Source: http://www.flickr.com/photos/aresauburnphotos/2678453389/
I have recently been considering buying a property (yes, even with the still-high real estate prices up north) since I have been renting for many years now and our rent is quite expensive, and no need to risk losing money and having to borrow or get online payday loans. We have managed to save enough for the down payment, yet there is one question on our minds:
Should we pay off the mortgage faster or should we keep some money to invest with, instead?
There is a lot of opinion out there, but nothing beats taking a look at the numbers and seeing for yourself. Here is the analysis setup:
- The mortgage will be $250,000 6% fixed, amortized over 25 years. Why 6% fixed? To leave breathing room for the possibility that interest rates are around there in a few years from now.
- A payment of $10,000 will either be applied to the mortgage after 1 year, or invested in the market.
- In the mortgage payment scenario, the mortgage payment will reduce the total amortization length. Once the mortgage is paid off, we will invest our mortgage payment amount into a 4% investment compounded monthly.
- I will look at a taxed scenario and a non-taxed scenario. In the taxed scenario, we pay 25% tax on our 4% investment earnings in the mortgage payment scenario, and on our entire market earnings in the market investment scenario.
Sources used to help prepare this data:
- Mackenzie Mortgage/Loan Amortization Scheduler
- MoneyChimp: CAGR of the Stock Market
Scenario 1: Pay down the mortgage
Our total payments over the amortization of 25 years would be $479,855. If we elect to do the lump sum of $10,000 on the mortgage principal, then our total amortization will be $450,869 over 276 periods or about 23 years. This gives us two years where our cash is free and clear to invest in something else.
If we continue to pay the same amount as we did on our mortgage and apply this to an investment with a 4% return, then by year 25 we will have $40,679 in investments, of which $1,693 is earnings. Our net position (ignoring the value of the home because it is the same in both scenarios) therefore looks like this: $489,855 total spent, $40,679 in assets.
If we pay 25% tax on the earnings, then we are left with $40,255 in assets. These numbers will be our baseline which we will compare to the market investment scenario.
Scenario 2: Invest the lump sum in the market
In scenario 2, our mortgage amortization is $479,855 by default. We invest an additional $10,000 at the end of year 1 in the market, to make a total of $489,855 spent. After 24 additional years, our market investment at a 6% growth rate will be worth $42,056. This is similar to the situation where we paid down the mortgage, which is at the same rate. However, we pay taxes on a full $32,056 in this scenario, so if our investment is unregistered, it will only be worth $34,042 after taxes.
Let’s take a look at the market advantage:
Chart 1: A market investment's advantage over paying down the mortgage, without taxes
And with taxes…
Chart 2: A market investment's advantage over paying down the mortgage, with taxes
Analysis
Data from MoneyChimp suggetsts that the cumulative annual growth rate (CAGR) of the S&P 500 over the past years has been as follows:
- Past 100 years: 9.55%
- Past 50 years: 9.51%
- Past 25 years: 10.43%
In order to be conservative, I decided to pick a lower end of 6% and a higher end of 10%. Even with tax, we see market investments pulling out ahead of paying down the mortgage at around 6.8%. However, paying down the mortgage does have some great advantages.
Advantages of paying off the mortgage faster
- You do not pay taxes on interest saved.
- The return is guaranteed, unlike a market investment which can be highly volatile. If you plan to retire on the day of a market crash and you are relying on your market investments to pull you through, then you might have to wait a few more years.
- Paying off your mortgage sooner frees up cash flow, when can then be used to retire early, start your own business, or spend more money on luxuries.
Advantages of investing in the market
- Over the long run (at least 25 years), it is rare that the market doesn’t return at least 7 to 8%. Over the past 25 years (1984 – 2009), it has returned 10.43% compounded yearly. Although historical returns are not a guarantee of future results, they can be a predictor. If you are young and time is on your side, then a market investment may be more worth it for you.
Conclusion
I believe that the best option is paying the mortgage as if higher interest rates were already here; that way, you get used to the higher payment and don’t “reallocate” the money to something else. As interest rates are currently lower, you also pay down the mortgage faster. Any additional money that you have above that can then be invested in the market in order to take advantage of long-term compound growth.
So, what do you think? Do you swear by getting out of debt as fast as possible? Or would you prefer to take on more risk in return for the upside of additional long-term gains?
Video
Additional reading
- Debate: RRSP vs. Mortgage
- Investing Versus Paying Ahead on Your Mortgage: Which Makes More Sense?
- Pay Off Mortgage Early? Or Invest?
I would like to see the following scenario:
Mortgage payment from 2000 to 2010 versus stock investing for the same period.
And a big what if the same decade repeats itself?!?!?
Good point, Mich!
In the short run, stock market returns can be highly volatile. If you were paying an average of 3 to 4% on your mortgage over the past 10 years, there’s a chance you got a better return off of that than you did in the market, given the 2000 dot com bubble and the 2008 credit collapse.
However, if you look over a 25-year period, you can see that the returns smooth out over time. If we look at 1982 to 2007, the cumulative annual growth rate (CAGR) of the S&P 500 is 13.12%. If we look at 1984 to 2009, after the credit collapse, it is still 10.84%. If we look at 1975 to 2000, we have a CAGR of 16.22%. Not too shabby, eh? If we look at 1977 to 2002, after the dot com bubble, we still have a return of 12.17%.
So, over the past 10 years the returns of the market have been pretty crappy, but let’s take a look in 2025 and then we’ll talk 🙂
This is a great question. I recommend whatever gives you the best cashflow. Cashflow is king when you are young. It opens up so much freedom. This is achieved by: having no debt, living below your means, no mortgage, having a tenant cover your mortgage (duplex living), dividends.
I speak from experience, and my article here (I’m not selling anything don’t worry) will elaborate:
http://www.lifestyleshock.com/2010/03/30/work-for-retirement-but-think-cashflow-for-freedom/
These types of questions (what is best for money / life) will be constant throughout life.
Hi Ryan,
I agree; having additional cashflow really does open a lot of doors. I was looking into the duplex living thing, but we couldn’t find any that both matched our criteria for price (still need to cover the downpayment, after all) and location. If we had, though, it would have been pretty nice to have a tenant paying a big chunk of the expenses!
Thanks for stopping by!