Should We Pay Down Our Mortgage or Invest?
Last week, in my 224th blog post, I introduced Gregory (Greg) and Olivia, a young married couple who had bought a house in the Greater Toronto Area (GTA). They considered two common ways to reduce the interest they would pay over the life of their mortgage and effectively reduce the amortization (the period it takes to eliminate the mortgage) of their mortgage debt. There is no magic bullet to accomplish this. They must put more money toward their mortgage, either by paying more every pay period – monthly, in their case – or paying a larger annual lump sum.
Greg and Olivia are making monthly mortgage payments of $3,623.69, which works out to an annual figure of $43,484.28. In last week’s blog, they were debating whether to go with doubling up their monthly payments or pay the equivalent in a lump sum on the anniversary date of their mortgage. It turned out that doubling monthly payments was slightly better than making annual lump sum payments.
What About the Investing Option?
This time, Greg and Olivia want to know if they will get further ahead by investing those extra payments instead of using the money for the mortgage. In the other rapid mortgage paydown scenario, they paid an extra $3,623.69 per month beginning on December 2, 2023, and running until June 2, 2031, the last payment of their current term. This works out to a total of 91 payments or 7 years and 7 months.
First, What Is the Mortgage Balance on June 2, 2031?
Let’s remember that the terms of the mortgage are as follows:
- Rate: 2.60%
- Compounding: Semi-annual
- Amortization period: 25 years (300 months)
- Term: 10 years (120 months)
- First payment date: 2021-07-02
- Payment frequency: Monthly
- Payment: $3,623.69
If they follow this pattern until the end of their 10-year term, their June 2, 2031 mortgage payment will consist of $1,169.36 for interest and $2,454.33 toward the principal. The principal will have dropped from the original $800,000 to $540,167.42.
Remember, in last week’s post showing the doubled-up monthly payments, the mortgage payment on June 2, 2031 would have only devoted $394.67 to interest and the remaining mortgage balance would have been only $176,288.13.
Note: With Doubled Payments, the principal payment is indicated at $6,852.71. If we were to ignore the doubled payment for this purpose, the principal payment would equal $3,229.02.
How Much Financial Capital Can Be Generated by June 2, 2031?
Let’s assume that Greg and Olivia are both 35 and earning fairly high incomes of just under $121,000 per year. They are employed but do not have any form of employer-based retirement savings plan. It’s all on them to save for their retirement. Coincidentally, when Greg and Olivia calculate how much they are permitted to contribute to their RRSPs, it exactly equals $43,484.28, or $21,742.14 each, annually. They choose to make their contributions on the first business day of each month. After trying a few online risk tolerance assessments as well as the expectation that they have a 30-year career ahead of them before they plan to retire, they decide on an 80% equity/20% fixed income allocation. They chose a globally diversified asset-allocation ETF with an expected long-term nominal return after fees of 5.58%.
Note: Estimated Return figures are based on the IQPF and FP Canada Standards Council Projection Assumption Guidelines.
The Investment Outcome
Greg and Olivia each contribute $1,811.85 per month toward their respective RRSPs. This pattern continues from December 2, 2023 to June 2, 2031. With compounding growth on their contributions, by the time their mortgage comes up for renewal, they each have grown their RRSPs to a value of nearly $205,000. In addition, thanks to the tax refunds generated by their RRSP contributions, estimated at $8,755 per year, they start contributing to their TFSAs, too, using the same 80/20 asset allocation. That gives each of them a TFSA balance of nearly $70,000 by June 2, 2031.
Comparing Net Worth
The goal of this exercise is to see how much difference it would make to aggressively pay down the mortgage versus investing. The outcome suggests that it would be advantageous to invest.
At this stage in Greg and Olivia’s journey, mid-year 2031, their net worth is estimated to be improved by $184,603 if they choose to invest. More than just the superior net worth, however, is the diversified asset base that Greg and Olivia now have. No longer will their net worth be entirely wrapped up in the value of their home. This reduces risk. Houses can go down in value.
However, this outcome should be considered against a couple of realities. First, they have a great interest rate right now. When the current mortgage term matures, the prevailing rates might be quite a bit higher, as is the case for homeowners and would-be homeowners who are trying to get a new mortgage now.
Second, investment returns are not guaranteed. The expected rate of return is reasonable over the long term, but results could be quite different over a relatively short period like eight years. Having said that, there is no guarantee that property values will go up or even hold steady.
Third, taxes need to be considered. While the RRSP contributions generate a tax refund which allows Greg and Olivia to invest in TFSAs as well, when withdrawn as RRIF payments or annuities, tax will be owed. On the other hand, their home will not be taxed when it is sold.
Fourth, and combining both investment returns and tax considerations, if we think about the fact that mortgages are paid with after-tax money, while the deduction available from an RRSP essentially allows us to invest on a before-tax basis, we need to think again about the mortgage interest rate. The marginal tax rate for an individual in Ontario earning over $120,000 per year is 43.40%. That 2.60% rate is more like 4.59% on a before-tax basis: 2.60% ÷ (1 – 43.40%) = 4.59%. And that return is guaranteed for as long as you are in that same tax bracket and paying that same interest rate.
What Should You Do?
I think this is probably a matter of personal preference. A low mortgage interest rate is an invitation to consider investing, but there is seldom a definitive answer available. Perhaps surprisingly, despite Canadians’ high borrowing levels, there are many Canadians who do not like debt. Being debt-free brings with it a greater degree of financial flexibility, which has value.
As is often the case, perhaps a good answer is to compromise. Instead of choosing to go all in on rapidly paying down the mortgage or keeping payments as scheduled while using all your surplus to invest, you may want to increase your monthly mortgage payments by 50% instead of doubling them, using the remaining 50% to invest. Alternatively, you can maximize your RRSP contributions but use your tax refund to put toward the mortgage principal instead of investing in a TFSA. In other words, when you can, try to put your eggs in more than one basket.
This is the 225th blog post for Russ Writes, first published on 2023-11-27
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.