Better to invest or pay off mortgage? - the evidence.

Case Notes 09: If you have extra money, is it better to invest in the stock market or to reduce the housing loan? This is a very common question that many seemed to answer in a theoretical manner. This article looked at the Malaysian historical evidence to provide a different perspective.

Better to invest or pay off mortgage - the evidence
This post was inspired by my friend’s son. Like many other young Malaysians, he bought his house about 5 years ago with an 80% housing loan repayable over 20 years.  He was promoted recently and now has some extra money.

He was not sure whether to shorten the loan period by paying an extra amount to the bank every month. This will of course reduce the total amount paid to the bank. Is this better than investing the extra money in the stock market?

His dilemma was because he saw two articles from iProperty.com that seem to suggest conflicting results. 

This got me thinking. We have the historical evidence. 
  • We knew of how house prices have changed over a 20 years period. 
  • We knew how the KLCI has performed over a 20 years period.
  • We also knew the historical housing loan interest rates. 

From a cash flow gain perspective, which would be the better choice based on the historical data?  A cash flow gain is defined as the difference between monies received (or receivable) and those paid.

Summary

The results from such an analysis for 4 categories of houses in 4 regions in Malaysia were very surprising. 
  • The 4 types of houses covered were Terrace, Semi-Detached, Detached and High Rise.  
  • The 4 regions were Kuala Lumpur, Selangor, Johore, and Penang. 

It showed the following:
  • The results were independent of the type of houses and the location. This meant that the purchased price of the house and the potential capital gain from the house are not factors to consider. 
  • Based on the historical evidence, you are better off investing any extra monies in the stock market instead of paying more for the housing loan.
  • This is because the gain from having a reduced total amount paid to the bank is more than offset by the lower gain from investing in the stock market.  This is illustrated in the chart below.
Terrace House: invest vs pay off mortgage
Chart 1: Terrace House - Invest or pay off the Mortgage?

We should not be surprised by the results.  The historical long-term returns of the stock market far exceeded the long-term housing loan interest rates. 

I can reconcile these findings with the above-mentioned two iProperty.com articles as follows:

The article comparing the housing gain with the stock market returns did not take into account the cash flow situation. It only considered the capital gain from the changes in the house price. When the cash flow is considered, the stock market provided better returns.

The article on paying off the loan early is actually in line with my findings.  It showed that if the returns from other investments are higher than the loan interest rates, you should not pay off the loan early.  This is consistent with my findings that the long-term returns from the KLCI are higher than the long-term housing loan interest rate.

When the returns from the stock market exceeded the housing loan interest rate, you are better off not to make the extra housing loan payment. 
  • It did not matter whether you were thinking of a large lump sum payment or several annual payments. 
  • It also did not matter when you make the extra payment.

What would you do if you don’t know how to invest in the stock market?  Well, the EPF has a Top-up Savings Contribution scheme where you can make additional voluntary contributions.  Actually, it is to your loved ones' account. 

If you had invested 100 each in both the EPF and the KLCI in 1990, what you achieved over the next 20 years is illustrated in the chart below.  You can see that what you have with the EPF far exceeded that from investing in the KLCI. This was because the EPF did not suffer any drawdown. 

If you invest via the EPF, you would also be better off than making additional mortgage repayment.

Malaysia KLCI vs EPF
Chart 2: Amount achieved by KLCI vs EPF with both starting at 100 in 1990

The reverse conclusion applies. If you had the opportunity to withdraw a lump sum to pay off some of the housing loans, the historical evidence suggests that you should not do this. You are better off leaving the money in the EPF to let the savings compound. 

As I said, the conclusions are surprising and counter-intuitive. 

The above of course assumed that the future will be the same as the past.  And of course, there are limitations to the conclusion. Refer to section 6. You have to judge for yourself. 

But I would like to leave you with a quote from Howard Marks. He is the founder of Oakfield Capital that was acquired by Brookfield Asset Management in 2019. Brookfield Group is the biggest public real estate investment company in the world. 

“History doesn’t repeat itself, but it does rhyme.”

Contents

1. Comparative analysis

2. Gain from the house purchase

3.  Stock market gain

4. Financial Model

5. Malaysian Employee Provident Fund (EPF)

6. Limitations

7. Pulling it all together

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Comparing investing with paying off mortgage

1. Comparative analysis

I compared 2 scenarios based on what you can do with the extra money. 
  • Scenario A - Invest the extra money in the stock market.
  • Scenario B - Pay extra to the bank to reduce the loan repayment period.

I compared the cash flow gain under Scenario B with that under Scenario A.  

If the gain from Scenario B is higher than that of Scenario A, this means that it is better to pay the extra to the bank. 

A cash flow gain is defined as the difference between monies received (or receivable) and those paid.

Apart from the 4 different types of properties in the 4 regions, I also analyzed the impact of both Scenarios with the following variables.
  • When you first start to have the extra money.  I covered 3 periods - in year 6, year 8, and year 10 after the purchase of the house. The house is assumed to be purchased in year 1.
  • The housing loan interest rate. I looked at 4 interest rates situations - 3%, 4%, 5% and 6%.  These should cover the range of Malaysian housing loan interest rates as shown below.
MBB lending rate
Chart 3: MBB Lending rates.  Source: Trading Economics
  • The extra money. I have assumed that a buyer would have bought the appropriate type of house based on his ability to repay the loan. As such, I looked at the extra money as a % of the house value. For my analysis, I looked at 3 situations - extra money based on 4%, 5%, and 6% of the house purchase price. 

1.1. Cash flow gain under Scenario A

The cash flow gain under Scenario A comes from 2 sources.
  • Capital gain from the house. This is the difference between the house price at the end of the loan period (ie year 20) and the monies paid to the bank as well as the down payment for the house. Refer to section 2.
  • Gain from investing in the stock market. This covers both the capital gain from the increase in the stock market index and the dividends received. Refer to section 3. 

The gain from investing in the stock market will of course vary with when you first have the extra money and how much extra money you have.

1.2. Cash flow gain under Scenario B

The cash flow gain under Scenario B comes from 2 sources as well:
  • Capital gain from the house as per Section 4. This is likely to be more than under Scenario A as you have paid less to the bank.
  • Gain from investing in the stock market. You may argue that if you are using the extra money to repay the bank, where would you have the money to invest in the stock market? 

The reality is that if you make the extra payment to the bank, you will shorten the loan period. So instead of repaying the bank for 20 years, you may only have to repay the bank for 15 years. 

After this, you will have the money that would have gone to the bank repayments for other investments. I have assumed that these are invested in the stock market.

The stock market investment here will be for a shorter period.

2. Gain from the house purchase

I computed that gain from buying and owning the house for 20 years based on the following assumptions:
  • 20 years housing loan.
  • The house was purchased based on a 20 % down payment from savings and 80% from a bank loan.
  • I ignored sales commission, legal fees, and stamp duties in my analysis.

The gain from buying and owning the house for 20 years can be represented by Equation 1.  The gain in cash-flow terms is the difference between the price of the house at the end of the original loan period (ie year 20), and what you incurred.

What you incurred is the sum of what you paid to the bank plus the down payment.

Equation 1:

Gain = [ House price in year 20 ] - [ Total payment to the bank ] - [ 20 % down payment ] 

where:
  • The House price in year 20 = House purchase price X average gain over 20 years.
  • The total amount paid to the bank will depend on the interest rate and the loan amount. The loan amount is dependent on the purchase price of the house. 
  • The 20 % down payment is dependent on the purchase price.

It is obvious that the house prices and gains will vary with both the types of houses and where they are located. Since I am looking at a 20 years period, I based my analysis on the historical data from 1990 to 2019.

The following sections describe:
  • How I derived the house purchase price.
  • The average gain in house price over 20 years

2.1 Purchased house price

I derived the purchased house price based on the first Quarter 2005 data from the Malaysian National Property Information Centre (NAPIC).  This is because 2005 is in the middle of 1990 and 2019.

The chart below shows the prices for the 4 categories of properties in the 4 regions covered in the analysis.

Malaysia House Prices 2005
Chart 4: House Prices 
Key to house price chart

2.2 Average gain in house prices over a 20 years period

I already had data for the average gain in the various categories of properties from my previous analysis.  Refer to “When is the best time to buy a house in Malaysia?

In that article, I analyzed that price gain over several rolling 20 years periods.  I reproduce the chart below for Kuala Lumpur as an example to show the gains from various 20 years rolling periods.  

Capital gains by types of houses in KL
Chart 5: Capital Gain by Types of Houses in KL

The average gains for each type of house were based on all the respective rolling 20 years period gains.  For example, the average gains over the 20 years period for Kuala Lumpur were as follows:
  • Terrace House - 242 %
  • High Rise - 107 %
  • Semi-Detached House - 271 %
  • Detached House - 318 %

3.  Stock market gain

There are two sources of gain from investing in the stock market 
  • Capital gain - refer to Section 3.1 
  • Dividends - refer to Section 3.2

I used the changes in the Kuala Lumpur Composite Index (KLCI) to represent the gain from investing in the stock market.

3.1 KLCI capital gain

To be consistent with the property gains, I looked at the stock market capital gain from a rolling period basis.  I derived the rolling capital gains as shown in the following example:
  • If you invest for 1 year, the average gain for a 1-year period is the average annual gain from 1990 to 2019.
  • If you invest for 2 years, the average gain for a 2-years period is the average gain for all the 2 years rolling gain from 1990 to 2019.  
  • If you invest for 10 years, the average gain for a 10-years period is the average gain for all the 10 years rolling gain from 1990 to 2019. To elaborate there are twenty 10-years periods as shown below with an average gain of 56 %

Periods

Gain

1990 to 2000

46 %

1991 to 2001

26%

1992 to 2002

7%

1993 to 2003

-26%

1994 to 2004

4%

1995 to 2005

-13%

1996 to 2006

-2%

1997 to 2007

144%

1998 to 2008

50%

1999 to 2009

37%

2000 to 2010

109%

2001 to 2011

112%

2002 to 2012

145%

2003 to 2013

120%

2004 to 2014

94%

2005 to 2015

82%

2006 to 2016

41%

2007 to 2017

34%

2008 to 2018

90%

2009 to 2019

22%

Average

56%


I computed the average rolling gains for the various holding period and then plotted them as shown in the following chart.

KLCI Capital Gain
Chart 6: KLCI Capital Gain - best fit line

You will note that the gain increases with the investment period. To simplify the analysis, I found the best fit line to represent the gain for various periods - this became Equation 2.

Equation 2 

KLCI gain = [ 0.0663 X Investment period ] - 0.0557

For example, if you invest for 5 years, then the capital gain 

= [0.00663 X 5] - 0.0557

= 0.2758 or 27.58 %

3.2 Dividends

Over the past decade, the dividends paid by the companies making up the KLCI generally ranged from 2.75% to 3.25% as can be seen from the chart below. 

For the purpose of the analysis, I have assumed that it is 2.75 % per annum. 

KLCI dividends
Chart 7: KLCI Dividends  Source: CEICDATA

I have assumed that the dividends received would be reinvested back to the stock market. 

Thus, the total gain from dividends is not just the annual dividends received but also the capital gains from the reinvested dividends. 

The above analyses show that some numerical skills are helpful when you invest in the stock market. This is especially if you invest based on fundamentals.

What happens if you don’t have the skills to do this yet want to invest based on fundamentals?  One way is to rely on third-party advisers to undertake the fundamental analysis for you. 

There are several financial advisers who provide such analyses. Those who do this well include people like The Motley Fool. Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.


4. Financial Model

The financial model was developed using Equations 1 and 2.

Total Gain = Capital gain from the house + Gain from the Stock market
  
                  = Equation 1 + Equation 2

For each of the Scenarios, I look at the results based on the following parameters:
  • 4 categories of houses - Terrace, Semi-Detached, Detached, High Rise.
  • 4 regions - Kuala Lumpur, Selangor, Johore, Penang.
  • 4 housing loan interest rates - 3%, 4%, 5%, 6%.
  • 3 points in time to start the additional loan payment - after 6 years, 8 years, and 10 years.
  • 3 additional loan payments as a % of the housing loan - 4%, 5%, 6%

The value of the house will depend on the type and where it is located. Together with the bank interest rate, this will determine the annual amount to be paid to the bank over the 20 years loan period.

The returns from the stock market as well as gain from the property will be affected by
  • When you start to pay the additional amount. 
  • The quantum of the additional payment.

I then computed the gains under both Scenarios for the various parameters. The chart below summarized a sample result.

Invest of pay off mortgage KL Semi-D
Chart 8: KL Semi-D. Invest or pay off Mortgage?

4.1 Reviewing the results 

For all the possible combinations of parameters, the results were that Scenario A outperformed Scenario B. In other words, if you had the extra money, it is better to invest in the stock market rather than pay extra.

It was a counter-intuitive result.

To verify that it was not a computation or modeling error, I decided to check the model mathematically. For those mathematically inclined you can refer to Appendix 1.

The mathematical model showed that the results are independent of the following parameters:
  • The type of house.
  • Where it is located.
  • The housing capital gain achieved.

Whether Scenario B would be a better option is very dependent on how large the housing loan interest rate is compared to the stock market gain.

For situations where the annualized stock market returns are greater than housing loan interest rates, Scenario B is never better than Scenario A.  

Mathematically, this can be explained. Refer to Appendix 1.

It was only when I set the housing loan interest rate at 9 % that I could get some situations for Scenario B to be the better option based on the Financial Model. These were for 
  • Starting the extra payment in year 6 with the extra amount based on 4% or 5% of the housing loan.
  • Starting the extra payment in year 8 with the extra amount based on 4 %.

Even with the housing loan interest rate at 8.5 %, there were no situations where the Financial Model had Scenario B being better than Scenario A.

The analyses showed that once the returns from the stock market exceeded the housing loan interest rate, it does not matter how the additional payment was made. 

Paying off extra to reduce the loan repayment period is not better off irrespective of
  • When you start to pay off.
  • How much additional you pay off   


5. Malaysian Employee Provident Fund (EPF)

For those who do not know how to invest in the stock market, there is an alternative way to invest - by making an additional contribution to the EPF

The EPF has a Top-Up Savings facility where the Topper may voluntarily make additional contributions to his family members’ (Toppee) EPF account.

The chart below shows the annual dividend paid by EPF from 1990 to 2020.

EPF Returns
Chart 9: EPF Returns

Assuming that a contributor started with 100 in 1990, I derived the amount the person would have using the annual returns in Chart 9.  I then compared this with those achieved by investing 100 in the KLCI starting in 1990.

You can see that what you achieve with the EFP over a 20 years period exceeded those from the KLCI as illustrated in the chart below.  This is because there is no drawdown for the EPF.

KLCI vs EPF
Chart 10: Amount achieved by KLCI vs EPF with both starting at 100 in 1990

Given that the returns from the EPF on a long-term basis exceeded those of the KLCI, there was no logic to further analyze. 

Nevertheless, I ran a few simulations with different amounts and different payment timing and found this to be correct.

In order to have a consistent approach, I computed the various rolling years' returns for the EPF as per the KLCI analysis.  I then plotted the returns and obtained the best fit line as shown below to use in the simulations.

EPF return cw best fit line
Chart 11: EPF return - best fit line

I also examined the EPF scenario from the reverse perspective. If you could withdraw a certain lump sum from the EPF to repay part of the housing loan, should you do so?

Logically you should not do so as you are reducing the potential gain from the EPF when you withdraw. At the same time, the potential savings from the housing loan is smaller as the housing loan interest is lower.

6. Limitations

The above conclusions are of course dependent on the differences between the returns from the stock market (or EPF) and the housing loan interest rates. 

It is valid as long as the housing loan interest rates are lower than the investment returns.

It is also dependent on what you do once you have fully paid off the housing loan. In my analysis, I have assumed that you would invest the additional money (from no longer having to pay the housing loan) in the stock market. 

Technically it is invested in the same asset class as what you would have invested in if you chose not to make the additional loan repayment. If the investment vehicles are different in both Scenario A and B, not only would the returns be different, but the risk profile would be different.

Finally, I would point out that my analysis is mainly a numerical analysis. In reality, you have to consider other qualitative issues such as liquidity, penalties for early redemption, or mortgage insurance benefits.


7. Pulling it all together

If you have “spare money” should you repay more of your housing loan or should you invest it?

This a very common question and there are many articles online about this topic. The general advice is that you should invest if the returns from investment far exceeded the housing loan interest. 

I looked at the question in the context of the historical evidence -  the actual performance of the KLCI, the actual change in property prices, and the historical housing loan interest rates.

In the context of using the "spare money", I covered several scenarios:
  • Lump-sum vs annual payments.
  • When you start the additional repayment.
  • The amount of the additional repayment

The conclusion is that in Malaysia, it is better not to pay more of your housing loan. Instead, invest the “spare money” in the stock market. 

Alternatively, contribute the “spare money” to the EPF.  And counter-intuitively, do not withdraw the EFP money to repay the housing loan.

The analysis showed that the conclusions are independent of 
  • The type of houses.
  • Where the houses are located.
  • How you use the “spare money” to repay the loan.


END


Appendix 1 

A mathematical model of the comparative analysis between Scenario A and Scenario B

Item

Item

Comments

House price at the start


P

Original house price - varies with the type and region

House price in yr 20

 

Q

House price at the end of the 20 years loan period. Varies depending on type and region

Loan amount

 

0.8P

Based on 80 % of the value of the house

Down payment

 

0.2P

Based on 20 % of the value of the house

Scenario A total paid to the bank


R

Payment for 20 years. Varies with interest rates and loan amount

Scenario A extra money


aP

a % of original house price

Scenario A housing gain


Q - R - 0.2P

 

Scenario A Stock market gain


S

Varies depending on “a” and investment period. The period is 20 minus the start of the year with extra money.

Scenario A total gain

 

Q - R - 0.2P + S

Housing gain and Stock market gain

 

 

 

Scenario B total paid to the bank


T

This is less than R

Scenario B available for the stock market

R - T

 

 

Scenario B housing gain


Q - T - 0.2P

 

Scenario Stock market gain


U

Varies depending on (R - T) and investment period

Scenario B total gain

Q - T - 0.2P + U

 

 

 

 

Scenario B - Scenario A

 

[R - T] - [S -U]

 


You can see that the house price at the start, the house price in year 20, and the down payment cancel out each other.

In other words, the value of the house is not important ie the results are independent of the type of house, where it is located and the capital gain achieved.

Rather it depends on 
  • [R - T] which is the difference in the total amount paid to the bank under the two scenarios.
  • [S - U] which is the difference in the stock market gain under the two scenarios. 

For Scenario B to be the better option, mathematically
 
[R - T] must be greater than [S - U]

Now [R - T] is a function of the bank interest rate.  T is also a function of when you start to pay the extra sum as well as the % of the extra sum.  

[S - U] is a function of the stock market return as well as when you have the extra money as well as the % of the extra sum.

If the loan interest rate is less than the investment return, it is unlikely for [R - T] to be greater than [S - U].  In other words, it is unlikely for Scenario B to be a better option. 








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I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

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