I think I need to get better at time management. It’s only 8:55 in the morning, and I’ve already gone off on a rant.
This is what my older sister Konra wrote to me this morning:
“Hey Megs, at one point you wrote an article on paying down your mortgage vs investing. My coworker sold her house and her financial person told her not to reinvest all the money in her new house, but to invest some and put some on the mortgage. I think you discussed this at some point but I can't find the article.”
I have a lot to say on this topic. Konra’s co-worker, this column is for you.
First, let’s look at why anyone would consider entertaining this idea.
To start off with, interest rates are really low right now. Our mortgage is renewing in October, and we're looking at renewing at 2.2%. Historically speaking, this is ridiculous. A leader in The Economist from mid-June says that according to Bank of England records dating back to the 17th century “before 2009, [interest rates have] never fallen below 2%”. And Charlie Munger, Warren Buffet's lifelong friend and business partner, has recently been quoted saying "if you have any degree of intelligence, this whole situation is baffling". Interest rates aren't meant to be this low. It's artificial, and it's not sustainable.
The second piece of the puzzle is that markets in general tend to have a higher growth rate on a long term basis than real estate. Over the last five years (May 2010 to May 2015), the Toronto Stock exchange has compounded at a rate of 5.0% per year (The Financial Planning Standards Council suggests an appropriate projection for an aggressive portfolio may be closer to 6%) while the Canadian Home Price Index has compounded by 3.9% per year.
So interest rates are low right now. Fact. And markets can provide a higher rate of return over time than Real Estate. Fact. Also, the markets provide diversification and liquidity, so there’s that (note that I’m not considering the tax-deductibility of interest borrowed to invest because a property-backed mortgage will have a lower interest rate than an investment-backed loan, so even in the most ambitious scenario it’s a wash).
That’s the basic summary of your upside potential. Paying 2% per year for the potential of earning an additional 2%+ of taxable growth.
That’s my first issue – upside potential is limited and often overly optimistic. Next time you get into a car, you’re probably going to arrive at your destination safe and sound. That’s the optimism part. But would you drive away without making sure your kids are buckled into their seatbelts? Heck no, you wouldn’t. Because the potential consequences of strategy failure can be catastrophic. So let’s talk about that part now, shall we?
We’ve got two potential investment components – Real estate and market based. I’ll hit on real estate first.
Remember during the 2008 recession when the US went through crisis? A lot of people were mortgaged to the maximum they could afford, which was fine for as long as the market value of houses kept going up. When prices swung the other way, a lot of people ended up owing more on their home than their home was worth. The exit strategy was to give the keys back to the bank, and so started the property-value implosion. It was devastating to some communities. Last week Detroit began auctioning off over 16,000 homes. Bids started at $1,000, and analysts suggest most of them likely won’t sell.
Now Canada’s at a place where the OECD is suggesting our housing market is overvalued by 30%. Multiple analysts are suggesting a looming correction could be as severe as 50%. So the downside potential for real estate right now is very high.
Our second investment component is the markets. Traditionally, significant market corrections occur every 5 to 7 years and we’ve now just past 7 years since the start of the 2008/2009 crash. Multiple indicators suggest that the Canadian market is currently overvalued, and the Buffet Indicator places us as the sixth-most overvalued of the 22 largest countries in the world. I can’t tell you with any certainty when the next correction will hit, but I can tell you for sure that there will be another one. And it looks like it might be sooner rather than later.
Since 1956 the depth of the average market correction was 28%. I’m going to use 20% as a proxy later on.
So there’s your summary of the downside potential. Overvalued housing and investment markets with the looming potential for significant corrections.
One more quick thing and then we’ll pull it all together.
I don’t know all of the fine details of the recommendation, but I do have a concern over a conflict of interest. Banks make money when you have a mortgage with them. They also make money when you invest with them. And if you’ve got a mortgage with them they’re probably going to try to sell you mortgage insurance as well, so that’s three things. It’s likely that the “advisor” who made this recommendation has either sales quotas or bonuses linked to all three things. In the face of such bonuses/quotas, it could be very challenging for the representative to place the client’s interests above their own. No one can serve two masters.
So here we have the facts. Upside potential is limited, and investments would be purchased near their all-time highs when signals for a recession are becoming predominant. Interest rates are likely to rise, and there is a real risk that property prices will fall. The mortgage itself won’t drop proportionally to housing prices – it’s still that big dark cloud casting a shadow over the whole thing.
Now let’s integrate some numbers so you can really see the full impact.
Scenario A - The house is worth $300,000 and the potential downpayment is $200,000. You split the downpayment in two and invest one half in the markets and the other half goes against your home. Boom. Recession. Property prices have dropped by 30%, so your property is now worth $200,000. That’s the same amount as your new mortgage, so they wash each other out. The $100,000 invested in the markets has dropped by 20%, so it’s only worth $80,000. Your total net worth is $80,000.
Sceanrio B –You put the whole downpayment against your mortgage. Boom – recession hits. Housing prices drop by 30%, so your house is now worth $200,000. Your mortgage is only $100,000. Your total net worth - $100,000.
In my opinion, and for my risk tolerance, the consequences of a collision without a seatbelt are too severe to consider driving without one. Even though an investment strategy may be suitable or the historical odds favorable, doesn’t mean it’s in your best interests. If you want an advisor who adheres to a Best Interests strategy and is banned from operating where a conflict of interest is present, then you need to speak with a CERTIFIED FINANCIAL PLANNER© today.
Written by Meagan S. Balaneski, CFP, R.F.P CERTIFIED FINANCIAL PLANNER®
Advantage Insurance & Investment Advisors
Investment Funds Representative
Manulife Securities Investment Services Inc.
The opinions expressed are those of Meagan S. Balaneski and may not necessarily reflect the views of Manulife Securities Investment Services Inc.