Derek, I’m wondering if it makes sense to pay off my mortgage instead of investing?
It seems that every week I have this same question posed to me, so certainly you’re not the only one wondering. My answer is the same whenever this question comes up and the answer is always: It depends on you. Let me explain.
The first part to consider is the math behind it all. The reality is that if you have a mortgage at an average rate today of around three per cent, any dollar that you put towards it will “save” you three per cent on that dollar.
Now if you have to make a decision as to where to put that dollar and you feel you can earn greater than three per cent by investing, it makes sense to invest. The math is pretty straightforward, but also not that simple. Any time you consider investing you need to determine what your “net” return is — essentially what have you made once the tax man collects. Taking another look at it, if you earn three per cent on an investment in a taxable account, you really have only earned 2.25 per cent (assuming a tax rate of 25 per cent).
So in that same example, it would have made better sense to pay down your mortgage. Using that same tax rate, you need to earn at least four per cent on your investment to justify investment versus paying down your mortgage. Put another way, earning four per cent on a dollar is equal to saving three per cent interest. If you’re investing in a tax-free account, like a tax free savings account (TFSA), then that may make investing more favourable. The next part to consider is what will interest rates do moving forward.
In the example above, if you would find yourself financially constrained if your mortgage rate went from three per cent to five per cent at your next renewal, it makes sense to pay down your mortgage more aggressively. Or, perhaps you invest that additional dollar (so long as you’re earning at least four per cent), and then take your investment and pay down your mortgage with your earnings at maturity.
With this in mind, the rate of interest is a factor that is known; this won’t change until maturity. The return on your investment is likely unknown, but has the potential to be higher than four per cent This is something that one needs to consider when looking at these numbers.
Another part to consider is whether the interest on your mortgage is tax deductible. Just like the equation above regarding the taxation on your investment earnings, if the debt is essentially a write-off, or an expense for you, it may not make sense to pay down the mortgage aggressively.
This may be the case if the mortgage is on a rental property, but be sure to discuss this with a qualified accountant. The final part to consider is how you feel about having debt. I’ve met many people who would simply rather not have any debt, and I don’t think there is anything wrong with that thinking. Put another way, even if the numbers make sense to invest rather than pay down your mortgage, but you simply cringe each time you look at your mortgage, it may be best to pay it down as quickly as possible.
There are others who don’t mind having mortgage debt and focus all of their attention towards investing. There is no magic formula here and it simply comes down to your personal preference.
Where I typically guide clients is to consider both options. There are many strategies that may apply, with the example being paying down your mortgage aggressively, but directing some cash flow to an investment. For some clients, they invest aggressively to their registered retirement ravings plan, and then use their tax return to pay down their mortgage. Others use their TFSA as an investment account for their future mortgage payout. These are only two small examples and I would suggest speaking with a qualified financial adviser to see what may work best for you.
Lastly, before you consider either choice, be sure to check the rate on your mortgage, contemplate about how you feel about investing for the long term, and decide if you’re the type who can’t stomach any kind of debt. Once you decide on those factors, have a talk with a qualified financial adviser and move forward with your choice. A little planning can go a long way.
Derek Fuchs is a wealth adviser with ScotiaMcLeod in Red Deer, and a certified financial planner, financial management adviser and a fellow of the Canadian Securities Institute. He can be contacted at email@example.com.