Mortgage or Investment
It’s an age-old financial dilemma: should you use extra savings to pay down your mortgage or invest for retirement?
A simple answer is to compare the expected return from your investments to the interest rate on your mortgage.
The right answer for you is more complicated and emotional.
A decade of low-interest rates and double-digit stock market returns has made investing seem like the smarter play – a no-brainer. However, as interest rates tick higher and stocks come due for a pullback, a more aggressive mortgage paydown starts to make sense.
You can accelerate your mortgage’s amortization schedule and pay it off faster with additional monthly contributions or an annual lump sum payment. Think of the extra payments as a guaranteed, risk-free return equivalent to the rate on your mortgage.
Reaching mortgage freedom in your late 40s or early 50s still leaves plenty of time to ramp up retirement savings while your biggest expenses are in your rear-view mirror.
On the other hand, expected returns for stocks have historically been around eight per cent. With mortgage interest rates still well under four per cent, there’s potential to earn higher returns by investing. That higher rate of return gets the magic of compound interest working in your favour for a longer period of time.
Investing also helps diversify the household balance sheet. Many Canadians have one asset – their house – and by single-mindedly focusing on paying off their mortgage, they effectively tie up their wealth in one relatively illiquid asset.
What happens if the main breadwinner in the family loses their job? Who is more secure: the family that has $100,000 saved inside their RRSP, or the family that has a smaller mortgage but no savings?
Sinking all your available cash flow into the mortgage in hopes of paying it off early can leave you in a tight spot should you become unemployed for a long period of time. Sure, you can reduce your payments back to the minimum, and even take a mortgage vacation for a few months, but eventually, your lender wants its money back. A healthy RRSP balance can help you weather the storm in the event of a long-term income drought. Sure, you’ll pay tax on any withdrawals from your RRSP, but that beats going into debt or losing your home.
Let’s say you buy a home worth $400,000 and use all your savings – $80,000 – for a down payment. You diligently pay down the mortgage, doubling your monthly payments and adding a $5,000 lump sum each year. After five years you’ve paid off $165,000 of the principal and owe just $155,000 on the mortgage. You’ll be mortgage free in four years.
Your family prioritizes their mortgage at the expense of saving for retirement, thinking that once the mortgage is paid off they’ll start investing for the future. You work full-time as a sales director and your spouse stays home with your two preschool-aged children. When a recession hits and you lose your job, your family has no emergency income buffer to see them through the difficult times. After a month, you visit the bank to apply for a line of credit, but to set it up the bank needs your recent employment history. Sadly, the bank turns down your application.
Now let’s go back to when you first bought the home. This time, instead of putting every last dollar onto your mortgage, you add $250 per month to your $1,500 minimum mortgage payment. With this approach, you free-up $20,000 per year to invest in an RRSP.
After five years you have more than $112,000 saved in your RRSPs and are still on track to pay off your mortgage in a reasonable 20-year time frame.
When you get laid off, you’re able to draw from your substantial RRSP portfolio instead of turning to debt or being forced to sell your house.
Although it might seem like paying off your mortgage early is always the most prudent use of your extra savings, this example illustrates how risky it can be to put all your eggs into one basket. Indeed, if you’re still having trouble deciding, you can always go with the tried-and-true Canadian approach of contributing to your RRSP and then using the tax refund to pay down your mortgage.
This article was written by Robb Engen from The Toronto Star and was legally licensed by AdvisorStream through the NewsCred publisher network