Pay Down Your Mortgage or Invest?
7/15/2008 EDIT: The information presented is based on the Canadian mortgage policies. It probably is not applicable to most Americans However, I believe Shaferfinancial’s comment below may better address the same topic, with knowledge of the American System. Please read it.
This is a question that comes up quite often, but I feel it is more of a personal finance question as it heavily depends on everyone’s own personal financial situation. Though, good investing does requires good personal finance to start with. That being said I will try to address this in a general manner, which should help you start thinking and do some further evaluation.
– Interest is not tax deductible (cannot write off) [Bad debt]. Should get rid of as fast as possible.
– When you pay this down its guaranteed. Think of it like a guaranteed investment in a GIC of the same rate.
– For most individuals this debt load is usually very high compared to our incomes (cash that could be used for potential investments and also life expenses).
– Paying down the mortgage has a significant impact on your daily cash flow. It leaves you with alot more money in your pocket.
– Used to make more money.
– Generally, maximum investment returns are realized over a long period of time (5 years or more to see the investment reach its fullest potential).
– Usually people talk about the non-guaranteed investments (stocks, real estate, businesses). Its difficult to find high return investments with absolutely no risk.
– Takes away cash that can be used to pay down the mortgage faster, and for other expenses.
*Loans On Investments
– Interest is tax deductible (can write off) [Good debt], which helps reduce your taxes and likely to give you a tax rebate at the end of the year.
– The tax rebate can be used to pay down your mortgage (bad debt that is not tax deductible). Reducing your mortgage means more money for investing.
– You always need to be careful with leveraging and know exactly what you are doing. You also need to be able to handle the minimum payments and eventually repay the loan.
– This doesn’t need to be part of your investment strategy, but can be effective for some individuals.
Because mortgage on your primary residence is bad debt, the goal should be to get rid of it as fast as possible. In this particular comparison, the investment return would be used to pay down the mortgage faster than you could by paying it down directly.
Which is better? This answer really depends on everyone’s own personal situation.
Things to look at:
– What is your personal financial situation?
Other debts (auto leases, credit card debt, investment debts).
– What are your financial goals?
– How large is the actual size of the mortgage? What percentage does it take out of your monthly cash flow? I would reduce it down to no more than 30% before making any investments. This will free up cash for unforeseen emergencies which could happen at any time. Investments usually take a while, where as paying down the mortgage is immediate. Every day that you have a large amount of bad debt, you are exposing yourself to the risk of unforeseen events that may lead to financial burden/disaster. Its good personal finance to not have a larger mortgage than you can really afford in the first place.
– How will your tax situation be affected?
– How knowledgeable are you with investments?
If you rely on the bank’s mutual funds or randomly select stocks you may want to start educating yourself more on investing.
– What are the risks?
Be realistic, aware of them, and know them!
– How comfortable are you with investment loans? (if you want employ this particular strategy).
– Which will provide the better return (mortgage or investment)?
For each potential investment, calculate the return after all expenses and associated costs. Also calculate the returns for different possible (positive/negative) scenarios. Does the investment candidate meets your numeric criteria?
My personal criteria for an investment candidate when weighing these two may differ from others, but it needs to provide a return that is at least three times the mortgage interest rate. Why? Because investments with such returns are usually not guaranteed where as paying down the mortgage is. Also there is tax on the investment returns. When I lock money away in investments, that is money I could have used to immediately improve my cash flow (return) though paying down the mortgage (the opportunity cost in this particular case). Time is also another cost to factor in. Time spent waiting for the investment to appreciate, or actual duties as in the case of real estate or business, could be spent doing something else (financial education, family, etc.). I usually do both at various times and magnitude in order to optimize time and opportunities, depending on if I find any good investments and the size of my cash reserves. However my investments when cashed out, are partially used to pay down the mortgage (because it is bad debt), and to fund new investments. The money from my investment returns help me pay down my mortgage faster than I could have done by paying it down directly.
As individuals, our cash resources are limited. The size of the mortgage has a significant impact on our daily lives. Our criteria should be set higher (this does not mean higher risk!) when we look for investment candidates to compare against paying down our mortgage. Again, the investment or mortgage question is more of a personal finance decision. But I hope my perspective helps you start investigating which is better for you. There are some excellent personal finance sites/blogs which I will write a small recommendation on in a future article.
Thanks & Happy Investing!
The Investment Blogger
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