Should You Pay Down Your Mortgage or Invest?

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.

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!

Let’s also say you have already maxed out your registered accounts (in Canada: RRSP, TFSA, RESP).

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.

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?

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.

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.

For someone with a family, defaulting on a mortgage simply isn’t an option.

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.

My conclusion

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.

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Bob Farrell’s 10 Rules for Investing in 2020

Bob Farrell is a Wall Street legend.

He spent decades working for Merrill Lynch as the chief stock market analyst and senior investment advisor. He is widely recognized for his acumen as a trader and technical analyst. He is best known for understanding the patterns of investing and some might say he indirectly helped pave the way for the formal study of behavioural finance.

Like all good traders, Bob Farrell knew people and the emotions of investing.

Based on his seminal work, Bob Farrell created 10 rules for investing. These rules are still passed around by investment professionals today.

One look at the world and it’s obvious why Bob Farrell’s rules are especially important for today’s investor.

It’s only February, 2020 and so far we’ve witnessed wildfires in Australia, a brush with WWIII, risk of a global coronavirus pandemic, Presidential impeachment and a growing battle between the left and right wing political parties in America and worldwide. Meanwhile, the S&P 500 keeps pushing up against all-time highs, Tesla just went parabolic and cannabis stocks have cratered. Are we risk on or risk off? What gives?

May 28, 2020 Update: Well, we had a pandemic, markets crashed and have since recovered in a v-shape, unemployment has skyrocketed to Great Depression levels and the economy has collapsed. The political divide widens and inequality expands. And we’re not even half way done!

Who could be blamed for not knowing what to do. In 2020, it seems like Bob Farrell’s 10 rules for investing area as relevant than ever.

Here are his rules:

  1. Markets tend to return to the mean over time
  2. Excesses in one direction will lead to an opposite excess in the other direction
  3. There are no new eras — excesses are never permanent
  4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
  5. The public buys the most at the top and the least at the bottom
  6. Fear and greed are stronger than long-term resolve
  7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
  8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
  9. When all the experts and forecasts agree — something else is going to happen
  10. Bull markets are more fun than bear markets
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How to Give Your Child a Massive Financial Head Start

Something that is often forgotten in the personal finance field is that young kids have a massively long time horizon. The finance industry tends to ignore the compounding capability between ages 0 and 20, only to think of people as savers once they start working.

Sadly, this is detrimental to children. Because young children have such a long time horizon, a fairly small amount of savings can go a long way due to the benefits of compounding. Effectively, savings and investments made during childhood can give a child a massive financial head start.

Because young children have such a long time horizon, a fairly small amount of savings can go a long way due to the benefits of compounding.

So why is this cohort ignored?

The personal finance industry – made up of advisors and asset managers – earn fees on dollars that come in the next quarter. The larger those dollars the larger the fees. So it doesn’t pay to provide advice to people with small account sizes. I’m hoping this article can help fill the void.

I’ve previously explored how high school kids can create $1,000,000 in wealth by working summer jobs.

The following idea starts even earlier than high school, is easy to implement, financially feasible and doesn’t depend on a child’s ability to find work. Frankly, anyone can do this and help give their child/grandchild a massive financial head start.

Most newborns have four grandparents. If each grandparent contributes a manageable $25 per month into an investment account earning 7%, the child would have accumulated $51,430 by age 20. Imagine what a 20 year old could (responsibly) do with this money: pay college tuition, make a down payment on a property.

But why would the grandparents fund the account alone? What if the parents also each contributed $25 per month? In this case, the child would have accumulated $77,145 by age 20. Just that additional $50 per month results in a massive increase in value. This alone gives the child a massive financial head start.

Let’s say the child at age 20 pretends this money doesn’t exist.

What if at age 20 the child opted to leave that money invested until retirement without making any additional contributions?

By age 65 the child would have accumulated $1,620,227. Of course, this doesn’t account for a higher cost of living down the road, but no matter how you look at it $1.6 million is a huge sum of money. Especially considering the child never had to invest a penny.

Of course, like most of us, the child would likely contribute to his own investment portfolio. What if – after receiving the portfolio at age 20 – the child continued to contribute $150 per month until age 65? By age 65 the child would have accumulated $2,153,876!

Time is on a newborn child’s side. Unfortunately, that time is typically wasted. An extra 20 years of compounding early in a child’s life can add massive amounts of financial wealth for little upfront investment. So if you or someone you know is about to have a baby or already has a young child, share this with them.

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