Paying for Your House with Dollar Cost Averaging
A family member recently used dollar cost averaging and the power of compounding in such a creative way, that I thought it would be useful to share it. This technique, which he developed after studying the various returns available on different asset classes, was designed to show that two factory workers, both earning the same salary, paying the same taxes, and having the same expenses, could end up with vastly different levels of wealth based on what they did with their surplus cash each month. Let’s take a look at this dollar cost averaging technique and how he hopes it will help him earn several extra hundred thousand dollars in profit over the coming decades.
How His Dollar Cost Averaging Plan Works
John Allen owns a house worth approximately $260,000. He has a thirty-year mortgage balance of $200,000 at 6% and monthly payments of $1,200 before property taxes.
For years, he had been making an extra $284 payment each month for a total of $1,484. This would allow him to pay off the mortgage in only 225 payments, instead of 360, saving him 135 payments, or $162,000.
According to his math, John would own his house outright in 18.75 years, save $162,000 in mortgage payments, and the property itself would have appreciated to $452,500 assuming 3% appreciation (that is, no real, after-inflation gain in property value). By the time he hit the 30 year point when his mortgage would have been paid off, his property would have a value of $631,100.
One day, John was doing math on the time value of money and reading about dollar cost averaging. He saw that stocks had returned an average of 10% per year compounded over the past century, despite experiencing extreme volatility ranging between the Great Depression and the Dot-Com bubble. He immediately opened a direct stock purchase plan account with U.S. Bancorp, the company that owned the mortgage to his house, and established a regular monthly withdrawal of $284. This money is taken from his bank account and used to buy shares of U.S. Bancorp. As part of his dollar cost averaging plan, John told the transfer agent to reinvest all of his cash dividends into additional shares of stock.
The result is that he went back to the regular $1,200 monthly mortgage payment, meaning he will own his house in 30 years instead of 18.75 years, and have to make the extra $162,000 in payments out of his pocket over those last 11.25 years. Yet, he is dollar cost averaging $3,408 per year ($284 per month x 12 months = $3,408 annually) into shares of the bank.
In 30 years, under this plan, John hopes to own his house outright with a value of $631,100, he expects he would have made an extra $162,000 in house payments, but that his direct stock purchase account contains an extra $506,500 in shares of stock he otherwise wouldn’t have owned; shares that he anticipates might pay cash dividends of $2,300 per month in income, which he could then use for day-to-day expenses rather than touching the principal. His assets would be $1,137,600 ($631,100 + $506,500) but he would have spent an extra $162,000 to achieve this so the “net” assets would be $975,600.
A Modified Form of the Dollar Cost Averaging Plan
One modified form of this dollar cost averaging plan is to continue to pay off the mortgage early so that the house is owned outright in 18.75 years. Then, for the last 11.25 years, take the entire $1,484 and invest it in high quality assets such as a diversified low-cost index fund. Had he done this, John would have ended up with almost the same amount of money in both his house and his investment account after adjusting for the extra payments saved (it would have been roughly $30,000 to $50,000 less). Yet, he wouldn’t have had the pressure of making a house payment for more than a decade. If that’s important to you, that may be a consideration.
Why am I somewhat skeptical of this approach? Human nature. The moment most people pay off their mortgage, they are going to see an extra $1,484 each month in spendable cash. That’s $17,808 annually. Kitchen upgrades, expanded bathrooms, new cars, nicer furniture, a new wardrobe … people find a way to expand their costs to fit their budget and it seems foolish to assume that most people would maintain a pure investing program of that magnitude for 11.25 years. Saving $284 per month, on the other hand, seems much less noticeable and you must make the mortgage payment if you want to avoid foreclosure so there’s no sense of deprivation or loss.
Choosing Investments for Your Dollar Cost Averaging Plan
I certainly don’t think you should invest all of your dollar cost averaging plan money into a single stock, even if it is considered a high quality blue chip. In the case of U.S. Bancorp, the shares have fluctuated from $40 to $8 and back to $25 over a relatively short period of time, allowing the regular, monthly investments to achieve a much lower cost basis for John than he would have been able to achieve if he had just dumped cash into the stock market. For most people, a much better choice if they weren’t going to build their own directly-held diversified portfolio, and they know little about the stock market, might be a low-cost, no-commission, extremely diversified mutual fund that mimics a major stock market index such as the Dow Jones Industrial Average or the S&P 500.
Update: Several years ago, this post was placed in the private archives. Due to requests from the community, I restored access to it on 05/20/2019 as part of a project meant to make articles, essays, and other content available if I felt they had some degree of educational, academic, or entertainment value. At that time, I made minor edits to the post to refresh it, including updating the format to better fit with the new site design. This post was the precursor to a related post in which I discussed this family’s members strategy with more depth. I want to reiterate, yet again, that none of this was intended to be investment advice. There are no guarantees that any of the figures used will materialize, they were simply the rough estimates my family member was using when he designed the plan. For example, while large cap stocks in the United States have generated long-term returns as a group of a bit more than 10% between 1926 and 2017, there is no guarantee they will do so in the future, there were long periods during that span when returns were lower, including even negative, and no individual stock is likely to exactly mirror the broad equity returns, anyway. In fact, such an approach may result in losses, perhaps substantial. The point of writing it a decade ago during a period when this site was almost exclusively read by close friends and family, and long before Aaron and I sold our private operating companies and established Kennon-Green & Co., our fiduciary asset management firm through which we now manage wealth for other successful individuals and families, was to explain that small decisions can add up to major advantages over time; that they compound in ways you might not realize but that, in the end, can be breathtaking. A few years after the original publication of this post, I reiterated the same underlying concept in a post called Measure the Success Of Your Day by the Seeds You Plant.