The decision process to pay off your mortgage first or invest is very simple when you are in control of your finances. It’s simple mathematics with some forecasting but there is an emotional component that comes to play and you need to overcome it.
There is an old saying that says to pay off your mortgage first, which is good advice, but it’s not necessarily the best return on investment for your money. Remember your home is technically dead money – that’s why I don’t focus on net worth but portfolio worth instead. Your home doesn’t generate any income and even if it appreciates, it doesn’t help pay for retirement. Downsizing doesn’t imply a big payday either. The old-age advice is a basic advice to help someone not waste their money and it’s very basic. It was good advice 40 years ago when many had a pension plan but it needs refinement these days. It’s like the 4% withdrawal rule – you cannot apply it anymore since bonds don’t pay.
There is definitely a balance approach to consider before you decide to invest first over paying off your mortgage. Check out the key factors and my real world experience below.
#1 Key Factor – Your Mortgage Size Matters
New homeowners can sometimes stretch themselves a little when they buy a home and the mortgage can be a little bit bigger than desired. If that’s the case, my suggestion is to focus on the mortgage first. Get it to the point where it’s manageable.
Find the number for your mortgage that would make you comfortable slowing it down and investing instead. This is based on your employable skills and cashflow situation. Yes, cashflow is king. The rich leverage their assets to make more money. It’s a very simple concept and your home is the first asset you can use to generate wealth.
#2 Key Factor – Cash flow is KING
Can you avoid the life-style inflation? This is where the old-age advice comes into play. If you cannot and you have to keep up with the Joneses, then pay your mortgage first. You may disagree with this but it’s really important you understand your income earning potential and stick to the life-style it can provide.
Be in control of your cash flow and where it’s going – how much flows towards debt, spending and investing. With a clear budget, even at a high level, you can understand how much you can put towards investing versus paying your mortgage.
When you focus on the mortgage first, I recommend you do voluntary bi-weekly extra payments and not increase your bi-weekly mortgage payment as it limits you down the road to make adjustments. When you increase the payments, you cannot change them until you renew your mortgage.
The budgeting strategy I recommend is to figure out the extra amount you can put towards the mortgage or investing and you keep it that way. Then it makes it easy to shift the money from the mortgage to investing.
#3 Key Factor – Your Investment Returns
This is where the math comes into play. If your investment returns are higher than your mortgage rates, you will be ahead by investing over paying off the mortgage. You need to know your investment returns. I put together a spreadsheet to help track the return on investment. It’s honestly very simple to setup.
You need to know what your investment performance is before you decide to focus on your investment over paying down your mortgage. Once you do, decide if the difference between your investment return and your mortgage interest rate is worth the effort. For example, my return on investment is 10% and my mortgage rate is 2.65% which gives me an additional 7.35% compounded return on my invested money.
A point to be aware of is that both investing performance (ROR) and mortgage interest are compounded, especially dividend investing with DRIP. When it comes to investing, the biggest factor is time in the market. IT beats timing the market so while people will tell you to double down on investing once your mortgage is paid, the reality is that you lost years of profits. It’s that simple. Even index investing returns approximately 8% for the TSX and more for the US market if you diversify.
Real World Example
In my case, I started with a $300K mortgage with a single income of $90K at the time. $300K was not a comfortable amount to start prioritizing investing over paying down the mortgage. My strategy was to pay off the mortgage fast at the time. As I started getting salary increases, I maintain the same life-style and increased my payments. I was still able to contribute to our RRSP and I also did what I could with RESP. After a number of years, my mortgage wasn’t stressful anymore and I realized at the $180K mark (many years later), that the amount was a comfortable debt. I had enough money in my TFSA and RRSP to deal with it if I needed. Home prices also appreciated significantly that my mortgage was now 18% the value of the home.
When the time came to renew in 2015, I reset my mortgage amortization to 25 years from 13. Boom. I had chosen to use the difference and invest it. My investment have performed well since and I can pay off the mortgage if I want to. My non-registered account and TFSA are now worth more than the mortgage. As you can see, growing my portfolio to achieve the long game is more important than eliminating the mortgage. When you are in a position of safety, it’s easy to make the decisions. That’s why the #1 Key Factor is critical.
It doesn’t mean I am not paying off the mortgage, I am just doing it slowly. My investment portfolio is working for me now. You can see my magic retirement number which should take approximately 6 years to achieve – the first million is always the hardest. At this point, my plan is to pay it off by the time I decide to retire. Retirement should be without a mortgage on your principal residence.