Mortgages are likely the largest debt most Canadians will ever have in their lifetime, and with high housing costs and ultra low interest rates, it's not out of the ordinary for the average Canadian to have very large debt in their homes in the 100's of thousands of dollars. Having upwards of a $500,000 loan can be pretty daunting and a lot of people will want to pay that off as soon as possible, but let's be prudent here and actually understand the alternative.
By looking at the numbers we can see that interest rates are low, and considering our current economic development, they are likely to stay relatively low for the near term and likely longer. Mortgage rates of around 2.5% are common right now and many are expecting them to go even lower, with some discount brokerages already offering 1.99%. Long term rates of return on your average diversified equity portfolio have beaten those returns handily over any long term period in the markets and can be assumed that will also continue in any 10 year to 20 year periods. A 7% annual average return over the next 20 years should be achievable with proper diversification and asset allocation.
Even by looking at the numbers, many risk tolerant Canadians would still prefer to pay down their mortgage sooner rather than investing any surplus cash flow. Many should actually consider doing both to maximize the efficiency of their cash flow and to increase their overall net worth.
For example, if a couple had a mortgage of $400,000 and had consistent mortgage payments of $2000/month at an interest rate of 2.5%, then it would take them approximately 22 years to pay off that mortgage. If this couple had an additional $400/month of additional cash flow and redirected that to the principal on their mortgage, then they would speed up the amortization on their loan and have it paid off in only 17 years. That sounds pretty good to me!
Let's change this couples plan though and take advantage of some compounding interest and start investing that $400/month in their TFSA's for the next 17 years and see what could happen. In 17 years at their regular $2000/month mortgage payment they would still have $102,000 left owing on their home...bummer, right? Well, that $400/month invested in their TFSA would have grown to $157,000 in 17 years. Sweet! Let's take $102,000 from the TFSA's and pay off your mortgage now. So, the mortgage is still paid off in 17 years and you still have an additional $55,000 in tax free money. Don't think 7% returns are feasible? At 6% you'd still have $42,000 and at 5% over 17 years you'd still have $27,000 of additional money in your TFSA after the mortgage is paid off. Even if your TFSA is maxed and you have to use a taxable non-registered investment account, your after tax earnings would still make this strategy effective.
Not only will this strategy increase your net worth in the long run, but it is a more flexible strategy as well. In 17 years time nobody will force you to withdraw the TFSA investments to pay off your mortgage if you don't want to. The TFSA could be used as an emergency fund for you in the short or long term or you could always allocate it to your overall retirement plan to provide yourself with additional income in your golden years. If you just use additional money to pay down your mortgage then the flexibility and liquidity is lost, and the only way to access that money again is to borrow and pay interest on it. After watching your TFSA compound into a nice little nest egg over the years then it might be a little easier to let that keep growing and just continue with the regular scheduled mortgage payments too.
PRO's of Investing Additional Cash Flow:
Liquidity - the investments can double as an emergency fund if needed, whereas if you pay down your mortgage instead then when an emergency arises you would have to borrow to pay for it.
Market Returns and Interest Rates - interest rates are at historical lows and are projected to remain low for the foreseeable future. Long term stock market returns have historically performed much higher than current interest rates are at, even through economic recessions.
Diversification - if your home is your only financial asset and you're planning your retirement around that, then you might be in trouble!
Increase Net Worth - allocating cash flow to something that earns more interest than it would be saving you on mortgage interest will increase your overall net worth.
CON's of Investing Additional Cash Flow:
No Guarantees - there is no guarantee on stock market returns, whereas paying off your mortgage is a guaranteed rate of return.
Higher Risk - some people have a low tolerance for risk and would be better suited to focusing on their mortgage instead.
Nearing Retirement - if you a nearing retirement or in retirement and are carrying a large mortgage then it would likely be beneficial to focus on the mortgage.
High Mortgage Interest - if your interest rate is high on your mortgage, then investing additional cash may not be the best plan.
If it fits their risk tolerance and their overall financial plan, then the flexibility and liquidity of using the investment strategy instead of focusing on paying down a mortgage can be a huge advantage for Canadians with their ever changing lives and evolving financial goals. If you're still unsure which strategy would work the best, then consult with your financial advisor today and implement a game plan that works for you.
Cheers,
Marty Metz, CFP, CLU
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