Invest or Pay Off Mortgage: The Winner Is…

Once you've filled your TFSA to the max and your RRSPs (if it's right for you), we enter a dilemma: do we pay off our mortgage, or do we save in taxable Cash/Margin accounts?

To analyze this properly, I divided Canadians into two groups. Group 1 are people who understand risk, volatility, and don't mind taking on smart debt to invest. Group 2 are people who are debt-averse or lack a solid understanding of the risk/volatility relationship.

We will begin by looking at considerations for Group 2.

Mortgage Pay Off

Our mortgage rates are near all-time lows: bank prime rate is currently 2.7%. Any Canadian with decent credit can get a mortgage at around 2.5% right now. Just 0.5% higher than our inflation rate—basically free money!

This makes mortgage pay-off math pretty easy. Your current rate of return paying off your mortgage is about 2.5%. We are not going to adjust for inflation, so we will use nominal return numbers. That equals 7.5% return on investments and house values increasing 2% annually.

We are doing this because your mortgage payment doesn't go up by the inflation rate over the 25-year mortgage amortization period—the only variable is the interest rate. This means the money for extra mortgage payments or investing doesn't increase with inflation either.

Mortgage Example

Investing While Paying Mortgage

For a $500,000 house we put 20% down (always), so our monthly payment over 25 years at 2.5% is $1,790. In 25 years, we outright own a house now worth $822,000. We also save $200 a month for 25 years in a taxable investment account at 7.5%. At 25 years, we have $173,000 in that account. Our total net worth on the $1,990 monthly payment+investment after 25 years is $995,000.

Pay Off Mortgage First, Then Invest

If we add $200 a month to each $1,790 payment, our mortgage will be paid off in just 21 years and 8 months. This leaves 40 months of saving $1,990 in our investment account. Therefore, in 25 years, we own the same $822,000 house, plus $90,500 in investments. Our total net worth on a $1,990 monthly payment+investment after 25 years in this strategy is $912,500.

We are better off by $82,500 when we invest from the start and make the minimum mortgage payment. However, that is at today's super low mortgage rates.

If we increase the mortgage interest rate to 7.5% for a $2,925 monthly payment + $200 savings, we will have the same net worth at 25 years if our investment return is 7.5%. (Makes sense because the mortgage rate matches the expected net investment return rate.)

Tax Considerations

Mortgage payments and investment contributions (not including RRSP) are made with "after-tax" money. This means we have already paid taxes on our earnings before making these payments/contributions.

Once a mortgage is paid off, you don't pay income taxes on the benefit a paid-off house provides: displacement of some housing costs. However, you are required to pay tax on realized capital gains and distribution income from your investments.

It is important not to let tax confusion direct your investment choices as it has a minimal impact. The biggest difference lies in the capital gains.

Paying off the house early and investing $1,990 for 40 months translates to a maximum deferred capital gain of $11,000 on a $90,500 investment account. The other $79,500 is your contributions and these won't be taxed again. If you are in a 20% tax bracket in retirement, your expected tax bill on the capital gains is $1,100. This reduces your "net" account value to $89,400.

When investing $200 a month for 25 years, the deferred capital gain is $113,000 on a $173,000 investment account. In the same tax bracket, your expected tax bill is $11,300. This reduces your "net" account value to $161,700.

Given all considerations, unless the mortgage interest rate is close to your nominal expected return on investment, you are almost certainly better off investing your extra money in a Cash/Margin account from the beginning than you would be paying off your mortgage early and investing later.

Psychological Considerations

One factor that can't be easily argued by a numbers nerd like myself is the oft-discussed psychological benefits of paying off your mortgage early. However, I believe this is a foolish and short-sighted defense for aggressive mortgage repayment.

At current rates on a $400,000 mortgage an extra $200 a month will help pay off a mortgage 3 years and 4 months early. An extra $500 a month will pay it off about 7 years early.

This seems significant, but it's only one side of the picture. Over 21 years and 8 months, $200 properly invested each month will grow into a $128,000 investment account. $500 a month over 18 years grows to $227,000.

Diversification is important! In my book a small mortgage balance and a fat investment account is much better than no mortgage and no investment account. If I run into financial trouble with no investments, I have to re-mortgage or sell my house (we know how pricey that is). Getting money could take months!

On the other hand, if I run into financial trouble with a fat investment account and a small mortgage, I can still refinance my house and I can also realize income from my investments at a very low cost. Selling some ETF units will cost me $10 in commissions and a bit of tax. The money will be in my chequing account tomorrow.

Come back on Monday; I will examine tax considerations for investing in Cash/Margin accounts during your investment growth period.

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2 Replies to “Invest or Pay Off Mortgage: The Winner Is…”

  1. Prairie says:

    What does “close” mean? Assume you have a $300,000 house. If the money is invested instead you’ll generate $22,500/year in capital gains (on average, 7.5%). In Alberta, the lowest tax bracket, this would incur a tax bill of $2,812/year a 0.9375% fee. You then add the tax fee to the interest rate on the loan to compare if its a good deal. A closed 5 year loan would have taxes (0.9375)% and loan interest (2.50% right now) of 3.44% compared to the expected 7.5% on investments. That leaves the expected return of 4%, that’s the payment for your risk.

    Close is 1%, it increases at higher tax brackets. If the interest rate was 6.5%, not 7.5%, you would break even after taxes.

    Feel free to correct my math. I find this way of calculating easier to follow.

  2. Mr. Rich Moose says:

    By my calculations, in the lowest tax bracket capital gains tax represents around 0.5% to 0.75% drag on investment returns. (Depends on the province.)
    For example:
    We’ll assume mortgages are 7% for a monthly payment of $1,681. We have $2,000 available for mortgage and investing and expect a 7.5% return on investments.
    Option 1: Invest $319 alongside your mortgage. Your investment account will be $270,673. $174,973 is taxable gains. Net account value at 12.5% tax is $248,801.
    Option 2: All $2,000 to mortgage payments. Your mortgage is paid off in 205 months. This leaves 95 months for investing $2,000. Your investment account will be $257,218 with $67,218 in taxable gains. Net account value at 12.5% tax is $248,815.
    So within a few nickels we’re even at 0.5%.

    I would agree with you that, if your mortgage rate is within 1% of your expected investment return, you should pay the mortgage first to take the guaranteed gain.

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