By paying down your mortgage earlier, you can reduce the interest you will pay on your mortgage each month. But is that really the best way to spend your money? Well, the cost-benefit of paying out your mortgage early depends on two main factors:
- How risk-averse are you?
- What is the mortgage term of your property?
If you’re risk-averse and like the idea of a guaranteed return, then you may consider paying your mortgage early. If you can tolerate risk for more reward, then you should consider investing that money in the stock market or a real estate investment property. To understand why and which choice is best for you, read on.
Should you consider off paying off your mortgage?
Many people use their savings to pay down their mortgage faster through pre-payments or accelerated payments. These can be lump-sum or additions to your regular mortgage payments that will accelerate the payment of your principal and decrease the total interest. Great, you save money! But is this really the best way to use your savings?
What it means when you pay down your mortgage faster
Think of your mortgage as a fixed income product, like a savings account or bond, that has a negative balance and an interest rate. Every mortgage payment you make goes towards paying the interest on the balance as well as a little bit of the principle. When you make pre-payments or pay down your mortgage faster, you are putting down more money to fill up that balance, decreasing the amount of interest that you will pay. As they say, a penny saved is a penny earned, and the extra money you put in will save you the equivalent of having it in a savings account at the same interest rate as your mortgage.
If you’re highly risk-averse, this might not be such a bad idea for you, especially if you are older and closer to retirement (and want stability more than risky gains). However, if you’re young, it is often advised to use that money that’ll be tied up in extra mortgage payment to create a diversified portfolio of stocks, bonds, and maybe even more real estate. The return on your “investment” into your mortgage payments will be at the same rate as your mortgage, which is often much lower than what you could expect to get from other investments. Using that money for other higher-return investments could be a much better option.
Comparing the returns of faster mortgage payments to returns from other investments
At its inception in 1926, the S&P 500 Index originally began its operations as the “Composite Index” comprising only 90 stocks. The average annual return from 1926 through 2018 for the S&P500 has been approximately 10%.
Depending on the sub-sector of the real estate industry, average returns for the past 20 years were 9.5%, 10.6% and 11.8% for commercial real estate investments, residential real estate investments and real estate investment trusts (REITs) respectively.
With mortgage rates less than 4%, you wouldn’t be gaining nearly as much when you pay off your mortgage early as opposed to when you invest in either stocks or real estate. Why lose out?
Comparing mortgage terms and conditions in the US vs Canada
Could your location be a huge factor in determining how smart it would be to accelerate paying down your mortgage? The answer, quite simply, is YES.
The typical mortgage loan term for close to 90% of US homebuyers is about 30 years and the implication of a lump-sum mortgage prepayment (or refinancing the mortgage term to a shorter-term e.g. 15 years as opposed to 30 years) is that you save on future interest payments. At the moment, January 2020, the fixed rate is around 3.5% per year. That’s better than any savings account available on the market, and the savings over 20-30 years could be significant. However, a much better option in the long run would be to invest that money in high-performing stocks or in rental properties which would likely be able to give you a return much higher than 4% annually.
In Canada, however, the typical mortgage loan term is 5 years, with an interest rate of about 3%. The money that you put into your mortgage will be stuck there for your amortization term (unless you refinance), and you’re only guaranteed the current rate of return for the length of your mortgage term (5 years). It is generally thought that rates would not go much higher within at least the next decade, which means you should not expect the return on your extra “investment” to be any higher than your current mortgage interest rate. When considering paying off your mortgage in Canada, you have to consider the possible changes in the interest rate that could change the cost-benefits of your pre-payments compared to other investments. Some people enjoy the peace of mind with paying down their mortgage faster since they’ll have less at stake during the next round of refinancing, especially if interest rates rise. But if you believe interest rates will only go down from here, then it would be better to invest your money in higher-return investments.
Whichever way you choose to look at it, a choice is a risk. When you pay off your mortgage early, you would have freed up some of the monthly mortgage amount which you have to pay, increased your cash flow (which may be especially important if you’re nearing or in retirement and have a limited income), saved money on interest, increased your equity which you could potentially tap into in the future, and very importantly, gained a peace of mind that comes with less debt. However, paying off an early mortgage requires that you weigh the risks against the benefits.
Is paying early more beneficial given that the money could be used for other investments with potentially higher returns? Have you considered the fact that you’d no longer be eligible for US mortgage interest federal tax deductions (if applicable)? Money in your mortgage can’t be accessed quickly – do you have an emergency fund and a large buffer in case of any unpredictable costs, like healthcare?
It is up to you and your own personal situation to determine the best option for you. We have provided you with the tools and information you need to get started – you (or your financial advisor) will make the final decision.