### Mortgages…. most of us have one, but do we really understand their true cost, not just in terms of money but also in terms of freedom?

According to the **Financial Conduct Authority Statistics on Mortgage Lending**, the outstanding value of all residential mortgages in the UK currently stands at **£1,417 billion**, an increase of 3.8% from a year ago *(Q2 2017).*

Did you also know that the word ‘mortgage’ derives its name from **Old French**… *mort gage* translates as **‘death pledge’**…. so called because the pledge *(deal)* ends *(dies)* either when the debt *(property loan)* is paid in full or when the payment fails and the property is seized.

So if you have a mortgage *(and I count myself among you!)*, we are on the hook for huge sums of money and it may be smart to focus our energy on finding creative ways to pay down the debt. Doing so could potentially save thousands in interest payments and reduce the mortgage term significantly.

If, you are currently renting and thinking you are **‘throwing money away to your landlord’** or contemplating your **first property purchase** this article might ruffle some feathers!

That is because in this post I would like to explore the concept of **‘opportunity cost of capital’** and use mortgages as the example.

**Opportunity Cost of Capital**

If you are not familiar with Opportunity Cost of Capital, let’s kick off with a trusty definition:

“Opportunity cost of capital represents the benefits an individual, investor or business misses out on when choosing one alternative over another.”

You see, most of our day-to-day choices aren’t made with a full understanding of the potential **opportunity costs**. If we are cautious about making a purchase, we usually reference our bank balance before choosing to spend money – i.e. do I have enough money to afford what I’d like to buy?

Mostly, we don’t think about the things we **must give up** when we make those spending decisions – i.e. what else could that money be doing for you?

It may seem a trivial example, but if you spent £2.50 per day buying a fancy Starbucks coffee every day on your way to work for the next 20 years *(assuming prices remained fixed of course!) *what opportunities are you missing out on?

Aside from the potential health effects, investing that £2.50 could add up to just over **£16,500** in that time frame, assuming a very realistic 5 percent annual rate of return.

*(based on an assumption of 260 working days per year, less 25 days annual leave = a daily coffee spend of £2.50 for 235 days per year, over 20 years at 5% per year) 😮*

While it may sound like overkill to think about opportunity costs every time you buy a coffee, it’s nevertheless an important concept to wrap your head around – one that can be applied to financial decision making in our everyday lives.

## The Opportunity Cost of Mortgages

To illustrate this on a grander scale, I’m going to use the scenario of **mortgages** – typically the biggest financial commitment we will ever make!

I guess a good starting point is to pose the question as to whether you think buying a house equates to **holding an asset?** In my opinion, the vast majority of people incorrectly perceive their house to be an asset rather than a **liability**. Let’s think about this a bit more…

When you take a mortgage from a bank, that bank has a **claim on your house** for the entire term of the mortgage, meaning you don’t actually own anything except a **contractual obligation to repay that debt**.

Over the life of the mortgage *(or multiple mortgages as you switch deals over time)*, you will repay a **serious multiple** of what you initially borrowed via the combination of principal repayments and interest charges incurred as you pay down the balance of the loan.

If you have a mortgage, go check your terms and you’ll probably see a line in there somewhere that states:

“For every £1 borrowed, you will repay £1.46”

That is exactly what my current mortgage particulars spell out by the way. It’s somehow easier to stomach when you see it boiled down to a **per-pound-borrowed** amount rather than the hundreds of thousands of additional pounds we end up paying 😉

Of course, yours will depend on the loan amount, the interest rate charged and term of the mortgage.

Now, traditional views would dictate that property is a **great investment** or a natural **hedge against inflation**. If the property value increases over time by an amount larger than the amount you paid for it, then, of course, you do ultimately make some **return** from it.

But what if we were able to truly quantify the **opportunity cost** of taking that mortgage vs. not taking that mortgage and establish what you **value your freedom** at in deciding to own the property and take on that mortgage?

## Valuing Freedom

Of course, the very first thing a mortgage does is take away most, if not all, of your **freedom**. You are obliged to pay that mortgage payment every month.

If the equivalent choice is **paying rent**, then you may hear comments such as:

“My rent would be the same as a mortgage payment so what’s the difference” or “at least if I pay a mortgage it goes towards my property and I’m not gifting money to my landlord”

I’m sure you have heard or similar comments a hundred times…

Well when it comes to valuing your freedom, actually you don’t** HAVE** to pay rent every month. You can at least up sticks and leave that rental property, seek a cheaper rental elsewhere, move in with friends…. whatever it might be in an effort to try and **live within your means** and not stretch yourself financially.

Okay, these may not all be preferred solutions, but you at least have a **good degree of freedom**, whereas with the mortgage you have **very little freedom**.

Before you even get the keys to your new property it is possible to sit down and **value your freedom** for the next 25-30 years. This is easy to do with a few simple assumptions…

**Introducing Jim**

Our dear friend **Jim** has been searching to find his dream property and finally settles on the one he wants to purchase.

Jim puts down a hard-saved **£75,000 deposit** and borrows the remaining **£425,000** to buy the house at the agreed purchase price of **£500,000**. The deal is done, the papers are signed!

Let’s assume Jim managed to secure his mortgage at an interest rate of **3.75%** over a term of **30 years** *(360 months)*.

While you can argue that a cheaper mortgage might be achievable in the current climate, rates have been at unprecedented lows. The long-term average mortgage rate in the UK is actually nearer **5%** *(typically trending at 1-2% above the official Bank of England base rate)* and a 30-year mortgage term is fairly typical for a first-time buyer.

Fast forward a month or two and Jim finally completes on his purchase and gets the keys to his new pad. It’s time to celebrate! Jim is finally on the property ladder and the proud owner of his own home.

But what does Jim really own here? In reality, Jim owns…… **absolute nothing!**

Jim did not really buy a house. Instead, he bought a **liability of 360 payments** over the **30-years**. If Jim were to miss one or two of those payments, the bank will come looking to **repossess** the property. Jim won’t, in fact, own the property until his loan is **paid off in full**. Until that point in time, Jim’s new house will remain a **liability**…… not an asset.

“Jim has not bought a house but a liability of 360 repayments over 30 years”

**Crunching the Numbers**

Let’s take a closer look at what Jim has signed up for…

Well, Jim’s mortgage equates to a monthly repayment of approximately **£1,968.24** per month. He needs to pay this every month for **360 months**. Clearly, over the life of the mortgage, Jim will pay considerably more than the £500,000 purchase price.

He will actually repay **£708,566 **on his original mortgage loan of £425,000. Add back in the **£75,000** downpayment he made, and that’s a total cost of **£783,566 **

That’s **57% more **than the purchase price of £500,000 or *(ignoring the £75,000 deposit)*, the equivalent of paying back **£1.67 for every £1 borrowed** on the mortgage loan of £425,000.

But let’s make an assumption here…. Property prices always go up over the long-term right? This is certainly something people generally subscribe to, so let’s roll with it…

Let’s say that after 30 years Jim’s property has **doubled in value** and is now worth a cool **£1m**. Has Jim done well in this situation? He’s a property millionaire after all 😉

Well, we already know that Jim has actually repaid a total of **£708,566 ***(not counting his deposit)*. If the house is now worth £1m, it means that Jim has a net profit *(in theory)* of £291,434. Of course, it’s not liquid profit unless he sells up. But let’s recall that in achieving this outcome, Jim also **gave up his freedom** for the whole duration of his mortgage. Jim undeniably has made money, but at what** cost?**

“Jim was rewarded for giving up his freedom!”

In terms of valuing that freedom, we can quantify this by showing that Jim effectively values his freedom today at **-£208,566**

* £500,000 (the full purchase price) less £708,566 (the full amount repaid excluding deposit). *

**But What About the Opportunity Cost?**

The £75,000 that Jim put down as a deposit could have been invested in something else other than as a deposit in his property. Something which could have **compounded for him over time**. A commonly quoted long-term return number for a low-cost, diversified equity product might be **10%**. So let’s go with that figure for argument’s sake and meet Jim’s best friend **Sally**…

**Sally**

Let’s say that 30 years ago, at the same time that Jim was signing his mortgage papers, Sally also had **£75,000 **saved for a deposit. She initially looked at buying a similar house to Jim’s but decided she could ultimately make her money work better for her by choosing not purchasing a house.

Instead, Sally opted to **invest **her £75,000 into a low-cost fund that delivered** 10% returns per year **compounded over 30 years.

So rather than buying a home *(a liability until paid for in full)*, Sally opted to be a **long-term renter**, enjoying a **greater degree of freedom** than Jim, and always living comfortably within her means.

With her money compounding in this way, over the same 30 year period, Sally’s £75,000 grows to **£1.3m** *(£1,308,705.17 to be exact!)*

**A Word On 10% Returns**

The **MSCI World Index**, a commonly referenced benchmark for broad global equity returns, returned 12% annualised in sterling terms over the last 10-year period to the end of September 2018. Yes, you *can’t technically buy an index*, but it is not beyond the realm of possibility that a low-cost tracker fund, could achieve similar returns over a comparable time frame.

**Decisions, Decisions**

Let’s recap …

So we have Jim who is rewarded for giving up his freedom. For 30 years he has to make that mortgage payment every month. He doesn’t own anything until that very last payment has been made. But, **IF** the house is eventually worth £1m after 30 years then Jim has made a tidy **£291,434** of profit.

And we have Sally who decides to stash her money away into a vehicle that gives her a 10% annualised return *(without any further investment)*, which compounds her original £75,000 into **£1,308,705**

**So What is the Opportunity Cost of Capital?**

If you believe you can make 10% per year on your money and live within your means, then the £500,000 property Jim purchased, would have to increase in value by **£1,308,705 ***(to be worth £1,808,705)* to

**pay for the freedom**you obtain by

**NOT having the mortgage.**

Let’s summarise those choices again…

- Take the mortgage and tie up the £75,000 for 30 years
- Put the £75,000 into an investment that makes 10% per year and compounds over 30 years

So in other words… the property would have to work by that much for you to not give up your freedom *(at a minimum)*!

**But Sally Has To Live Somewhere Right?**

With her **FIRE mindset** well and truly engaged, Sally decided to allocate maximum rental costs of **£20,000 per year**, living well within her means – i.e. **£1,667 per month in rent**. This is a fairly decent monthly spend, perhaps even more than most people’s mortgage repayments.

If she rented at this level she would have spent **£600,000 on rent** over the 30-years.

Taking Sally’s compounded investment pot of **£1,308,705, **and less than **£600,000** she spent on rent, Sally would still be left with **£708,705** at the end of 30-years.

So when comparing the two scenarios, Sally *(over the 30 year period)* is left with **£708,705 even though she spent £600k on rent over that period. **In addition, Sally maintained her **freedom 100% of the time**. No liabilities or debt to service. Free to move between properties or even overseas without worry of meeting a mortgage repayment month after month.

In other words, when taking the mortgage Jim was willing to forego his freedom on day 1 for a price of **£208,566**, have essentially **zero freedom over 30 years** as he must pay the mortgage in full each month for 360 consecutive months or the bank will repossess his home as collateral against the loan.

At the end of 30 years, Jim can finally look back and say “well what was my reward for giving up my freedom every year for the past 30 years?”

£291,434or£9,714 per year(if the property is actually worth £1m!)

So, if you believe you can make 10% on your money and you decide to take a mortgage on a £500k property over 30 years, you are basically **speculating** that the property will increase in value to **£1.8m** in value over the 30 years…

Property speculation has worked well in most Western economies historically. Whether it can continue is something to consider…

**Assumptions, Assumptions…**

Now, you may **pick holes** in these arguments. Perhaps a 10% net return in an equity product is pie in the sky *(in fact many commentators in the FIRE community settle on 8%)*. Even assuming 6%, 7% or 8% you’ll likely find that Sally wins out in

**pure math terms**.

You may argue that Sally’s rent would go up with **inflation** – perhaps… but, by the same token, we might assume her earnings might also rise with inflation and she could have added to her initial £75k over time. Similarly, Jim is unlikely to stay in the same home – perhaps with increased earnings over time he’d be tempted to trade up to a larger house, itself having benefited from inflation in terms of purchase price.

We are also assuming a **best case mortgage repayment scenario** here. Where do you think rates will be in 3-5 years from now? I’d strongly argue we are more likely to be nearer the long-term **5% average** than at the 1% many have become accustomed too in recent years.

That’s not even considering the fact that something like 40-50% of mortgages outstanding in the UK are **interest-only **mortgages, so we can argue we are being generous here.

## Closing Thoughts

While of course, this is a **hypothetical argument** – it’s still a very compelling one in pure math terms. But of course, owning a home brings with it a lot of **emotional benefits** and **intrinsic value** that goes far beyond the financial implications.

Perhaps, if you don’t have a mortgage yet it will at least allow you to consider **true opportunity cost**. I’m also aware that renting for such a long period is somewhat less attractive in the UK than it might be elsewhere in Europe where long-term rents are more common. Finally, if you are wrestling with the burden of a mortgage, it may encourage you to explore **accelerated repayment** options.

I’ll cover some **strategies** in an upcoming post! Needless to say, just as the opportunity cost is a consideration when choosing to **buy vs. rent**, it also very much applies when considering how to **clear your mortgage faster**, particularly in making the distinction between **amortization interest** and **compound interest** – i.e. does it pay to overpay your mortgage *(principal)* versus investing those overpayments to earn compound interest? Two different things entirely, each with their own risks.

I personally am **not making overpayments** towards my mortgage principal while mortgage rates are at these low levels as the opportunity cost *(foregoing the compound interest alternatives via investments)* is too much in my opinion.

So, tell me your thoughts – do you view your house as an asset? What are your thoughts on your mortgage situation? Are you paying it down faster or banking on investment returns to get you there? It is such an emotive subject and there is, of course, no right or wrong answer.

As always, I’d love to hear your thoughts below.

Until next time!

Dan

## This Post Has 8 Comments

What about after the 30 years… Jim’s monthly payment then becomes 0 for the rest of his life. Where as Sally still has to cough up rental money until the end of her days eating into that opportunity cost.

Not really. Sally does not have to cough up anything if she does not want too. With in excess of £700k in the bank, I don’t think Sally is forced to rent until she dies! Remember, this is based on Sally not investing a single penny more than the initial £75k – a highly conservative scenario. By not locking herself into a long mortgage she retained her freedom. She is 100% liquid, whereas Jim’s much smaller wealth – once you subtract all that interest he paid in getting to 30 years – is tied up in his house which, by the way, as any homeowner will tell you, will always cost you money over and above the mortgage. Sally, would have amassed considerably more money than Jim. After 30 years she could (if not before) buy a property for cash if she chose too, rather than paying double the purchase price, including interest charges, as Jim did. Jim would not be in a position to take the same investment risk as Sally (he’d be c.10 years from retirement).

Thank you for this. We have decided to go down Sally’s path but still look at the property market to try to spot opportunities, I guess out of habit?

This article is a very good critique of the common statement that taking a mortgage on a property one lives in is a great investment. We are thinking potentially buying for cash in the future and taking in a lodger to use the tax free £7500/year. One can truly do much more with their property if it is not owned by a bank.

Thanks, great article to start the day with.

Thanks Happyinscotland! Of course, its a toss-up between the pure maths and opportunity cost (which proves that borrowing money to secure a mortgage versus a compound interest return is an inferior choice) vs the emotional attachment one pursues/desired in owning their own home regardless of the considerable long-term cost it may bring. Buying for cash I think is a great strategy if you can wait, as is using a lodger to extract some additional funds.

Sorry for the late commenmt. I have only just discovered your blog (enjoying it btw).

Haven’t you overlooked the fact that after 30 years Jim owns his house outright and at an increase of 5% per year, is now worth £2.16m? Basically you are comparing Sallys investment (75k) in stocks with Jims leveraged investment (500k) in property. You can argue about percentage returns but it comes down to whether the unleveraged investment in stocks is a better prospect compared to the leveraged investment in property.

Good questions Lee – As I think the article spells out (at least hypothetically), Jim’s house would need to be worth over £1.8m to offset the opportunity cost of investing the money. So, taking a 5% annualised growth assumption (if achievable) he might come out ahead in monetary terms but he still gave up his freedom in the process so I guess it depends what intrinsic value one might place on that. While 5% growth (nominal i.e. not inflation-adjusted) may be the long-term average, who is to say that will continue. We all know that the gap between house price growth and earnings growth is at an inflexion point and of course, annualised rates of house price growth (on average) turned negative for a few years post the credit crisis, and in some areas (like Northern Ireland) have yet to fully recover. So I guess its always a subjective exercise versus reality with so many variables. Good questions though and I appreciate you asking them. Do you feel we will see the same house price appreciation that our parent’s generation did in the coming 20-30 years? I don’t see it personally.

Great article, great thoughts and controversial ones as well. I was crunching my own numbers for the last 2 months and would say Rent vs Buy is not always that simple decision even if you look at it from the purely financial point of view. What I found is you losing if 1. Rent and do not invest 2. If your property doesn’t grow at least 5.5% annually 3. If you smashing your mortgage instead of investing the extra (here we have a lot of opportunity cost involved). I would recommend to have a look at this Rent vs Buy calculator https://www.rentvsbuy.app and run your personal numbers. Cheer.

Hi Alex and thanks for your comments. I totally agree that there is no right or wrong answer and it really depends on perspectives, emotional wants and needs versus the pure maths of it all. I agree with your observations also, that if you rent, but don’t invest, then that really is an inferior choice to buying and that overpaying your mortgage (particularly in a low-to-mid interest rate environment) versus investing is also most likely a losing outcome. That being said, people have that emotional appeal of clearing their debt fast, even if that transpires to missing out on potentially higher investment returns. I’ll be sure to check out the calculator. Thanks