Most homeowners have a keen awareness of the size of their mortgages since it’s likely the largest debt they’ll ever have. So, in the perennial debate of what to do with excess cash — pay off mortgage or invest — it’s understandable why some have a knee-jerk response to get out of debt ASAP, even if it comes at the expense of skimping on other investments.
But the numbers tell a different story. A variety of factors, including return on investment, interest rates and inflation, can make investing a much better financial choice than paying down the mortgage — especially if you use a pre-authorized contribution plan to a discount brokerage account, or set up a pre-authorized “set it and forget it” investment solution with one of Canada’s robo advisors.
Here’s what you should take into account when deciding whether to pay down the mortgage or invest.
Pros of Keeping Your Mortgage
There are several reasons why carrying mortgage debt can be a wiser option than paying it off early:
To maintain liquidity
- It’s vital to have an emergency cash fund so that a job loss, health issue, sudden home repair or other unexpected expense doesn’t derail you from your financial goals. If you’ve sunk all your money into your home, you’ll have to borrow to pay for emergencies.
Mortgage interest is cheap
- You will pay a much higher rate of interest on other forms of borrowing, such as personal loans or credit card debt, than on a mortgage. Lenders will always give a preferential interest rate with a mortgage because the funds borrowed are secured by the value of the home.
Long-term investments outperform mortgage-interest savings
- By keeping your mortgage and putting extra funds into long-term investments instead, chances are you’ll come out ahead. How so? A diversified mix of investments tends to earn more over a 25-year period (the standard mortgage amortization length in Canada) than the amount you’d save in interest charges by paying off the mortgage early.
- There are a limited number of ways you can reduce the income tax you pay each year, and making contributions to a Registered Retirement Savings Plan (RRSP) is at the top of the list. By putting money that would have gone toward paying off the mortgage early into an RRSP, you will reduce your taxable income. The greater your marginal tax rate, the higher the savings.
- Your home is an isolated investment in a single sector (real estate) in one region. If that’s your only investment and, for whatever reason, the housing market bottoms out in your area, you’ll be in trouble. You need a broad portfolio of varied investments to minimize risk and maximize gains.
Pros of Paying Down Your Mortgage Early
There are also benefits to discharging your mortgage ahead of schedule, especially for homeowners who have a high-interest rate mortgage, are conservative investors, or are nearing retirement. These benefits include:
Mortgage interest savings
- By paying down your mortgage early, you will save thousands of dollars in interest costs. The higher your interest rate, the greater your savings.
A guaranteed ROI
- For some conservative investors, the savings in mortgage interest may be greater than what they would earn on other low-risk investments.
Lower monthly costs
- If you are nearing retirement and still have a large mortgage, you probably aren’t wondering whether to pay down the mortgage or invest. Obviously, in this situation, it makes sense to try to pay off the debt as soon as possible. Otherwise, you may not be able to cover your monthly expenses in retirement when your income decreases.
Create Wealth By Investing
If you invest in a balanced and diversified low-fee portfolio, you will achieve solid returns and build wealth over time. In the past 30 years, for example, even a very conservative 50% stock/50% bond portfolio would have delivered compound annual returns of about 7.75% — much more than the guaranteed ROI of mortgage interest savings, which currently sits at less than half that rate.
To get the best bang for your buck, Young and Thrifty recommends one of the following approaches for smart investing, choose between:
- Use a pre-authorized contribution plan to a discount brokerage account, such as Questrade. Our comprehensive guide to the best online brokerages in Canada can help you choose the right one for you.
- Set up a pre-authorized “set it and forget it” investment solution with one of Canada's robo advisors, such as Wealthsimple or Questwealth Portfolios. Our comprehensive guide to the best robo advisors in Canada can help you choose the right one for you.
Doing so will not only ensure you prioritize savings by “paying yourself first,” but will also maximize your investment earnings because the fees charged by discount brokerages and robo advisors are very low.
You should put those savings into registered accounts, such as a TFSA or RRSP, which are like a basket of investments sheltered from tax. You can hold a number of investments within a TFSA or RRSP, including GICs, stocks, bonds, mutual funds, index funds and exchange-traded funds.
The main differences between an RRSP and TFSA are how and when you are taxed on contributions and earnings.
- With a TFSA, there is no tax deduction when you contribute, and your investments grow tax-free while inside the TFSA. The real benefit comes when you withdraw the money — completely tax-free. The current annual TFSA contribution limit is $6,000 (2019) and the cumulative maximum is $63,500 for those who were 18 or older in 2009 when TFSAs were first introduced.
- With an RRSP, you get the benefit of a tax deduction for your contributions in the year you make them, and your investments grow tax-free while inside the RRSP. But you must pay income tax in the year you withdraw funds. Your annual RRSP contribution limit is 18% of previous year’s earned income, up to a maximum of $26,500 for 2019.
Final Word: How to Make the Right Decision
In an ideal world, everyone would have enough money to invest and pay off the mortgage, rather than decide whether to pay down the mortgage or invest. Most of us, however, have to pick and choose where to put our hard-earned dollars.
By deciding to invest when you’re still young, you give your portfolio a longer period of time to withstand market fluctuations, compound and grow, which will maximize your returns. For many, prioritizing RRSP investments can be the best option, especially since the resulting tax refund can go toward paying off the mortgage sooner — offering the best of both worlds.
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