A tale of two sisters
Often clients are exclusively focused on paying off the mortgage. Only once the mortgage is fully paid-off will they start looking at retirement savings and other investment opportunities. By accessing home-equity many people can get their money working sooner, which can lead to magical results over time due to the power of compound interest.
Two twin sisters, Jennifer and Emily, bought homes on their 30th birthday for $500,000. Both put 5% down and chose a 3% fixed rate mortgage, and both homes had appreciated in value to $750,000 after 5 years when both sisters turned 35. On renewal both took very different approaches…
Jennifer decided to focus exclusively on paying down her mortgage for the 20 years remaining on her amortization and then started to invest (at age 55) for retirement.
In a previous post (https://kevinbell.ca/is-home-equity-a-good-investment/ ) I described how only investing in home equity fails three tests of a prudent investment – liquidity, safety, and rate of return.
Meanwhile Jennifer’s sister Emily decided to access $100,000 or dormant equity from her property to invest in a diversified portfolio.
Assuming Emily’s after-tax cost of borrowing is 2% due to the tax deductibile interest on money borrowed to invest, Emily will be paying $2,000 annually in after tax interest cost to execute this strategy as she diversifies from a single investment in her home.
Many people consider Emily’s strategy risky since she initially borrowed money to invest, some will point out that the investments could go to zero (these are generally the same people who think borrowing to buy a car is a good idea). Realistically its much more likely that a diversified portfolio of global investments will continue to perform in line with historic averages.
If her $100,000 investment returns 6% annually, after 10 years the investment would be worth $179,084.77, after 20 years would be worth $320,713.54. Keep in mind Emily would need to pay back $140,000 in principal and interest and ‘only’ net $180,713.54 after 20 years.
If the $100,000 investment returns 8% annually, after 10 years the investment would be worth $215,892.25, after 20 years would be worth $466,095.71. Keep in mind Emily would need to pay back $140,000 in principal and interest and net $326,095.71 after 20 years (on a $100,000 initial investment!)
With investing the choice is between investing and not investing. In this example, you could potentially borrow money from your home equity to invest (like Emily) or not borrow from your home equity to invest (like Jennifer). The results are clear, at age 55 both Emily and Jennifer own homes that are paid off, and likely appreciated further in value.
Depending the returns realized, Emily would have an additional $180,713.54 or $326,095.71 based on the $100,000 initial investment. Keep in mind that Emily could always access more equity to take advantage of this strategy and the power of compounding.
Which is a riskier strategy, when you consider both the possibility of losing money, but also having enough money to support your goals in retirement?