The definitive answer to paying down your mortgage or investing
Should you be paying down your mortgage or investing?
In a perfect world, we would all have enough cashflow to pay down our mortgage aggressively AND invest for our future financial selves in abundance.
The reality is, most of us need to make some very tough choices on where our money goes.
If you’re like me, you probably dream a little about paying off the mortgage on your home/condo. In our case, that would free up about ~$1,600 per month in cashflow or $19,200 per year in after-tax money.
This is not a trivial sum of money.
(Our former home.)
Imagine what we could do with that cash? Invest more is certainly one option. Work less might be another. Regardless of the dreamy option, I believe the less you need to pay others, the more money you can keep or utilize yourself. This makes one of our big financial goals (becoming debt-free in a few years) essential for our long-term financial health.
Investing time is on your side
While long-term debt obligations increase risk to your financial health, investing early and often has the potential to create tremendous wealth.
Using some simple calculators on my Helpful Sites page, all FREE stuff by the way, you can see that there is tremendous power in establishing a disciplined investing plan sooner than later.
Example 1: A 25-year-old who aspires to retire at age 65, starts with an initial deposit of $1,000, and automates $500 per month towards her Tax Free Savings Account (TFSA) without fail for decades on end.
Example 2: A 40-year-old who also aspires to retire at age 65, starts with an initial deposit of $1,000, and automates $1,000 per month towards his Tax Free Savings Account (TFSA) and Registered Retirement Savings Plan (RRSP) to play catch-up, cannot come close to the 25-year-old wealth even if they doubled their savings.
So, on one hand, you focus on the mortgage, you pay it off and invest later.
On the other hand, you could focus on investing while killing mortgage debt more gradually.
What should you do?
Before I give you my definitive answer on this subject, let’s look at some pros and cons for this decision.
Pay off the mortgage, first
- Save money. By paying down your mortgage early, you will save thousands of dollars in interest costs. Certainly the higher the borrowing costs, the greater your potential savings will be the faster you pay down this debt.
Using my very own numbers for the last house we owned, before we moved to this downsized condo, we took on a whopping $363,000 mortgage. (Yes, my personal finance heart nearly stopped when I signed that paperwork.) Assuming we stayed there in the former home, and continued to pay down our debt using an average borrowing cost of 2.97% (over the years we lived in that home); with a few more assumptions in mind I calculated our total borrowing costs would be close to $500k to own that home. That includes paying off over $130,000 in interest.
- A guaranteed rate of return. Based on my own case study above, you can likely see that paying off my mortgage sooner than later would yield some significant savings – a guaranteed rate of return. Meaning, over a 22-year plus mortgage payment schedule, the savings in mortgage interest would be greater than what I would earn in some lower-risk investments.
Over the decades of being a homeowner for a couple of homes, when it comes to mortgage debt, I would encourage others to use these primary methods to reduce your total borrowing costs:
- Use a mortgage broker to find a very competitive mortgage rate and terms for your situation.
- Enroll in bi-weekly, accelerated payments to increase the mortgage payment frequency.
- Reduce your mortgage amortization period over time (i.e., I tend to start with 20-years; I reduce to 15-years after my first mortgage term (5-years in this example) is up).
- Make a few lump-sum payments early in the mortgage payment schedule to put down more against the outstanding principal owed.
When it comes to paying off your mortgage, the goal is rather simple:
the lower the amount borrowed + the more frequent the payments = the less interest you’ll pay.
- Debt freedom. Another reason to pay off your mortgage debt before investing, is it will provide financial flexibility. Monies formerly funneled to paying someone else first (i.e., the bank) will now go to you.
As we have seen above, tens of thousands of dollars may be charged in interest costs on your mortgage. Once your mortgage debt is gone, that cashflow can be allocated to your retirement savings, your child’s post-secondary education, or simply invested in you.
When not to pay off the mortgage, first
I believe there are several reasons not to pay off your mortgage aggressively, and instead, consider an investing first/balanced approach to managing debt and investing.
- When borrowing costs are cheap. Unless you’ve been living under a rock for the last decade, you’ll know that mortgage costs (borrowing costs in general) are historically-speaking cheap. While I believe it’s prudent to pay down debt in any interest rate environment, one could argue that there is no urgency to kill debt when borrowing costs are so low. Use that money to invest, instead.
- Long-term investments should outperform low-interest rate mortgage payments. Related to my point above, by maintaining your minimum mortgage payments, and putting your extra funds into long-term equity investments, chances are you will come out ahead with investing. Although past performance is never a perfect indicator of any future results, a diversified mix of investments over a 20-25 year investment time horizon (approximately the same period as your mortgage amortization) should deliver close to 8% return. This would be by far and away more money earned than any amount you’d save in interest charges by paying off the mortgage early – all things being equal.
The bottom line – if you expect the rate of return on your investments to be consistently higher than your mortgage interest rate over the life of your mortgage, you will have more money by paying the minimum amount on your mortgage, and investing the difference inside your TFSA or RRSP.
- Diversification. While owning real estate and your home, or multiple properties for that matter might be fine and good, I would encourage investors to consider diversification as part of wealth-building. Diversification, in a nutshell, can bring higher potential returns for less investment risk. Said other way, consider diversification like a healthy diet. While eating a variety of healthy, diverse foods over time won’t guarantee your body will be healthy, doing so will increase the probability you will be healthier all things being equal.
Having an investment portfolio that extends beyond real estate, will allow you to participate in growth opportunities that are not tied to that sector. While potentially very nice, your home is an isolated asset in a tiny part of a global investment world. If for whatever reason something happens to your localized asset, I believe it would be smart to invest in other assets around the world.
- Liquidity. Have you ever tried to sell a home in a few days, AND move out? I wouldn’t bet on doing that successfully. By having your assets invested beyond your primary residence, you will have more liquidity should you need the money for something.
In our case, we aspire to keep our cash emergency fund at this level. Other than for a few months now and then over the years, we’ve done that.
With all your money siphoned to your mortgage, not in any cash savings let alone in long-term investments, a sudden job loss, health issue or major capital expense could leave you in a financial crisis. The ability to sell investments assets or better still, draw on cash savings for any emergency without borrowing more money for it, is a very liquid and healthy proposition.
- Tax advantages. Unlike the U.S. where upon fulfilling a few simple requirements, you can deduct mortgage interest costs, in Canada this cannot be readily done. (There is of course the Smith Manoeuvre which you can read about here.) In some cases, depending upon your tax situation, I believe paying off your mortgage should be a low priority.
- You are self-employed or run a small business. A portion of your mortgage interest will be tax-deductible to reduce your taxes payable.
- If you own an investment property or multiple investment properties. Those investment properties also have tax deductions that may be applied against them.
- Making an RRSP contribution is a method to reduce your taxes owning. While you should know that always reinvesting the RRSP-generated refund is the linchpin any RRSP vs. TFSA investment debate, contributions to your RRSP offer two great benefits a) you can reduce taxes payable today and b) you can participate in long-term tax-deferred growth as long as investments stay inside this account.
Is it really one or the other, paying down your mortgage OR investing?
Ultimately you are the only person that can decide if paying down your mortgage is the best risk-adjusted return you can make, over other forms of investing.
Personally, when it comes to our financial playbook, I’ve pursued the following:
- When our mortgage balance was initially high (years ago at $363k), we paid down mortgage debt more aggressively.
- When our mortgage balance became more modest a few years ago (<$250,000), we increased contributions to our RRSPs – until the point mine was maxed out of contribution room consistently every year. (My wife still has some RRSP contribution room left. We hope to max her account out in 2020.)
- Now that our mortgage remains at an acceptable-level, for us, we will continue to strive and max out our TFSAs every year – first, and continue to invest in our RRSPs to the point they are also maxed out of contribution room until semi-retirement.
I don’t subscribe to any definitive answer on this subject for everyone.
Instead, my definitive answer for you is: “it depends”.
It depends for you because your decision should be goal-based and personal.
Do you desire to be debt free sooner than later? Regardless of opportunity costs?
Do you dream of financial independence, travelling the world? Debt and mortgage free will help you accomplish that.
Do you aspire to have “money in the bank”; you’re comfortable with your debt load even like some retirees are (who have a mortgage) in retirement?
Only you know your answers.
That said, if part of your financial plan is to diligently invest money inside your registered accounts for many years, if not decades on end, then I believe it usually makes sense to slowly pay off your mortgage while you invest at the same time. In doing so, you’ll reduce your debt burden while feeling much more confident about your long-term financial future self.
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Happy investing and thanks for reading.