Should You Repay Your Mortgage or Invest in Stocks?

Source: Images Money.

The received financial wisdom whenever you have some extra money is to pay down your mortgage. Now, worryingly, there is a growing army of naysayers questioning this.

Mortgage rates are at an all-time low of 3%-4%. Taking into account mortgage interest tax relief, it drops in net terms to about 2%-3% which might be considered practically free money by some.

So, keep the mortgage running, they say, and instead invest your money in higher-yielding assets such as the stock market -- after all, the S&P 500 rose 30% last year. Looking at the longer term, if you invested $100 in the stock market in 1993, it would have grown to nearly $400 by 2013, an annual growth rate of 6.7%.

Taking an average post tax mortgage cost of about 2.5%, the net return on capital for a long-term investor in the stock market would be (6.7%-2.5%) = 4.2%!

The argument seems tempting on the face of it. Why pay off your low-interest mortgage when you could make more money just by investing it in a S&P 500 index fund?

This is exactly what homeowners in the U.K. thought in the 1980s, and they proceeded to conduct a real-life experiment with a mortgage product called an Endowment Mortgage. Instead of repaying the principal, borrowers only paid the interest, and the principal repayment was invested in the stock market, which was booming then like it is now. The plan was that the end amount would not only pay off the mortgage, but give you an additional windfall.

By the end of the 1990s, however, it was clear that in many cases, the endowment would not even repay the principal, let alone make any money, and by the 2000s, the product was banned. A lot of people (about 1.1 million) lost a lot of money in the process, and this was after their money was invested by the so-called experts. They now face the prospect of losing their homes as they approach retirement.

So, why did these products fail when the numbers seemed so attractive?

First, let's look at the return projections of the stock market. Yes, the S&P 500 turned in a stellar performance in 2013, but the last time it posted similar returns was in 1997. Right now, every return calculation is being artificially bumped up by the 2013 performance. And as recently as 2008, the S&P 500 fell by 37%.

These, of course, are the peaks and troughs. A long-term prudent retail investor has defined entry and exit points into the market, and so it is perhaps more revealing to look at a rolling annualized return over various 10-year periods.

While past performance is no guide to the future, it does bear testament to the volatility of the stock market, so bear with the historical data as a proxy for various scenarios on how the S&P might perform.

Source: Money Chimp, S&P 500 CAGR Calculator.

What this table highlights is that stock market returns are very volatile, even over long-term periods.

These of course, are the headline figures for the index in general. However, a retail investor can only access the S&P 500 via a tracker fund like the Vanguard S&P 500 ETF (VOO 3.25%), and this depresses the returns even more. The Vanguard ETF has consistently underperformed the index -- by about 0.5% over three years, 0.8% over a year, and 0.4% since inception. In addition, even this low-cost fund has fees of 0.05% per year.

Finally, when you eventually sell your shares, you typically lose another 0.03%, and your profits are then taxed at about 15%. Layering all of these on to the S&P returns gives an even lower CAGR.

Source: Money Chimp, S&P 500 CAGR Calculator.

This is what happened with endowment mortgages in the U.K. in the 1980s. The stock market was booming, which led homeowners to believe it always would, and they ignored the risks. In that case, returns were further depressed by the fund under-performance and higher fees.

This is not to say that the stock market is not a good investment avenue, it's just that given its unpredictability, it is a bad idea to borrow money secured on your home to invest in it. So, the traditionalists had it right -- pay off that mortgage first with your spare cash before dipping into the stock market.