The purpose of a financial simulation is to determine if you are going to reach your goals. If you have a goal to pay off your house before you turn 50 then how much extra do you have to pay on top of the minimum payment to be able to reach that goal? A financial simulation can help you determine that number. Furthermore, if you had a choice of multiple loans to pay off first or multiple strategies to try to accomplish your goals you can try them out in simulation before making the decisions in real-life.
In this post we walk through a simple scenario in which a person has a mortgage and has some level of extra income to be used for either paying down the house debt or saving in the stock market. We look at two different types of stocks in the stock market. The first is the classic S&P 500 represented by VOO. This class of stocks are classified as growth stocks which means that the money that the companies earn stay in the company to grow the company. The investor is rewarded with a larger share price if the company grows successfully.
Another type of stock is a REIT which are slightly different that a growth stock. To be classified as a REIT the company must pay 90% of its profit as a dividend. This difference is something we can take advantage of since we do not need to sell our share of the REIT to be able to take money out from out investments. In this way REITs are a more liquid investment.
Net Worth Strategies
Net worth is defined as your assets minus your liabilities. So in our little scenario the house is a liability and any savings in our stocks would be considered assets. So day one we have a negative net worth. Our goal in our financial simulation is to dig out of the hole and increase our net worth the quickest. Lets define three strategies to see which one is the best.
Buy VOO with Extra Income
In our first strategy we have decided to make the minimum payment to the house and putting all of the extra income toward buying shares of VOO. This strategy is choosing the stocks that have the highest rate of return on average. Of course VOO shares will fluctuate but over the long term they provide the largest rate of return over REITs. The only drawback is that VOO has a very low dividend to share price ratio.
Buy REIT shares and Put Dividends to Debt
In the second strategy we will again make the minimum payment to the house but buy shares of REITs with the extra income. The benefit here is that as we earn dividends on a quarterly basis we will use the dividends to pay down the house faster. In the beginning we maybe making a minimum payment plus 10 dollars. But as time passes and we keep our shares of REITs our extra payments will allow us to pay off the house faster.
Pay off Debt then invest in VOO
The final scenario is included since this is what most people think they should do. Since they have a house payment they decide to focus on it. In this final strategy the extra income is used on top of the minimum payment to pay off the house faster.
In all of these strategies once the house is paid for the minimum payment that was going to the house is then freed up and in then invested. For strategies 1 and 3 the money is invested in VOO and in strategy 2 REIT shares are purchased.
Next lets model the VOO and REIT shares.
|Initial Price Per Share||$400||$23|
|Annual Share Price Growth||7%||5.2%|
|Divided Per Share||$1.01||$0.38|
|Initial Number of Shares||0||0|
From the above table we can see that VOO has a larger price point with a smaller dividend but the share’s value increases at a higher rate (7%) over the REIT at (5.2%).
For these simulations we assume the follow loan is taken out for the purchase of the house.
|Parameter Name||Parameter Value|
Next we will look at the house balance and the net worth calculations as a function of time. We will see that these strategies perform differently over time. So we will take a couple of snapshots in time and look at how the strategies are performing compared to each other.
Paying off the house the fastest
The strategy that pays off the house the fastest is Strategy 3. This is because this strategy attacks the principle of the house the fastest by putting all the extra income and reducing the interest paid over time.
At 15 years and 6 months the third strategy pays off the house but if we look at the net worth graph we see that even though the liability is paid off we have no savings so now our net worth is zero. As opposed to Strategy 1 and 2 where the house is not paid off but the amount saved in VOO and REITs respectively is worth more than the house balance, making the net worth positive.
At 30 Years
Originally the house loan was for 30 years but because the dividends or extra income were used to pay the house down in each of the strategies the house is paid off faster.
We see that the first Strategy is the slowest to pay off the house which makes sense since its the strategy with the least amount of help paying off the loan. But we see that the first strategy is the best in terms of net worth since at around 23 years there is a switch over between the first two strategies. Even though the house is paid off for Strategy 2 and the extra income from the house payment is going into the REITs the REITs can’t keep up with VOO since they are growth stocks as discussed earlier.
Strategy 3 Finally Catches Up
At this point Strategy 3 has a high return and eventually has to catch up to Strategy 2. We see that this happens at 45 years. But Strategy 3 can not catch up to Strategy 1 since they are assumed to have the same rate of return.
There are a lot of simplifying assumptions in these simulations, but we can still glean some important points from these results. First, Invest any extra income you have in the stock market whether it be VOO or REITs or any other equity you understand.
Next there is a place for REITs in your portfolio in a certain time frame. If we look at 5-23 year range Strategy 2 had the highest net worth. This was mostly because the REITs enabled paying off the debt faster while maintaining the asset.
These strategies are not mutually exclusive. Well Strategy 1 and 2 can be chosen depending on the current and near term needs. You could use strategy 2 until debt is minimized or eliminated then switch to Strategy 1 for further growth. Even from here you could maintain your REIT portfolio while allotting a portion to growth stocks.
We can very quickly make these simulations way more complex. With a myriad of hybrid decisions and solutions. As long as you are making educated decisions you can manage your expectations and meet your financial goals.