Thousands of Canadians have one financial dream that trumps all others. It’s right up there with retiring early and being able to travel whenever you want as goals.
Yes, I’m talking about paying off the mortgage.
I don’t want to scoff at this dream, because it’s a good one. In today’s real estate market, you’re looking at a mortgage of $300,000, $400,000 or even more to get a decent house in a good neighborhood, especially if you live close to Toronto or Vancouver. Other cities are more reasonable, but only barely. Unlike in the United States, there’s a real absence of reasonably priced real estate markets in Canada, unless you’re willing to live in the middle of nowhere.
But in today’s zero interest rate world, is paying off your mortgage really a good idea?
Let’s look at a very simple scenario. Say you bought a $400,000 house on January 1st, 2010. That’s an odd closing date, but let’s go with it.
Each year, you could either put $20,000 down on your mortgage or $20,000 into a TSX Composite index fund, ticker symbol TSX:XIC. Which would end up with the better return?
We know the return of the mortgage prepayment. It’s whatever your mortgage rate is. Let’s assume a 3% mortgage, which works out to a 3% guaranteed return. That’s not bad, especially when you compare it to other guaranteed forms of investment, like a GIC (a CD for you ‘Muricans) or government bonds.
Let’s look at how well it would have done in the TSX Composite ETF, with dividends reinvested. These are annual returns over the life of the investment
January 1st, 2011: 2.83%
January 1st, 2012: 5.43%
January 1st, 2013: 5.36%
January 1st, 2014: 2.24%
January 1st, 2015: -6.68%
*These returns are as of the closing price on Friday, November 20th.
The strategy worked relatively well, at least until this year. But it’s not a clear winner compared to just paying down the mortgage. In fact, once you factor in the appreciation seen from the house during that time, there’s a very legitimate argument to be made that paying down the mortgage was the better choice, at least over the last five years.
How about the long term?
This is when the argument starts to favor investing over paying down the mortgage.
Typically, over a 20 or a 25-year life of a mortgage, investing in stocks beats paying down the mortgage. This happens almost every time.
There have been exceptions throughout history, like in the early 1980s when interest rates were sky high, and in the late 1990s when the market was riding the last waves of the tech boom. And with today’s interest rates as low as what they are, it’s not hard to create an argument that equities almost have to perform better. After all, there are many stocks that yield more than 3%, while the going rate for a five-year fixed mortgage is around 2.5%. Even the dividends alone should beat paying down the mortgage.
But that doesn’t mean investing is the better move all the time, because psychology matters. I know certain people who simply don’t trust the stock market, especially after 2008-09. Others very badly want the mortgage gone, because that debt represents a huge burden on their shoulder. And others still want the security of knowing nobody can kick them out of their house. These desires might not be the most logical, but if they’re important to you, I guarantee you don’t care about logic. You’re chasing the high that only paying off your mortgage can bring.
How about a hybrid approach?
Maybe a hybrid approach is best, like putting half the extra cash on the mortgage and then using the other half to fully fund your RRSP or TFSA.
Many investors have zero (or close to zero) exposure to fixed income in their portfolio. Putting down money onto the mortgage is a pretty good alternative to having bonds. The return on fixed income is typically right around where mortgage rates sit, and getting a guaranteed return on paying down a mortgage will help smooth out negative returns in the stock market.
And if you’re feeling really frisky, paying down the mortgage will create equity you can borrow against later if stocks look particularly attractive.
There’s no easy answer about whether you should delay paying off the mortgage or get it taken care of as soon as possible. I would delay it as long as possible, but that’s because I’m confident I can earn more than 2.5% annually on my investments. Your confidence level may differ. Which is why perhaps the hybrid approach is best.