In a perfect world, we would have enough cashflow to pay down our mortgage aggressively as well as invest. But most of us eventually get to a point where you start to ask yourselves the big financial question; should you pay down your mortgage or invest?
If you’re like me, you dream about a day where you have no mortgage. In my case, that would free up about $1,700 per month in cashflow or $20,400 per year.
With that kind of extra cash flow, investing is one option, but working less, or retiring early might be another. It all depends on your goals and where you are financially.
Pro 1 - With investing, time is on your side.
Investing early and often has the potential to create tremendous wealth.
Using some simple calculators found on TD Canada Trust’s website, you will see that there is tremendous power in establishing a disciplined investing plan sooner rather than later.
Example 1: A 25-year-old with 40 years until retirement starts with an initial deposit of $1,000 and automates $200 per month towards a Tax-Free Savings Account (TFSA).
We assume earning an 11% per year average on the investment, which is in line with the market.
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Example 2: A 40-year-old with 25 years until retirement starts with an initial deposit of $1,000, and automates $500 per month towards his Tax-Free Savings Account (TFSA) doesn't come close to the 25-year-old even if they double their monthly contributions.
We assumed earning an 11% per year average on investment, which is in line with the market.
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By maintaining your minimum mortgage payments and putting any extra funds into a long-term equity investment, the chances are you will earn more money investing than you would save in interest. Past performance is not a perfect prediction of the future, but history shows that by even investing in the broad market of the Toronto Stock Exchange or the US Based S&P 500 will average a 7% per year gain in the Toronto Stock Exchange and an 11% per year gain in the S&P500 over a 10 year period. This performance is a lot better than saving the 2.50% on your mortgage.
Pro 2 - Diversification
While owning real estate and your home, or multiple properties for that matter might be fine and good, I would encourage investors to consider diversification as part of wealth-management. Diversification can still bring higher potential returns but for less investment risk.
Having an investment portfolio that extends beyond real estate, will allow you to participate in growth opportunities that are not tied to the real estate sector. While your home may be very nice, your home is an isolated asset in a tiny part of a global investment world. If for whatever reason something happens to your localized asset, I believe it would be smart to invest in other assets around the world.
Pro 3 - Liquidity
By having your assets invested beyond your primary residence, you will have more liquidity should you need the money for something. The only way to access the money you have paid down on your mortgage is for you to re-apply for a second mortgage or increase your current one or sell your home.
On the other hand, the ability to sell investments is very easy.
Pro 4 - Tax Advantages
In some cases, depending upon your tax situation, I believe paying off your mortgage should be a low priority.
- You are self-employed or run a small business. A portion of your mortgage interest will be tax-deductible to reduce your taxes payable.
- If you own an investment property or multiple investment properties. If you absolutely have to pay the mortgage down, you should pay down the mortgage on your personal residence before you pay the mortgage down on your investment property. Interest on the rental property is a tax-deductible expense but it is not so on your personal residence.
- Making an RRSP contribution is a method to reduce your taxes owning. So, you get the chance to invest and paying lower overall taxes.
The bottom line
If you expect the rate of return on your investments to be consistently higher than your mortgage interest rate over the life of your mortgage, you will have more money by paying the minimum amount on your mortgage and investing the difference inside your TFSA or RRSP. Investing in an unregistered account will cause you to have tax implications on your capital gain.
Paying off the mortgage first
Pro 1 - You pay less interest
Remember that interest accumulates, and you end up paying more the longer you have the loan. So, the shorter time frame would save you money.
By paying down your mortgage early, you will save thousands of dollars in interest costs.
I recommend using these techniques to lower your borrowing costs.
- Use a mortgage broker to find a very competitive mortgage rate and terms for your situation.
- Enroll in bi-weekly, accelerated payments to increase the mortgage payment frequency.
- Reduce your mortgage amortization period over time by increasing your monthly payment.
- Make a few lump-sum payments early in the mortgage payment schedule to put down more against the outstanding principal owed.
When it comes to paying off your mortgage, the goal is rather simple: the lower the amount borrowed + the more frequent the payments = the less interest you'll end up paying.
Pro 2 - Increased cash flow
Another reason to pay off your mortgage debt before investing, is it will provide financial flexibility. The money that was formerly funneled to paying the bank will now go to you and can be allocated to your retirement savings, you
