Who doesn’t dream about paying off the mortgage and freeing up all that monthly cash? Even if the end goal seems so far away, the idea of paying off the single largest line item on the liabilities side of your net worth statement just sounds so appealing. Perhaps that’s why books have been written devoted to the topic.
Now, with interest rates rising in the U.S., and the threat of higher mortgage rates coming soon to Canada, the perennial question resurfaces: Should you pay off your mortgage early? Or invest the money instead?
Pay off the mortgage, first
Reason No. 1: Save money
Every loan comes in two parts: the principal and the interest.
The principal is the amount you want to borrow. For instance, if you have $100,000 saved but you want to pay a $550,000 home, you will need to borrow $450,000 in order to complete the transaction. That $450,000 in the principal—the money you’ve actually borrowed.
The interest is the fee you pay in order to borrow the money. It’s the cost of using someone else’s money to buy an asset.
In Canada (and America), it’s standard to amortize a mortgage loan. All this means is that the loan repayment is scheduled equally over a set period of time. This enables the lender to calculate the expected earnings of their risk (loaning you the money), as well as establish a timeline for when the loan will be repaid in full.
The easiest way to save money, when it comes to mortgage debt, is to reduce the amount of time it takes to repay the principal debt. For example, if you borrowed $450,000 and the amortization schedule was for 25 years with an interest rate of 3%, you would actually pay just a little under $639,000 back to the lender (assuming no interest rate increases during the 25 years). In other words, you paid the lender close to $190,000 in interest on a $450,000 loan. Reduce the amortization of that loan to just 15 years and you shave $80,000 off the interest payments you make to the lender.
Now, anyone with a simple mortgage calculator will point out that reducing the number of amortization years will prompt an increase in your monthly mortgage payments—for many homeowners, this is not a viable option. But there are other ways to lower the amount of interest you pay. One option is to make accelerated or lump sum payments. This allows you to pay more against the outstanding principal, reduces your interest payments, and shortens the length of time required to pay off the loan. Just remember: the goal is to take less time to pay off the mortgage, as this will lower the principal amount of the loan, the decrease the amount of interest you pay.
Reason No. 2: Financial freedom
Another reason to pay off your mortgage is that owning a principal residence without debt gives you the financial freedom to funnel money that formerly went to your mortgage into your savings or to pursue lifelong dreams, like travelling.
Mortgage interest adds tens of thousands of dollars to the real cost of a home, so a shorter mortgage slashes the amount you pay in total. The money that’s freed up can then be allocated to another priority, such as retirement savings, saving for a child’s education, or pursuing some passion projects.
When not to pay off the mortgage
Paying off your mortgage as quickly as possible should be an important goal for any homeowner—whether you’re halfway through the process, just starting out, or even just contemplating buying a house. But there are circumstances when making the mortgage debt a priority to pay off just doesn’t make sense.
For example, if a person is self-employed or runs a home-based business, it may not be as beneficial to pay off the mortgage early. That’s because a portion of your mortgage interest becomes tax-deductible when you’re self-employed—this deduction helps to bring down your taxable income.
Also, if your property is both your home and an investment property, it may not make sense to focus on paying off the mortgage quickly. Instead, investors should focus on paying off the mortgage on their primary residence, first, before tackling the mortgage on an investment property.
Flip the coin and prioritize investing, first
However, some homeowners would rather put every spare penny into an investment rather than paying down their mortgage debt. Their rationale is that the return on the invested dollar is greater than the guaranteed return you’d get for paying off your mortgage.
Take for instance, a homeowner with $50,000 to invest. They could make a lump sum payment towards their current mortgage. The additional $50,000 would reduce the principal borrowed and this reduces the overall interest paid. For instance, if the mortgage was $450,000 and the homeowner had locked in their mortgage rate at 2.85%, if they made no other accelerated or lump sum payments, this additional $50,000 would reduce the overall amount of interest they’d pay on their mortgage by $44,880 (assuming a 25-year amortization, the lump sum was made in month six of the loan and there were no other interest rate increases). This is like getting a guaranteed return of 2.8% on your invested money. Compare this to high-interest savings accounts that pay between 1.5% and 2% or GICs that pay 1.95% or 2.25% and this return looks good.
But if you’ve been a disciplined saver or if you have a pension you can count on in retirement, it may be possible to take the $50,000 and invest it in riskier products, which will get you a better return.
Another option is the Smith Manoeuver. In simple terms, this is a process of cashing out your investment portfolio to pay off your outstanding mortgage debt. Then taking out a loan against your paid-off home and using that money to invest. The advantage is that outstanding loan is now fully tax deductible (as interest paid on loans used to invest are tax deductions, according to the CRA). But be careful. This is a much more advanced used of leverage and can blow up in your face quickly. For instance, if the market were to drop significantly, you would lose money and still owe the loan used to invest.
Tips for reducing the overall cost of your mortgage
When you get your first mortgage, it’s hard for many people to focus on the end game, especially given that so many people put so much effort into saving up the minimum down payment, or even making use of grants or various cash-back programs that some lenders offer. But it’s important that you keep all of your options on the table so that when you’re ready to focus on your long-term strategy, your mortgage allows you to take action, whatever that may be.
Option No. 1: Start smart and maximize your down payment
While it’s possible to get away with only putting 5% to 10% down on a home purchase, the single biggest cost-cutting measure you can do is to maximize your down payment. Not only will you owe less, reducing the overall interest you pay, but you’ll avoid having to pay mortgage loan insurance premiums—a fee buyers pay for the privilege of putting less than 20% down on a home. (This insurance doesn’t protect you, the buyer, but the bank should you default on your mortgage loan.)
One good way to maximize your down payment is to use the federal Home Buyers’ Plan, which lets you withdraw up to $25,000 in a calendar year ($50,000 for a couple) from your RRSP to put toward a home you will live in (or build).
Option No. 2: Buy what you can afford
Yes. It sounds simple. Buy a home that fits your budget; the reality is when it comes to buying a home most of us struggle. On one side we want our dream home. On the other is the desire to be fiscally smart. Quite often, it’s a trade-off. But if you focus on buying within your budget (not the maximum mortgage amount your bank has agreed to lend you, but the mortgage that works with your financial plan), then you’re less likely to dip below the 20% down payment, and more likely to stick to your plan of paying off the debt sooner.
Option No. 3: Shop for the best rate
Buying a home is stressful. Quite often, then, buyers will stick with banks or financial institutions they know. But when shopping for mortgage rates, it’s actually better to cast your net wide and far.
Consider credit unions and mono-lenders (lenders who use mortgage brokers and only deal with mortgage loans), as quite often these institutions can offer much better rates and terms than big banks.
Option No. 4: Pay attention to when interest is charged
Most standard mortgages in Canada charge interest semi-annually—that means twice a year the lender calculates what interest you owe, based on the outstanding principal debt and the accumulated interest on that outstanding debt. This is known as semi-annual compounding interest (compounding, because it’s interest on interest).
The rate at which compound interest grows depends on the frequency of compounding; the higher the frequency, or the number of compounding periods, then the greater the compound interest. For that reason, a loan with a 10% interest rate, but compounded annually, will actually accrue less interest than a loan with 5% interest that is compounded semi-annually, over the same time period.
Option No. 5: Accelerated payments
When finalizing your mortgage consider going from one monthly payment to accelerated payments. This adds two extra payments per year, which reduces your principal debt just a tad bit faster.
Option No. 6: Lump sum or extra payments
But the real key to paying off your mortgage debt faster is to get a mortgage that allows you to make extra payments. Most mortgages allow borrowers to make annual prepayments of 10% to 20% of principal, without extra fees. These extra payments go directly towards paying down the principal. If possible, however, try and avoid mortgages that only allow you to make extra or lump sum payments on the mortgage anniversary—as this can reduce the likelihood of the extra payment.
Option No. 7: Lower your amortization
Those who want to pay off their mortgages sooner should choose the shortest possible amortization. While typical amortization periods are for 25 years, you can opt for as short as 10 years or as long as 30 years (if you made a down payment of 20% or more on your home).
Forcing yourself to pay off the mortgage in fewer years translates into lower interest costs and substantial savings. The hitch? Your regular monthly or accelerated payments will be much higher.
Option No. 8: Increase your regular payments
To give yourself the best of both worlds, consider going with a longer amortization, but increasing your regular payments using your mortgage loan prepayment privileges. For instance, if your monthly mortgage payment is $1,200 you could increase this to $2,400 per month if your loan terms allowed for double-up payments. In effect, you would be paying off a 20-year mortgage in just 10 years. Better still, you’d have the flexibility to switch back to the lesser regular monthly payment if you were to experience any changes like a sudden job loss or the birth of a child.
In the end, the answer as to whether or not you should pay off your mortgage early really boils down to what’s important to you in both your short-term and your long-term financial plan.