To pay down a mortgage or invest?

By | Financial Planning

So you have some extra cash flow, or an investment opportunity promising significant returns. With mortgage payments looming over you, it’s hard not to wonder how you can use it to tackle debts.

Who among us doesn’t dream of a paid off mortgage freeing up all the money spent on monthly payments?

Doing away with the largest drag on your net worth statement sounds tempting. But, so does investing for the future. If you don’t have enough cash flow to do both – and most people honestly don’t – which is a better bet?

As with most financial planning decisions, it’s never a simple choice.

In theory investing should win out over debt repayment – provided you’re a long-term, aggressive investor. With mortgage rates sitting near record lows, it’s natural to assume the return on an invested dollar should exceed the guaranteed savings from additional payments on a mortgage.

But with many experts warning rates will rise in Canada in the coming years, you can’t help but wonder whether chipping away at that mortgage is the smarter bet.

In the end, it all really depends on your personal financial situation.

Financial planning decisions are never a simple choice

Financial planning decisions are never a simple choice

Credit history

If your credit history has seen better days it may be better to reduce the mortgage rather than invest.

Those with weak credit generally find borrowing less attractive due to higher interest rates, piling on the existing mountain of debt. Bad credit often leads to losing control of your personal finances.

Paying off the mortgage will not only lessen your burden, in the process your credit score is also fortified.

Length of Amortization

An important factor that should never be overlooked is the length of your amortization and risk of default.

If you have a longer amortization period, but don’t have a lot of equity in your home, you may want to lean toward paying down your mortgage. This is especially encouraged if you’re a new home buyer already stretched to the max.

Making extra payments help ensure you can retain ownership of the house in case of a negative event. With home equity you can potentially refinance the mortgage with lower payments and be okay.

Paying off a mortgage will not only lessen your burden, but also improve your credit.

Paying off a mortgage will not only lessen your burden but also improve your credit.

Propensity to save 

Maintaining a mortgage leads to a form of forced savings. If you lack strong savings discipline, and have a tendency to spend available funds, paying off the mortgage is a good idea.

The behavioural enforcement aspect of a steady mortgage payment is always a bonus too.

Investment allocation

The rule is: more aggressive the investment allocation, better the mortgage and investment approach.

Unlike a conservative investor who favours fixed-income investments like bonds or GICs, a more aggressive investor — or someone with no less than 50 per cent stocks in their portfolio — is more likely, although not guaranteed, to net a higher return.

Tax rate

Generally, the tax benefit of a mortgage interest deduction best serves those with high income and significant itemized deductions. Otherwise, there’s little or no real tax savings from the mortgage interest.

If you’re leaning towards investing you need to ask yourself, are you investing in a taxable account? In doing so, your real investment returns are greatly reduced.

On the other hand, if you have contribution room available in RRSP or TFSA accounts it’s always best to utilize the government program. The added benefit of tax refunds or tax-free growth from these government programs goes a long way.

Keep in mind though, non-registered accounts are probably the least beneficial place to invest when you have a mortgage.

Cost

When prioritizing the investment option you also need to consider the fees being paid.
Cost is a really important consideration when investing because it’s probably the most reliable factor determining how you will do.

The more products cost the lower your return will be – costs eat into returns.

Cost is probably the most reliable factor determining how you will do when investing.

Cost is probably the most reliable factor determining how you will do when investing.

Risk tolerance

Investing in a portfolio of stocks and bonds is naturally riskier than using those funds to reduce a mortgage. The greatest risk involved is the fact that nothing is guaranteed with investing.

So for someone with low risk tolerance, it’s best to just pay down the mortgage. Repaying will have a high guaranteed rate of return even if your interest rate is low.

Paying off debt is possibly the safest bet available to the homeowner. Granted, it’s not nearly as exciting as investment prospects.

The emotional benefit of knowing you’re one step closer to being debt free is definitely worth considering. Owning a principal residence without debt will give you the financial freedom to take the bit of money previously spent on monthly mortgage payments, and use it for whatever you please. Some prefer this freedom and peace of mind over all potential economic gain.

The decision to invest or pay off ultimately boils down to the cardinal rule of financial planning: avoid unnecessary risk.

Without an absolute need to take on additional risk it’s hard to justify investment over a payoff – even with the prospect of a potentially significant, if uncertain, economic windfall.

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