Who doesn’t crave the financial freedom that comes with having no debt? In the perennial debate over what to do with some extra cash—throw it at your mortgage or invest it and save for your future—the MoneySense position has always been the pragmatic, conservative and responsible one: Pay off your home, then use the surplus cash to double down on your retirement savings.
It’s a one-size-fits-all strategy. And no question, being mortgage-free feels great. The problem is this advice dates back a decade or more, when mortgage rates were dropping from the double digits and investors could bank on a steady 3% to 5% return from GICs alone. Times change—and so does money advice. So I’m about to make a suggestion that’s akin to financial heresy: Don’t bother paying down your mortgage. Use the money to invest. You’ll come out ahead in the long run.
Risk is smart.
No one would argue that paying off your mortgage faster isn’t a sound investment. This strategy translates to a risk-free, after-tax return of between 2% and 3%—or whatever your negotiated mortgage rate happens to be. That’s certainly more than you’d earn with any other risk-free investment out there, such as a GIC or savings account. But for many homeowners, it also means leaving money on the table.
“The decision to pay down debt, at the expense of retirement savings, is often an emotional one that isn’t driven by the numbers,” explains Jamie Golombek, managing director for Tax & Estate Planning at CIBC.
What do the numbers say?
Over the last 50 years, the prime lending rate has hovered around 8%; the average annualized return for the TSX over the same period was 9.5%. Consider that if you were to pay an extra $1,000 a month against a $350,000 mortgage; you could be debt-free in less than eight years and save almost $98,000 in interest payments. But invest that money in a balanced portfolio with a conservative annualized return of 5% and, over the same period, you would have saved more than $154,000. It’s a simplified example, for sure, but the point is that without risk you could end up flipping hamburgers in retirement—wishing you’d saved more.
A new normal.
You might ask: What happens when rates rise? While analysts from RBC Economics, Morgan Stanley and the C.D. Howe Institute expect rates to rise in 2016, they don’t anticipate a return to the “normal” prime rates of 5% or 6% anytime soon.
There are a few reasons for this. Aging baby boomers are leaving the workforce, which puts downward pressure on the nation’s labour market, which in turn lowers productivity growth, limits the economy and suppresses inflation. Also, America’s recovery from the 2008 credit crisis has been slower than expected. And the dramatic decline in oil prices has yet to show signs of reversing. Regardless of the reason, rates are predicted to remain low—at least for the next half a decade, maybe longer—and this is an opportunity to take advantage of that.
More eggs, more baskets.
Let’s say you’re a safe, conservative investor with 20 years ahead of you before you retire and no desire to chase returns. Should you concentrate on eliminating that mortgage debt?
No. The reason boils down to a basic building block of sound financial planning: diversification. By paying off your mortgage first you may become debt-free, but the bulk of your net worth will be tied to just one asset—your house. If your neighbourhood real estate market tanks, those anticipated savings would drop. Worse, if sales stall, you might not be able to access your equity or be forced to accept less. Just ask Calgary homeowners, who suffered a 32% drop in housing sales earlier this year.
The choice to invest means you’re putting your savings in more than one basket—and that’s a smart savings strategy.
This is not for everyone.
There are two exceptions to taking this advice. Those nearing retirement risk leaving the workforce with a sizeable debt hanging over their heads. The shorter the time frame the more you should focus on paying down your house debt. The only other time to ignore this advice is when you have a massive mortgage. A large mortgage puts you at greater risk of rate shock, when your monthly payments rise dramatically due to an increase in lending rates. The key is to stress-test your debt and examine your cash flow. If you can’t meet your expenses without struggling—either now or in the near future—then your priority should be to tackle debt first, including that massive mortgage.
The decision to pay down your mortgage or invest shouldn’t be based on emotion. Yet we often opt to be debt-free because it feels better. As Ted Rechtshaffen, president of TriDelta Financial, says: “The foundation of every investment decision is that the money you invest should earn more than you owe.” With a longer investing horizon and the power of compounding, sometimes it makes sense to owe a little longer.