The Overpay or Invest MISTAKE

Summary

This video dives into the complexities of deciding whether to overpay a mortgage or invest, explaining why traditional comparisons of mortgage rates and investment returns often lead to misleading conclusions. It highlights the interconnectedness of mortgage rates and investment returns, along with the psychological factors influencing decision-making. While simple math might seem to favor one option, the real decision depends on factors like certainty, risk, and personal preferences. Ultimately, the choice isn't just about maximizing returns, but finding the right balance between financial growth and security.

Takeaways

• 😀 The common approach of comparing mortgage rates with investment returns is flawed and often misleading.
• 😀 Mortgage rates and investment returns are influenced by the same risk-free rate, making the decision complex and interlinked.
• 😀 Asset prices and investments are impacted by the risk-free rate, with higher rates generally leading to lower asset prices.
• 😀 When mortgage rates rise, it often coincides with an increase in expected future investment returns, creating a tricky decision for homeowners.
• 😀 The simplified 'napkin math' of overpaying a mortgage versus investing fails to consider factors like leverage, volatility, and sequence of returns.
• 😀 Paying off a mortgage guarantees a fixed return, but mortgages in the UK tend to be shorter-term, creating additional unpredictability.
• 😀 Leveraged investing in stocks amplifies risk, and your exposure to leverage diminishes over time with mortgage repayments.
• 😀 Investment performance in the early years of borrowing is critical due to the higher leverage involved, making early returns more significant.
• 😀 In the UK, shorter mortgage periods compared to the US make the dynamics of overpaying vs investing less straightforward.
• 😀 The decision to overpay a mortgage or invest isn't purely a financial one—it also involves understanding your risk tolerance and desire for certainty in outcomes.
• 😀 The metaphor of choosing between taking the motorway or back roads to the airport illustrates how people often prioritize certainty over potential returns, even if the latter seems more mathematically favorable.

Q & A

What is the main issue with the common approach of comparing mortgage rates to investment returns?

The main issue is that this approach oversimplifies the decision-making process, ignoring the complexities of volatility, leverage, and future market uncertainties. It assumes that comparing the mortgage rate to expected returns is a straightforward decision, which isn't the case.

Why are mortgage rates and investment returns so closely linked?

Mortgage rates and investment returns are linked because both are influenced by the risk-free rate—essentially the return on loans to governments. As the risk-free rate increases, asset prices often decrease, making risky investments less appealing compared to government-backed securities.

How does the volatility of investments affect the decision to overpay a mortgage versus investing?

Investments, particularly stocks, are volatile, and when combined with leverage, this volatility can be amplified. The higher the leverage (such as with a mortgage), the greater the potential impact of poor investment performance, especially in the early years of the mortgage.

What is the concept of leverage and how does it relate to mortgage decisions?

Leverage refers to using borrowed money to make investments. In the context of mortgages, high leverage means borrowing a significant amount relative to the home's value. This increases exposure to risks, as small changes in asset prices can have large impacts on the homeowner's financial situation.

What is the sequence of return risk, and how does it affect mortgage and investment decisions?

Sequence of return risk refers to the risk that poor investment performance in the early years (when leverage is higher) can severely impact long-term financial outcomes. In the case of mortgages, the earlier years of a loan are more critical in terms of leveraging, which makes the impact of volatility greater during this time.

Why does the decision to overpay a mortgage versus invest depend on individual risk tolerance?

The decision largely depends on an individual's comfort with risk and uncertainty. Some people may prefer the certainty of paying off their mortgage early to ensure financial stability, while others may prioritize potentially higher returns from investing, even if that comes with more risk.

What does the paper referenced in the video suggest about the decision to overpay a mortgage or invest?

The paper suggests that, in the U.S. market, the decision to overpay a mortgage or invest could yield similar outcomes. However, in the future, the model showed that paying down the mortgage would likely be more beneficial, especially in markets with shorter mortgage terms, like in the UK.

What is the impact of a Lifetime ISA or pension on the decision to invest versus overpay a mortgage?

Using a Lifetime ISA or pension to invest offers tax advantages, such as tax relief or a government bonus. These factors can make investing more attractive compared to overpaying a mortgage, but there is also the risk that tax laws or pension rules could change in the future, which could alter the benefit of investing through these channels.

What does the motorway vs. backroads analogy illustrate about decision-making?

The analogy illustrates how people often prioritize certainty over potential higher returns. Even though the motorway offers a faster average journey, the uncertainty of traffic delays makes the more predictable but slower backroads a more attractive option for many people. This mirrors the choice between overpaying a mortgage (certainty) and investing (potential higher returns but more risk).

Why might someone choose the backroads over the motorway, even though the motorway has a higher expected return?

People might choose the backroads because they prefer the certainty of a guaranteed outcome, even if it takes longer. The fear of missing a flight due to traffic on the motorway reflects the human tendency to avoid uncertainty, even if the numbers suggest the motorway is the more efficient choice.