The last and final topic in debt reduction is the mortgage debt. As I mentioned in an earlier post about the water not being fine, massive escalation in housing prices relative to income has resulted in sky-rocketing mortgage debt. However, mortgage debt is different than other forms of debt such as credit card or student debt because it is tied to a tangible asset – your house.
In the road to financial independence, the two most common questions that get asked are:
1. Should I pay off my mortgage before I start investing?
2. What is the maximum mortgage I should have?
I will attempt to answers these questions in a simple way.
Pay off mortgage or invest?
First of all, mortgages rates tend to be significantly lower than credit card or student loan rates – mostly between 3%-5%. An investment portfolio built on low-cost index funds (more on that later) can conservatively return between 6%-7% on an annualized basis. So, it definitely makes sense to make the minimum payments on your mortgage and divert the extra funds towards investing. Unless, of course, you are one of those people who sole purpose in life is to have a mortgage-free home! In that case, you might want to check out Sean Cooper, who went hardcore and became mortgage-free in three years! (You always learn the most from people who hold an opposing point of view).
Anyhow, the answer to the first question depends on what interest rate you have on your mortgage. Typically, if your interest rate is 4% or lower, you are better off paying the minimum and investing the rest. If your interest rate is higher than 4%, then you should target to reduce your total debt down to an acceptable level or refinance to a lower interest rate.
Some thoughts on refinancing
Refinancing has its own quirks. There is no single perfect answer as everyone’s situation is different. Here is an excellent article on refinancing which you can use to make the best decision. Two rules of thumb for refinancing are:
a. Select variable rates – the reason is simple. You will pay lower interest. But what if interest rates rise? Well, numerous studies have shown that borrowers are likely to pay less interest with a variable rate loan compared to a fixed rate loan. Lenders will often exaggerate the risk to push you to signing up for a fixed-rate mortgage. If even interest rates do rise, then often go up gradually. The only scenario when variable rates can become more expensive is when there is a 1981-style crisis where the Fed sharply raised interest rates. However, that was a once-in-a-blue-moon event and is unlikely to happen anytime soon again. Remember what I mentioned about risk exaggeration in my post on consumer debt??
b. Know the differences between US and Canada – depending on where you live, different rules apply. Make sure you know the differences in mortgages in US and Canada. Here is a good discussion on what the differences are.
Maximum mortgage amount
In an earlier post, I talked about the findings from Generation Squeeze where housing prices need to significantly drop to make them affordable. When it comes to the maximum mortgage amount, I like to use the CMHC definition – total housing cost must be a maximum of 30% of pre-tax household income. However, I like to change it slightly – total mortgage cost must be a maximum of 25% of pre-tax household income – after all, there are costs associated with property taxes, utilities, insurance and general maintenance. Using this definition, you can easily plug the numbers in a standard mortgage calculator and disregard the other household costs (which depends on a lot of factors such as where you live, you big your house is and how old it is).
In an earlier post, I mentioned that the road to financial independence lies in developing a rich mindset and eliminating/substantially reducing your debt. This is where it comes into play. If you can reduce your total mortgage debt to a level where your servicing costs are 25% or below of your income, then you have achieved that goal. If you are there, that’s great! Otherwise, direct your firepower there (after you have completely destroyed your consumer and student debt).
A simple example
You can use an online mortgage calculator to see how it works. Lets walk through a quick example. Lets suppose your annual household pre-tax income is $100,000 (round numbers used). Also, assume that the interest rate is 3.5% and amortization period is 25 years.
Income = $100,000
Affordable servicing cost = 25%@100,000 = $25,000 (your mortgage servicing cost should not exceed that).
Go into calculator and enter the following:
Mortgage amount = $375,000 (this an approximate amount)
Term = 1 year (this will give you annual costs)
As you can see, the total mortgage costs come out to $22,467.17. Since this amount is less than $25,000, you can make estimates of the total mortgage amount until you hit that your $25K limit. In this case, a total mortgage amount of $417,000 will give a total mortgage cost of $24,983.49 which is where we want to be.
So what does it mean? With a pre-tax income of $100K, if your outstanding mortgage is $417K or below, then your debt is affordable. If not, then you should target to make extra payments over and above your regular ones to bring the monster down to size.
Please note that this not intended to be a full-scale discussion on mortgage debt. There are other variables as well such it whether it makes sense to pay down mortgage debt if your house is underwater (you owe more than the house is worth) or whether should you include rental income, if any, in your total costs? Those are separate discussions on their own (see what I meant when I said that housing is too complex of a topic to discuss in a simple post).
Summary
In the last few posts, I have gone extensively over the different types of debt. The three different types of debt are consumer debt, student debt and mortgage debt. There are different ways to overcome each one but the keyword is discipline. Once you come up with your specific game plan, stay strong and stick to it. I cannot emphasise that enough. Discipline will reap you huge benefits, especially as you continue your journey to financial independence and transition from the debt elimination stage to the wealth generation stage (more of that in later posts).
That’s about it.
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