One of the major debates of personal finance has been the question of whether it is better to pay down your mortgage or invest your money instead. Of course, there is no simple answer to that question and the fact that the media is constantly reminding us that we have too much debt, on the one hand, and aren’t saving enough for retirement, on the other, can make one feel like they are being pulled in two opposite directions.
First, let me just say that if you find yourself wrestling with this question then you are in a better position than most people.
Not too long ago when I had a mortgage balance of less than 30k it seemed obvious to me to just pay the sucker off and be done with it. That would have freed up a lot of cash that could be directed toward investments.
Now that I have a very large mortgage balance I’m forced to rethink my approach. So let’s take a look at the debate surrounding the mortgage vs investing question to see if it can offer any guidance.
Generally speaking, the mortgage vs investing debate centers around 2 key questions: (1) your personality type (ie. your risk tolerance) and (2) the math (ie. the interest rate on your mortgage vs the average expected rate of return on your investments – all net of taxes).
A person’s risk tolerance can be one of the most difficult things to accurately gauge because, with few exceptions, it can be subject to wild fluctuations. For instance, in a Bull Market when stock indices are soaring to new heights on a daily basis, it’s easy to say to yourself that you’re willing to take on a lot of risk. The irony here is that we are willing to accept greater risk when we perceive that risk as being relatively small and unlikely to actually materialize.
On the flip side, the true test of one’s risk tolerance comes after steep declines in equity markets when we’re in the depths of a Bear Market. Anyone who had money invested during the 2008/2009 market meltdown knows what I’m talking about here. If you can’t stomach watching your portfolio lose 40%-50% of its market value then you should probably take a closer look at your “real” risk tolerance and adjust your asset mix to reflect it.
So your risk tolerance is basically the amount of risk that you’re willing to take and be able to sleep at night. If having a large outstanding mortgage stresses you out then paying off the mortgage might be the way to go. On the other hand, if you’re comfortable with risk then going the investing route may be your preferred choice. It really all depends on how you approach risk and what works for you.
When it comes to doing the math on the question of whether to invest or pay off your mortgage, the answer just isn’t that clear cut. The reason being is that the 2 most important variables in the equation (mortgage interest rate and average rate of return on investments) are simply out of our control.
Today we have record low interest rates and because most Canadians typically refinance their mortgage every 5 years, they can’t be sure what the interest rate will be upon renewal. The general consensus seems to be that they will most certainly be higher than they are today. Although at this particular moment in time, with record low interest rates prevailing, it may appear to be a no-brainer that you’ll be better off investing; once interest rates rise you may find that the reverse is true and that paying the mortgage is the better option.
The average rate of return on your investment can also be a bit tricky to determine because markets fluctuate. Most financial analysts use the average rate of return from a balanced fund as a baseline from which to gauge whether or not to invest or pay off the mortgage. So if the average rate of return on a balanced fund is 6% and if your mortgage interest rate is 3% they will say that it is better to invest the money. But that’s if you have the mental and emotional fortitude to stay the course over the long term and not panic and sell your investments during a market meltdown.
To complicate matters even more, we need to be mindful of the fact that mortgage interest is paid for in after tax dollars. So for any investments outside of the RRSP and TFSA tax shelters, we must also calculate the balanced funds’ rate of return net of taxes. Thankfully there are a variety of online calculators to assist you in doing so. Suffice it to say that outside of an RRSP or TFSA there really isn’t a very strong argument to be made for investing the money.
So where do I stand on the pay down mortgage or invest debate? Well, I think I’ll try a bit of both. Increasing my passive dividend income is a high priority for 2015. I place a very high importance on continually growing my investment income because in times of need it is always nice to have another income source to draw upon. That said, I also think it’s smart to pay down debt; especially in the early years of a mortgage when you pay all of the interest up front and very little goes toward the principal.
That’s my approach…what’s yours?
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