Q: I have a mortgage of $120,000 with an interest rate of 2.25% variable.
I have some monies which I move around depending on the interest I get with the bank.
My income is $48,000.
I have some monies in TFSA. With these monies, I could pay off half my mortgage.
Should I pay off my mortgage partly or continue as is?
A: The question of whether to pay down your mortgage or invest is an age old one in Canadian personal finance lore, Jane. There are varying opinions. Some people even suggest borrowing to invest à la “Smith Manoeuvre.”
I’m generally not a big fan of borrowing to invest, as I feel most investors don’t have the temperament, patience or risk tolerance to ensure it is worthwhile. Often those who borrow to invest are convinced to do so by mutual fund salespeople and the high fees on their investments negate much or all of the potential benefit anyway.
The thing is, Jane, you are indirectly borrowing to invest right now. By not paying down your mortgage and instead building up savings, it’s kind of like borrowing to invest. Let me explain.
It sounds like you have about $60,000 in savings if you could pay down half of your $120,000 mortgage. If you instead had a $60,000 mortgage and borrowed $60,000, you would have $120,000 in debt and $60,000 in savings – which is exactly where you stand right now. So I would argue that you have indirectly borrowed to invest.
When you borrow to invest, you generally do so on the assumption you can earn a higher rate of return on your investments than the interest rate you’re paying on your debt. You mention you’re moving money around depending on the interest rate you get with the bank. I would be surprised if you can earn more than 2.25% from savings accounts or GICs these days – the interest rate you are paying on your mortgage.
If your entire $60,000 in savings were in your Tax-Free Savings Account (TFSA) earning 2.25% tax-free while you pay 2.25% on your mortgage, it would literally be a wash. But since some of your savings are presumably in a taxable non-registered account, it’s even less advantageous to keep those savings, Jane.
Say you’re earning 2.25% on your savings account. You earn $48,000 of income and if we ignore any other potential tax deductions you might have, you’re paying a marginal tax rate of between 28-37% on your interest income, depending on your province of residence. So on $100 of savings, you’re earning $2.25 of annual interest income at a 2.25% interest rate, paying at least 63 cents of tax and you’re left with at most $1.62 of after-tax interest income. That’s a 1.62% after-tax rate of return – but you’re paying 2.25% interest on your mortgage!
To come out ahead, you’d have to earn at least 3.13% interest on your non-registered savings for it to be at least a wash after-tax. This is an important consideration for anyone with debt and money in a savings account.
If you are keeping some of your cash savings as an emergency fund, Jane, why not consider applying for a secured line of credit on your home if you don’t already have one? It could act as a potential emergency fund if you ever needed it, but in the meantime, you could use your cash to pay down your mortgage and avoid the interest costs in the interim.
Even if you wanted to have a cash emergency fund, $60,000 is 125% of your annual pre-tax income, which is many multiples of any rule of thumb emergency fund target I’ve ever heard.
If you have Registered Retirement Savings Plan (RRSP) room, I’d rather see you making RRSP contributions than sitting on savings in a taxable account. At least that way, you’re getting a tax refund of 28-37% based on your income and depending on your province of residence, meaning a low return is easily offset by the up-front tax refund.
If you had a higher risk tolerance, Jane, I could better justify the decision to invest in a TFSA or non-registered account instead of paying down your mortgage. But for a conservative investor like you, paying down debt provides a great, guaranteed return.
I assume with a $120,000 mortgage and a $48,000 single income, you probably have a healthy amortization period remaining for your mortgage payments. Despite interest rates being low right now, rates will rise in the future. If you pay down your mortgage with a lump-sum payment, your future mortgage payments will go more and more towards principal. This could be a great strategy for you.
Personally, I wish they had used a better name for TFSAs. So many investors literally use them as a “savings” account, but when you have debt with a higher interest rate than your savings are earning, TFSAs are a losing proposition. You’re basically just lending the bank your money at 1% so they can lend it back to you at 2%, 3% or more on your mortgage, line of credit, car loan and credit cards.
I think “Tax-Free Investment Account” or “Tax-Free Retirement Account” may have better conveyed the best use of these vehicles. Maybe that way Canadians would use TFSAs more effectively.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.
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