years term, then after 25 years, assuming you don’t miss any single repayment, you will pay off your debt and you fully “own” your home.

When you take “Interest Only” loan, your intention is just to control the property, there is no intention of paying it off. In this example, after 25 year your debt is still not a cent less.

Now let see why – for smart investor – controlling  is a much better alternative compare to ownership. (by taking “interest only” loan – even for your own home)

The real key is the cash flow saved by “interest only” loan. In “Principal and Interest” loan, every repayment consists of 2 component: interest component and principal component. In “Interest Only” loan, you don’t pay the principal component. Hence you make cheaper repayment month after month. The question is: What a smart investor can do with this ‘spare’ cash flow ?

For example: You buy $440,000 house. You pay 10% deposit of $40,000 and take a home loan of $400,000 for 25 years term with 7.75% interest rate. Your monthly repayment if you take ‘normal’ Principal and Interest loan will be $3021 per month. On the other hand, Interest Only loan only ask you to pay $2583 per month. A cash flow saving of $438 per month (or around 14% cheaper).

(You can use this online home loan calculator to check the your own number)

Let say we stick to the real estate sector. What can one do with $438 per month / $5252 per year? Can’t it be invested on a say small $225,000 bachelor unit in the outskirt of the city which can attract rent of $225 per week?

Let’s do some rough calculation:

• Let us take 100% LVR (Loan to Value Ratio) loan. Say we got 8.0% p.a interest only loan (usually 100% LVR loan will have higher interest rate, so we use higher rate than 7.75%), the interest payable yearly is $18,000 per year.
• Say we need around $2000 per year for council, strata/owner corporation and landlord insurance.
• So, total cash flow required to maintain this second property is around $20,000 per year.
• $225 per week rental income converts to $11,250 per year (assuming 2 weeks / 4% vacancy rate, hence 1 year = 50 weeks only )
• If you’re on 40% income tax’s bracket, the deduction you received at tax return will be 40% x ($20,000-$11,250) = $3,500.
• Total cash flow available: $11,250 (rental income) + $3,500 (deduction) + $5,252 (spare cash flow) = $20,002 per year. Just enough to cover the expense.

Now let’s do side by side comparison what happen after 25 years (when you supposed to pay off the mortgage):

So, by taking ‘interest only’ loan and invest the ‘spare’ money if it were ‘principal & interest’ loan, at the end of loan (after 25 years) you end up $340,671 richer (average additional $13,627 per year) or better off by whopping 18%.

Important Parameters:

The important factors that make the numbers works, in order of importance:

1. Negative Gearing scheme. Your tax system need to give a tax deduction if an investment makes a loss (In this case, on second property costs you $20.000 per year while only making $11,250 per year rental income). If Negative Gearing is not available, you need to ‘chip in’ the additional money required to serve the 2nd loan (In this case: $3500 per year or $291 per month)
2. Property Growth Rate. The higher the growth the more benefit you can reap. In Australia, for the last 30-40 years, the property doubled in value within 10 to 15 years or around 10% per year. If I were to say “This $300,000 property will worth $600,000 in 10 years”, people tend to question that as if they don’t believe it. But if I say “This $300,000 property worthed $150,000 10 years ago”, people tend to believe it and comment “Gee, I should buy 2 before”. But the figure exactly the same: average 10% growth per year. That’s what we call the hindsight.Trying to be more conservative, we only use 6% growth in the calculation. Of course, in short term, even property can get negative growth (subprime mortgage crisis, ring a bell?). But over longer time peiod (in this case 25 years), as long as demand (population growth) more than supply (property availability) the price of the property will always always go up.
3. Interest Rate. The lower the interest rate, you will save more (percentage wise) between Interest Only loan and Principal+Interest loan.

• Loan of $300,000 for 25 year with 8% interest p.a: P&I=$2,315p.m. I(interest only)=$2,000p.m. Save 13.6%
• Loan of $300,000 for 25 year with 6% interest p.a: P&I=$1,933p.m. I=$1,500p.m. Save 22.4%
• Loan of $500,000 for 25 year with 8% interest p.a: P&I=$3.859p.m. I=$3,333p.m. Save 13.6%
• Loan of $500,000 for 25 year with 6% interest p.a: P&I=$3,222p.m. I=$2,500p.m. Save 22.4%

Things to remember:

• No deduction for interest on your place of residence (the 1st property above)
• People usually pay off their loan faster by paying extra on their Principal+Interest loan. The comparison effect can be achieved as well on ‘Interest Only’ loan by using “offset account”. You just put the extra repayment in the offset account so the amount of interest will be reduced accordingly (the amount of extra money will reduce the total debt)
• You need to calculate your own number. For every different circumstances, there might be different kind of 2nd property that need to be purchased. (In the near future, I will put this calculation tools on this website)
• If you can afford extra money, you can consider buying bigger property for the second one. This will bring more benefit at the end
• There is additional risk that need to be considered: for the 2 properties in the example you need to carry total $625.000 debt. And the debt will never decrease (as you only pay interest only, not the principal). Hence, in the event of unwanted situation, you need to make sure life insurance/trauma insurance or income protection insurance can cover the expenses and you o your family can still serve the loan.

Conclusion

Explained above with quite detail example of why by not paying off your mortgage you will end up with more profitable situation.

The key is to save some money by using ‘interest only” loan instead of “principal + interest” loan. Then use the money to invest in another property (of course you can do it in the stockmarket as well). The significant difference is that you will not gain the ownership of the property although still gain full control. Also you need to be comfortable having debt and have the necessary cash flow to serve the loan.

— Denis Kristanda

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