Once upon a time, racing to become mortgage-free was akin to a national sport. For many, it’s still the Canadian dream.
But putting discretionary income towards a mortgage is often not the winning play. A veritable smorgasbord of alternatives could potentially outperform a mortgage prepayment’s humble interest saving, including:
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- Paying down high-interest credit cards;
- Paying down other high-interest loans (for example, a car loan, personal line of credit, etc.);
- Registered retirement savings plan (RRSP) contributions, which get you a tax deduction and the tax-deferred growth of a diversified portfolio;
- Tax-free savings plan contributions — a great option when you’ve maxed out your RRSP contributions;
- An investment property with a high yield;
- A side business with a reasonable probability of success;
- Registered education savings plan contributions.
Making extra mortgage payments entails an opportunity cost if your return after taxes is higher elsewhere. Consider that a $1,000 prepayment on an average five per cent mortgage might save you about $630 of interest over 10 years.
Suppose you contributed that same $1,000 to, say, an RRSP with U.S.-listed exchange-traded funds. If you earned seven per cent net of fees — near JPMorgan Chase & Co.’s estimate for long-term, large-cap equity returns — a $100,000-a-year earner would defer between $305 to $421 of income tax upfront, plus earn about $967 over 10 years.
Liquidity
Generally speaking, unless you have a home equity line of credit (HELOC) linked to your mortgage, you can’t access the principal payments you make on the mortgage unless you refinance or sell. But if times get tough and life throws you an income curveball — job loss, divorce, health woes — refinancing may be off the table. Moreover, if it’s a buyers’ market, you may take a hit on any sale on top of realtor fees and closing costs.
By contrast, you can sell a well-diversified, blue-chip stock portfolio in a pinch. There’s some risk depending on whether the market is up or down when you sell, but that’s a picnic compared to the alternative: defaulting on your mortgage and other bills.
Canada’s standard mortgage amortization is 25 years, but stretching a mortgage to 30 years can pay off for someone with a long investing time horizon. Yes, you pay more interest, but you also get to funnel more cash flow to higher-earning investments that outrun inflation and pay your mortgage with cheaper dollars in the future.
To illustrate that last point, suppose you make the average full-time wage — $1,468 per week, or $6,359 a month — and your mortgage payment is fixed at $2,000 monthly. That payment amounts to 31.5 per cent of your gross income.
But if your income grows at Canada’s long-term average of roughly three per cent a year, then after a five-year mortgage is up, you’ll be earning $1,013 more per month. Meanwhile, assuming you don’t move or refinance, your fixed-mortgage payment is frozen in time at $2,000. It drops to just 27.1 per cent of your income, lowering the relative burden of that mortgage.
The cons of not prepaying
Investments entail risk, whereas prepaying a mortgage is virtually risk free and tax free — opportunity cost and liquidity aside.
Yet, as mentioned above, prepaying a standard mortgage typically means you can’t get that money back unless you refinance or sell. Hit a bump without the safety net of liquid assets, and it’s like needing a parachute, but finding a backpack instead.
One way to counter this inflexibility is to tie a HELOC to your mortgage, so you can re-borrow those funds in an emergency. You just need to be creditworthy and have more than 20 per cent equity to get a HELOC.
Sometimes, it’s not about the return on investment. Sometimes, it’s about the psychic return on investment, that cozy feeling you get from knowing a lender can’t take your home because you don’t have a mortgage.
Prepaying a five per cent mortgage yields a guaranteed tax-free, almost risk-free, net return of five per cent. The older most folks get, the less they can afford to gamble, and the more prepayments make sense, assuming they have a rainy-day fund.
If you’re at a crossroads on this, a financial adviser makes a trusty co-pilot. They wield programs that run multiple scenarios, factoring in mortgage interest savings, potential total returns after fees and tax ramifications. They can also confirm investment suitability and compare higher-yielding options (stocks, ETFs, mortgage investment corporations, etc.). The one-time outlay for good advice is often the difference between financial wine and vinegar.
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