Note: this article was written with a Canadian audience in mind. In Canada, mortgage interest isn’t tax deductible but the appreciation of your personal residence is tax-free. If you’re from a country where mortgage interest is tax-deductible, you should adjust the mortgage rate accordingly. Also note that the comparison assumes a taxable investment account. Some tax deferred accounts (e.g. RESP) come with additional incentives (e.g. grants) that must also be considered.
Let’s say you’re a family man or woman with $100,000 in cash, an outstanding mortgage balance of $100,000 at an interest rate of 3.5%. Amortized over 25 years, you’re paying $499 per month.
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Debt costs money. In this scenario, you’d be forking out $49,781.05 in interest payments over the life of the loan – almost 50% of what you borrowed!
So does it make sense to pay down your mortgage or invest that cash in a taxable non-registered investment account?
(Note: the mortgage actually spills into one extra month, but that’s only a $0.05 payment to close off the mortgage).
Should you pay off your mortgage or invest the money?
This is not an easy question to answer. While this is a math question, the real answer comes down to psychology.
Many will simply point to the interest rate on the mortgage and say if your portfolio can beat it you should invest. For many this makes intuitive sense. In this example, you’d need a 3.5% after-tax return to break even.
One of the problems with this comparison is that it doesn’t incorporate risk. The 3.5% return gained by paying down the mortgage is a known. The after-tax 3.5% return from an investment portfolio is an estimate based on historical precedent for a given asset allocation. Moreover, the estimate is an average of returns calculated over many years, some of which were higher and others lower. Indeed, actual returns can remain below expectations for many years. Can you imagine the regret if – instead of paying off your debt – you invested the $100,000 only to lose 10 or 20% in the first two years?
The inherent volatility plus uncertainty means that you should expect greater compensation from your investment than from your ‘guaranteed’ mortgage investment. In other words, the estimated return for the investment opportunity should be significantly above 3.5% after-tax to account for additional risk-return ratio.
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There is also a psychological aspect not captured by the risk-return ratio that deserves a premium. For many, debt is an albatross around their neck. They live at the mercy of their creditors, who can choose to call their loans at any time. They remain in jobs they hate because they can’t miss a payment. They worry about losing income in the next recession while their debt payments persist.
Thoughts of bankruptcy, liquidation and repossession force them to lead a less-risky lifestyle, barring them from entrepreneurial and meaningful career shifts. For someone with a family, defaulting on a mortgage simply isn’t an option.
Big debts mean relentless payments, requiring steady income. Not fun.
After tax payment vs. after tax return
You’ve probably noticed I’ve specified ‘after-tax’ returns a few times. This is an important distinction.
You are paying your mortgage with cash that has been already taxed. So your mortgage ‘return’ of 3.5% is effectively an after-tax return. When comparing against portfolio returns you must also consider tax. For example, if your tax rate on your investments was 30%, you’d have to earn 5% to come out mathematically even. Of course, you’d actually need more once you factor in additional risk of investing vs paying down a mortgage. Loosely, you could be looking at a 6-8% portfolio return requirement.
From a cash flow perspective it looks worse
The mortgage example above requires a $499 monthly payment. That equates to $5,988 per year.
Could you find an investment to adequately cover your $5,988 annual net-of-tax mortgage payments? Some will argue that this overstates the true requirement, as this amount includes both interest and principal. I agree the principal portion isn’t a true cost, but it is still part of the repayment you must provide the bank whether you want to or not. So from that perspective, it’s still a fixed cash outflow that must be made (even if a portion of it is technically going from one hand to the other).
Assuming a 30% tax rate on investments that’s equivalent to $8554 or an 8.6% annual return on the $100,000 portfolio. Possible, but doesn’t sound like a slam dunk.
Over the long run the math often works in favour of investing extra cash in a taxable non-registered account. However, in my opinion, there is quite a high psychological hurdle to justify not paying down your mortgage. Humans evaluate gains and losses in ways that can’t be captured in a spreadsheet. Right or wrong, this is a fact that must be accepted by the personal finance community. After all, many people seek happiness, comfort and security as primary life goals.
If you’re like me the thought of debt keeps you up at night. Especially when that debt is financing the roof you keep over your family’s heads. The downside of defaulting on that debt is simply too great.
If I were in this situation, I think the ideal compromise would be to pay off the $100,000 mortgage and then divert the canceled monthly $499 mortgage payments into an investment account.