Present Value Revisited

By David McEwen

Monday 30th July 2001

A couple of weeks ago I explained that long mortgages aren't as expensive as they seem because the present value of repayments diminishes over time. This sparked a number of letters from readers.

One reader from the Hawkes Bay endorsed the concept of longer mortgages. She had heard of sad cases where people lose their jobs "who are 40-60 years, trying to find work and who, having paid off their mortgage above all else, have literally NO cash flow to call upon. The only thing they can do, and the last thing they want to do, is sell the house."

Another reader, from Wellington, asked about the benefits of paying off a mortgage as soon a possible then investing the monthly payments.

Let's revisit our two couples, the Short-terms, who borrow $100,000 for ten years at 8% ($1,213 per month) and the Long-terms, who have the same terms but extend the mortgage to 20 years ($857 a month).

When the money they pay is translated into present-day value, the Short-terms repay a total of $125,890 to the bank. The Long-terms repay $150,257, or an extra $24,000 for ten more years of borrowing.

Now let's see what happens if the Short-terms finish paying off their mortgage then invest the same $1,213 a month into government stock. Their total investment over ten years would be $145,660. Let's assume the stock pays a yield of 6.5%, with interest paid yearly and reinvested. After allowing for tax at 33% and inflation at 3%, the present day value of that money at the end of ten years would be $160,346 for a net benefit of around $15,000.

Meanwhile, the Long-terms had invested the $377 savings from their lower monthly mortgage payments on the same basis over 20 years. This would amount to an investment of $90,480 and have a present day value after 20 years of $103,066, or a net difference of $12,586.

Therefore, the net profit to the Short-terms in paying off their house in ten years rather than 20 is a mere $2,500.

However, they have saved more. After 20 years, the Short-terms would have a mortgage free house and a nest egg with a purchasing power of $160,346. The Long-terms would have a mortgage free house and around $108,000.

The message from this example is basically the same as in my last column. Paying off the mortgage quickly is a better option than dragging it out. However, those who want immediate cash flow for other purposes should take into account that longer term borrowing is not as expensive as it may seem.

The really scary thing about these calculations is how much wealth gets eaten up if you invest in assets that produce income.

In this country, every interest or dividend payment is taxed. If you reinvest the difference, you will pay more tax next time.

It is far better to invest in assets that deliver capital gains, which for most people are not taxable.

Let's take the above example, where the Long-terms invest $377 a month at 6.5% a year. After 20 years of paying tax on yearly payments and reinvesting the difference they would have an asset with a present value of $103,066.

The same amount of money invested in an asset that produces a capital gain of 6.5% a year would be worth $125,404.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz.

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