Top 5 reasons not to pay off your mortgage early
There’s a natural tendency to want to get rid of your mortgage as fast as possible. After all, having hundreds of thousands of dollars owing to a mortgage lender isn’t the nicest thought, and interest on such a large amount can really add up over the years. But is it always a good idea to pay down your mortgage early?
It turns out it might not be and in this article we will look at the 5 main reasons why not to pay off your mortgage early.
Low mortgage rates and cost of borrowing
As we move through 2020 amid the covid pandemic, it is increasingly apparent that we are entering an economic down cycle where mortgage rates will remain low for quite some time.
For example 5-year fixed mortgage rates in Ontario are currently in the 2.00% – 2.50% range and are expected to drop even further as economies stabilize and as Banks remove market risk premiums are removed from rates.
Such low mortgage rates may create opportunities to invest strategically, in tax sheltered accounts like TFSAs or RRSPs, because we may be able to earn a higher rate of return over time in the investment then we are paying on interest.
For example, if a modest 5% per year return was earned in an investment, and if your mortgage rate is 2.50%, you would still be ahead or ‘profiting’, by 2.50% per year.
Earning a 2.5% annual ‘profit’ is quite literally the opposite of paying 2.5% per year. In other words, by not paying down your mortgage you are earning 2.5% per year. This of course is an example, however throughout every economic crisis in history, investment markets demonstrate that 5% is a reasonable return to achieve.
From a tax advantage perspective, it’s also worth keeping in mind that if an RRSP was purchased, instead of paying off your mortgage faster, then you would be benefiting from a tax refund. Saving on taxes, as a sure thing, can help to put low costs of borrowing in perspective as well.
If you have kids, there is also the RESP that, for every $2,500 annual investment, pays $500 per year for free with the Canada Education Savings Grant. This represents an instant 20% per year guaranteed return on saved/ invested money.
Finally, there are some safe RRSP eligible investments that can offer reliable returns in the 6% – 10% per year range. We have a good understanding of these asset backed investment types that may be of interest to many investors, and invite you to contact us for details.
Higher interest rate debt
If there are any debts with a rate that is higher than is paid on your mortgage, this should be cleared first. This could be a credit card, loan, credit line or any other debt with a higher interest rate.
Often there are car loans available at very low interest rate, if not 0% rate. However it would be wise to look into the unseen cost of these loans. It is often the case that the purchase price of the car is thousands higher in order to benefit from he lower cost of financing.
Even for a 0% car loan, if we include the additional cost of the car as a cost of borrowing and spread this cost over 5 years we arrive at an annual cost of borrowing/percentage rate (APR) that can easily be in the 4% – 6% range.
Savings safety net – ‘rainy day fund’
Any financial planner will encourage a savings safety net or ‘rainy day’ fund – and for good reason. Usually this would be 3 – 6 months worth of salary, saved in a very safe account that does not have potential to fluctuate in price.
The safety net provides a solution not for if, but for when a major expense comes up – or worse – a job loss or sickness.
This is beyond something necessary only for peace of mind. From a very real, cost of borrowing perspective, those without a savings safety net are almost destined for higher interest indebtedness when financial trouble strikes. Then, once this debt is in the picture, it can be very hard to get rid of.
If there is not a good financial safety net in place, it’s a best practice before attacking the mortgage.
Inflation and Increasing real estate prices
It is good to know that, even though mortgage interest is being paid, the value of the home is likely to grow over time. Therefore we should have some expectation that the growth in the value of the home will at least equal the cost of mortgage interest.
Also, if your home’s value is considerably higher than your mortgage amount owing, then a 2% increase in your property value will result in a greater net return, if the mortgage rate is also in the low 2% range.
At the very minimum if we assume a 1% – 2% per year inflation rate, as targeted by the Central Bank of Canada, then this inflation rate has the effect of reducing mortgage rates because wages are going up, even though rates are remaining the same.
Enjoying life now
Especially for those who have some time until retirement, it’s important to remember that the whole reason for optimizing our financial picture is to enjoy life over the short and long term. This can be seen as a bit of a balancing act where, if we sacrifice some now, then we can get a lot more later.
However if too much is sacrificed now, and life becomes financially strained, then the balance may be out of whack.
For those who find more enjoyment and peace of mind with major financial sacrifice now, for major benefit sooner than later – this is one thing. But for those stressed out for financial reasons, it may be a good idea to ensure our financing are organized for enjoyment now, and later in life.