What would you do if you won one million dollars today? Pay down cash for a house or invest it? If you think this is a tough decision, imagine having to choose this with a regular source of income. Many Canadians face the dilemma of using any excess income - after paying bills and offsetting living expenses - to pay off an existing mortgage or invest in the financial market.
Like any personal finance journey, this decision may very well depend on the surrounding circumstances of an individual while considering other factors such as long-term financial goals, risk appetite, interest rates, opportunity costs, amongst others. Here are the factors you may want to consider when deciding whether to pay off your mortgage earlier or invest any spare cash.
For several people, the decision to pay down a mortgage earlier can be due to emotional and psychological factors tied to debt and owing money. Some people dislike the idea of having a financial liability, and so paying off a mortgage earlier would make them feel more confident about their financial health. This can be considered a valid reason if you choose to pay off your mortgage earlier as against investing more.
When considering the financial implications, an excellent aspect to factor in is the potential savings you get on interest rates over the years of holding a mortgage. Usually, financial institutions apply interest rates on your outstanding principal. The interest rates may be seemingly meager, but in the long run, the amount of money paid towards your mortgage interest rate may end up being almost equal to the principal borrowed.
Paying off your mortgage earlier means you become debt-free earlier, and you save on interest rates. Also, you have the peace of mind that comes with living in a house that has been fully paid off. However, it is essential to consider any underlying contractual terms that prevent you from paying off your mortgage earlier. Some financial institutions set a limit to how much you can pay over your periodic mortgage payments and any allowable lump sum payments. Going against the contractual agreements may result in penalties that would cost you money.
Of course, a rational decision would consider the underlying rates associated with holding a mortgage versus investing. Generally, you should be more inclined to pay off any debt faster if the borrowing rates are higher than any returns you would get from investing. This also applies to your mortgage. For example, an average 25-year mortgage rate for a 5-year fixed term can range from as low as 1.7 percent to as high as 3.5 percent or more, depending on which financial institution provides you with the house loan and your creditworthiness. Generally, the average market rate of return is higher than prevailing mortgage rates. For this reason, it could be more beneficial to hold off paying excess money towards your mortgage and instead invest more aggressively.
Yet, there is also the consideration of the future value of your house. If you intend to sell your house later, the value may have appreciated, resulting in capital gains. The question then lies in comparing such gains with any returns you may have received from a long-term investment in the financial market, either through traditional or non-conventional assets. While capital gains on a primary residence are not taxable, they will be taxable if it is a rental property or not your primary residence.
Choosing to pay off a mortgage earlier can make you lose out on tax benefits available from investing in tax-advantaged retirement savings plans such as the registered retirement savings plan, for example, using a vehicle known as the Registered Retirement Savings Plan (RRSP). Paying extra money towards a mortgage means putting off investment of that equal amount. The compounding aspect of investing makes earlier participation more beneficial than a later start. For this reason, your investment returns could be lower in the long run if you delay your investments.
When planning for retirement, it is essential to determine what the safest financial decision would be. The primary objective is to ensure that you can provide for your basic needs when you retire. If you focus solely on paying off a mortgage, this is almost the same strategy as investing in just a sole asset, in this case, your home. If anything happens to your home, this can harm your financial well-being.
On the other hand, investing allows you to diversify your retirement portfolio, and this can provide a cushion against losses in specific sectors or assets in the financial markets. Additionally, the eroding feature of inflation may make a sole investment in a house less effective when planning for retirement.
Most mortgaged homes serve as a primary residence for the average Canadian, so the intent is not to sell a home in retirement. However, if you intend to sell your home and downsize in retirement, the gain on your home may not be sufficient to combat the rising cost of inflation.
Unfortunately, not everyone gets to win the lottery, and many people are still torn between the decision of paying a mortgage early or investing. The best approach is unique to your financial situation and your retirement goals. The Underlying interest rates and possible returns from investing in the long-term are key factors that impact your decision. It is recommended to speak with a financial advisor to help you understand and simulate the financial implications of any specific decision.
Can there be a balance? Absolutely! You can do both - put more money towards your mortgage and invest. For some, the most effective approach is finding a balance that addresses both the emotional need to pay off debt early and the chance to take advantage of higher returns through investing. You can allocate a proportion towards paying your mortgage and another portion towards investing for any extra income you have. The critical part is that you do not lose out entirely on the positives of investing and any tax advantages that accompany investing towards your retirement.
