How to Manage Debt Efficiently

Should You Pay Off Your Mortgage Early or Invest Your Excess Funds?

By Matko Pevec, Financial Planner

Many people dream of being debt-free. They cherish the belief that all their efforts should be directed towards repaying their mortgage or other debts as soon as possible. While having no liability payments definitely offers peace of mind, it might not make sense financially. Let’s look at the example below.

Assume a mortgage applicant is considering the following two options. First, a 25-year mortgage of $400,000 at a fixed rate of 4.50 per cent. This would bring their monthly payment to $2,214, and the total interest paid over the life of the loan would be $264,127. The second option is if the applicant considers repaying the mortgage early and selects a 10-year mortgage, increasing their monthly payment to $4,138. As a result, they would end up paying $96,502 in total interest. At first, looking only at the total interest savings ($165,625) brings us to the conclusion that the latter option makes more sense.

The above example could be a sufficient argument, especially for someone who is debt-averse, to focus on repaying the mortgage early. However, this example fails to provide the other side of the coin, which is the opportunity cost. If an applicant who selected a 10-year mortgage continues to invest $4,138 per month for the next 15 years at an assumed average rate of return of 7.50 per cent, the total value of investments would be $1,227,734. On the flip side, if an applicant opts for a 25-year mortgage, the difference of $1,924 per month ($4,138 - $2,214) could be invested right from the start, which would grow to $1,420,900. That is $193,166 more than in a 10-year mortgage scenario. Since the savings in interest payments were $165,625, this brings the net benefit for a 25-year mortgage to $27,541. Again, at first, it does not seem like a significant benefit, but there are other important benefits that should not be overlooked such as:

• Liquidity: Property is not a liquid asset, which means that in case of a financial emergency selling your home might be the only option, and it could take months before the sale is closed. Having your money invested means you can easily sell and access your money if you need to. Also, whether you decide to invest excess funds long term or short term, having some emergency funds (zero per cent return) is equally important.
• Tax breaks: Before repaying the mortgage, consider contributing to various tax-advantaged accounts such as an RRSP, TFSA, RESP, etc. Another tax-efficient strategy if mortgage is tied to rental property is that the interest becomes tax deductible. This reduces the effective interest rate. In our example above, if the applicant’s marginal tax rate is 50 per cent, this reduces the amount of interest payable by 50 per cent. The effective interest rate, therefore, would be 2.25 per cent.
• Inflation: If inflation rates are higher than a mortgage interest rate, then you are actually coming out on top by having an active mortgage. While the value of the dollar depreciates, the payments are fixed and the real estate presumably continues to appreciate in value.

Looking at arguments above, you can easily conclude that investing early vs. accelerated mortgage repayments makes more sense. However there is no one-size-fits-all approach. It is important to consider the risk tolerance, long-term goals and the timing. Over the last decade, the low interest rate environment would have definitely reinforced that school of thought. However, the rapid increase in interest rates over the past year – while the stock market is still relatively high – has put a pause on the above strategy.

It is, therefore, paramount to assess the client’s needs and circumstances as well as the current interest and stock market environment. When it comes to buying a real estate property, your clients need to be aware of all the risks and opportunity costs involved before making the final decision. For many, this is often the biggest purchase of their lifetime.

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