Much of personal finance is common sense. We know we should spend less than we make. We know we should avoid credit card debts.
But there are some choices that we need to make that aren’t so clear. Whether to use extra money to pay off your mortgage or to invest in one of those choices.
My first mortgage was amortized over 35 years. Now, I’m planning to be mortgage free at 35 years old.
I’ve lived both sides of the argument. Here’s how I see it now.
What Do The Numbers Say?
Let’s do some quick calculations to see if there’s a winner on paper.
I live in Ottawa, Canada. According to the Ottawa Real Estate Board, the average sale price for a home in December was $381,936.*
To avoid paying mortgage loan insurance here, we need to put down 20%.
So, let’s use a 20% down payment of $76,387 and a mortgage balance of $305,549 to run our scenarios.
Let’s use the common 25 year amortization and 5 year term.
I checked a major bank and their rate 5 year fixed rate was 4.79%. But, you usually get a discount, so I’m going to use the 2.94% rate advertised by a local mortgage broker instead.
Let’s be crazy and assume that this rate stays the same forever.
Let’s be even crazier and assume that investment returns in this low interest rate environment will be a steady 6% forever.
Just to summarize:
- Mortgage Principal: $305,549
- Mortgage Rate: 2.94%
- After-Tax Investment Returns: 6%
If this person has an extra $1,000 available each month, what would be the best way for them to use it? Should they pay down their mortgage or or should they invest?
For the calculations, I used a Canadian online mortgage calculator and an online investment calculator. The calculators weren’t very precise with the time lines, so the results aren’t exact. But they’re super close enough to prove the point.
Scenario 1: Pay Down the Mortgage First, Then Invest
If they make an extra $1,000 payment every month, it would only take about 12.5 years to pay off the mortgage instead of 25 years. That’s half!
The total cost of the mortgage would be $365,004. That’s $305,549 of principal and $59,455 of interest.
If they had paid the mortgage on their original schedule, they would have paid $125,392 in interest. By paying off their mortgage early, they’ve saved $65,937 in mortgage interest.
After the mortgage was paid off, they would have 12.5 years to invest their extra money.
$1,000 a month for 12.5 years invested at 6% would grow to be: $154,753.
Mortgage interest save of $65,937
Investment Returns of $154,753
That means they’re up $220,690
Scenario 2: Even Money Against Mortgage Or Investing
If they only make an extra $500 payment every month, it would take about 16.5 years to pay off the mortgage. Still, 8.5 years early.
The total cost of the mortgage would be $386,020. That’s $305,549 of principal and $80,471 of interest.
If they had paid the mortgage on their original schedule, they would have paid $125,392 in interest. By paying off their mortgage early, they’ve saved $44,921 in mortgage interest.
While paying $500 towards the mortgage, they would still have $500 to invest.
After the mortgage was paid off, they would have 12.5 years to invest their full $1,000 of extra money.
$500 a month for 16.5 years and then $10,000 a month for the next 8.5 years invested at 6% would grow to be: $211,831.
Mortgage interest saved of $44,921
Investment Returns of $211,831
That means they’re up $256,752
Scenario 3: If They Focus on Investing
If they just made the minimum mortgage payments, it would take the full 25 years to pay off the mortgage.
Since they paid their mortgage on the original schedule, they’ve saved no mortgage interest.
The total cost of the mortgage would be $430,941. That’s $305,549 of principal and a whopping $125,392 of interest.
While paying nothing extra towards the mortgage, they would have the full $1,000 to invest.
$1,000 a month for 25 years invested at 6% would grow to be: $319,485
Less mortgage interest paid of $0
Investment Returns of $319,485
That means they’re up $319,485
Scenario 1: up $220,690
Scenario 2: up $256,752
Scenario 3: up $319,485
After 25 years in our little scenario, they would be ahead $98,795 by using all of their extra money towards investing.
Put another way, the decision to pay off their mortgage first instead of investing would cost them almost $100,000.
Wait! A 6% rate is too high for investment returns, You Should Only Use 4%!
As long as the investment returns are higher than the mortgage interest rates, it will always be better to invest instead of pay down debts. It’s called leveraging and it can be pretty powerful stuff.
But yes, if the investment rate was lower, there would be a smaller difference between the investment and mortgage rates, and it wouldn’t be as bad a choice on paper to pay off your mortgage.
But if the investment rate was higher, then it would look even worse.
So, Why Would Anyone Even Consider Paying Off A Mortgage Early?
Despite the calculations that show what a terrible decision paying off your mortgage is, many seemingly intelligent people continue to shave years off their mortgage amortization schedules.
Why would anyone pay off their mortgage?
Because life doesn’t always follow our most careful calculations and there’s always more to financial decisions than just numbers.
1. Paying Down a Mortgage Gives a Guaranteed After Tax Return
Historically, the markets have always trended up and have made between 8%-12% per year.
Historically, the markets have had higher returns than mortgage rates.
But the markets don’t rise in a straight line. They rise and fall. A lot.
It’s possible that you could invest your money and 10 years later be no further ahead than where you started. If you started investing in 2000, by 2010 you might have even been down a bit.
Making extra payments on your mortgage earns you a return equal to the mortgage rate. Paying $1,000 now means you won’t have to pay interest on that money for the rest of the loan.
It’s a guaranteed rate and it’s after tax earnings too.
While your mortgage interest rate is known, if you’re investing in stocks or mutual funds you can’t say for sure what your investment return will be. You can only guess.
Over a long stretch of time, the variations in stock prices tend to work themselves out.
We’re planning to have the mortgage paid off in less than 5 years. Because it’s a shorter time frame, we’re looking at lower risk investments. The guaranteed return from extra mortgage payments looks pretty appealing next to our guaranteed investment alternatives.
2. If Rates Rise Your Mortgage Could Become Unaffordable
The low mortgage rates have allowed some people to qualify for a mortgage on a home that would be out of reach if mortgage rates were even a percentage point or two higher.
When your mortgage term is up, you lose your mortgage rate and need to renegotiate a new one.
Let’s look at that average home in Ottawa again selling for $391,936.
With 20% down, that $313,549 mortgage at 2.94% over 25 years would have a payment of $1,474.22 a month.
If rates rose from 2.94% by just 2% to 4.94%, still a historically low rate, the payment would go up to $1,812.92.
If you’re already stretched, $338.70 might break the budget.
We keep our monthly budget pretty tight. I can think of a whole lot of things I would rather spend $338.70 on than interest…
3. Mortgage Payments Are Forced Payments
The plan to get ahead by investing instead of paying off your mortgage only works when you actually do it.
At the end of the month, it can be hard to find any money to invest.
Yes, you can and should pay yourself first. Yes, paying yourself first will get you to change your spending to make room for your investments first instead of whatever it was that you wanted that day.
But it’s still easier to pass on a voluntary contribution to your own savings than it is to skip a mortgage payment to your bank.
There’s also the question of whether or not the money will stay where you intended.
What is it about an investment account that tempts me to want to use it for something else?
TFSA’s can be taken out at any time. Why not use that money for a trip? Or a renovation? We can just pay it back next year. No taxes or penalties!
I guess if we had a large home equity line of credit then the house might start looking like a vacation too…
But, we know there would be hoops to jump through to increase our mortgage, and those hoops take away the temptation.
4. Mortgage Interest is not Deductible
Mortgage interest is not deductible in Canada.
Interest on loans for investment purposes is deductible in Canada.
If you want to leverage your investments, why use your non-deductible mortgage when you could pay it off and use a deductible investment loan instead?
When we asked ourselves if we would borrow against our house to invest, we knew our answer was no.
When we realized that’s what we were doing by investing while making minimum payments on our mortgage, we decided to change our plan.
5. Making Extra Payments Can Lower Your Monthly Mortgage Payment
When we renewed our mortgage this summer, I asked how low we could set our payment.
Because we have been paying down the mortgage, we’ve shaved quite a few years off our mortgage amortization.
The bank said that they were able to stretch the mortgage back to the length we’d have if we hadn’t made any extra payments.
We pay about $1,500 a month now, but they were able to lower our payment to less than $500.
In the new year, I’m planning on taking them up on their offer. With extra payments each month we’ll still end up paying about $1,500 each month and paying the mortgage off quickly. But, we’ll only be required to pay the $500.
As a family that relies on one income, knowing that we could cover our expenses even with a low paying job would really help us sleep at night.
When you run the numbers, it looks silly to put an extra cent towards your mortgage.
But, there are many situations where it might actually be smart for you to pay your mortgage off many years ahead of schedule.
It’s impossible to make a smart personal finance decision without taking into account the personal factors involved.
Yes, for some carrying low interest debt and investing is the right choice.
We decided becoming completely debt free was the best choice for us.
The important thing is to pick an option and actually follow through with it.
What About You?
Are you paying off your mortgage?
Are you making minimum payments on any low interest debts?
Are you planning to rent for life and never have a mortgage?
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* “November Sales Up Slightly Over Last Year” Ottawa Real Estate Board Dec. 3, 2014. This is the link for the “Latest News Release“. So, you’ll only be able to match up the number in the post until the December results come out. I can’t find archived links. Sorry!