Why I choose to pay down the mortgage faster instead of investing

paying off the mortgage over investingBack in the summer of 2008 I bought my house and went with a variable rate mortgage at prime – 0.50. When I picked my mortgage I did not expect seeing the subsequent economic events unfolding. I did not think I would go through 50 bps rate cuts and end up with a rate as low as 1.75%. It was all in hindsight, no claim to fame in this post.

I chose a variable rate at the time because I perceived the economy to be somewhat exhausted. I never tried to predict where the rates would be in the long run, I simply said to myself that for the short term, there was a good chance rates would not be moving higher. I also knew that I can always switch to a fixed rate mortgage if I started losing sleep over interest rate increases. My initial variable rate in July of 2008 was 4.25% and I was willing to wait until it broke my psychological risk level of 5.00% before fixing it.

Did you notice that I had my risk level identified? I also acted on my perception of the economy at the time by keeping a close eye on economic data while ignoring any outstanding predictions. Finally, my ace in this game was to be my lump sum payments every year for the first few years which would help me get ahead if interest rates were to rise in the future.

Fast forward to 2010, Canada’s growth is being revised downwards and the US economic recovery has stalled. A hold in interest rate hikes is justified in the short term in my opinion. This makes my decision to stick permanently with a variable rate mortgage more feasible with a low risk since there is still a lot of margin before rates hit 5% again.

The lump sum strategy

My mortgage started at 200k in 2008 and should reach about 130k by the end of 2010. Every year I pay a lump sum of 20k, 10% of my mortgage which is the maximum my bank allows me to pay.

You see every dollar you inject in your mortgage immediately gets to work for you by reducing your principle and saving you interest. You will save time because you just shaved years off of your mortgage time-line and money from the all the interest you would have paid.

Let’s use the average Montreal mortgage for our case study:

Average Montreal Mortgage:

Average Applicant Income: $65,529.00

Average Co-Applicant Income: $44,763.00

Average Loan: $222,582.00 (rounded to $222,000 for our example)

Using the following mortgage calculator, we will take a look at 3 cases for 3 amortization periods (25, 30 and 35 years) assuming a fixed interest rate at 4%.

Case 1: No lump sum payments

Interest paid over 25 years: $128,330

Interest paid over 30 years: $158,035

Interest paid over 35 years: $189,003

Case 2: 10% lump sum paid in the first 2 years ($22,000 in year 1 and $22,000 in year 2)

Interest saved over 25 years: $53,156 + you finish 6 years and 11 months earlier

Interest saved over 30 years: $69,529 + you finish 9 years earlier

Interest saved over 35 years: $87,911 + you finish 11 years and 3 months earlier

Case 3: $10,000 lump sum paid in the first 2 years ($10,000 in year 1 and $10,000 in year 2)

Interest saved over 25 years: $27,486 + you finish 3 years and 5 months earlier

Interest saved over 30 years: $36,627 + you finish 4 years and 6 months earlier

Interest saved over 35 years: $47,273 + you finish 5 years and 9 months earlier

I have linked to the calculator above if you wish to run your own numbers. Those amongst you with bigger mortgages or higher rates will be even more surprised at the results.

Mortgage over Investing

I choose to invest my lump sums in my mortgage before anything else. Even if the return is as low as 2.5% it is risk free return. Higher returns require bigger risks, just look at my portfolio for an example.

The one return that is priceless is the peace of mind once the mortgage is reduced to an insignificant amount or completely paid off. My lifestyle security is above any other return since the household runs on 1 income.

The 2.5% I mentioned is my current mortgage rate, but what I will end up saving is much more than that compared to current fixed rates and especially if the rate increases dramatically during subsequent years that I will avoid paying due to finishing earlier or to having a much lower amount outstanding.

Donating to Banks

Amongst the things I hate the most is giving my money to banks for free. When you don’t make any effort to accelerate payments on your mortgage, you are essentially benevolently giving a lot of your after tax money to the bank in interest payments.

In the scenario above, interest paid over the amortization period is between 2x and 3x the average applicant’s income. Investing a little bit of effort into budgeting would go a long way in saving you the equivalent of a year’s salary pre-tax. Imagine how much money you could recover from the government if the interest you saved is invested in an IRA or an RRSP.

You can do it too

Many amongst you have mortgages; don’t let the lump sum numbers scare you. You can put together a lump sum by the end of each year without sacrificing your family’s lifestyle. Play around with the numbers as it will give you a good idea for a plan and work on it. Any amount of money you decide to put on your mortgage produces a winning scenario in the end whether your mortgage’s interest rate is fixed or variable.

What did you pick for your money? Investing over paying off the mortgage or paying off the mortgage over investing and why?

47 comments to Why I choose to pay down the mortgage faster instead of investing

  • Hey Mich,

    It seems like variable rate mortgages outperform except in regimes of rising interest rates (which we will find ourselves in sooner or later), so I am with you on paying down the mortgage faster, if for nothing else than security as well as saving on possible future interest rates.

    At the same time, I would not dump everything on the mortgage and I would still invest at the same time. The opportunity cost of paying down the mortgage faster is that the economy could do better than you expect and those lump sums could grow much faster than the interest paid. I think I will split between investing and paying down the mortgage, as I would feel pretty comfortable with the accelerated payments which reduces risk, especially if rates do eventually increase, while still being exposed to some upside and building long-term capital.

  • Mich

    @IIW, Thanks for pointing out the importance of investing at the same time. I am glad you singled out this item that I should have included in the post. I have to say that even with my focus on the mortgage, I still invest 11% of my salary on a monthly basis into my RRSP account. As such I am not neglecting this part of nest egg building let alone for my DIY portfolio.

    Your approach for dividing your free cash flow 50/50 between the mortgage and investing is a great decision since it fits your vision and you feel comfortable with this decision. This is very very important as we don’t all share the same worries or risk tolerance.

    Thanks for an excellent comment,

  • Great article… interesting perspectives. I have to admit, I tend to use investing as a way of paying down the mortgage quicker. I suppose it is because I make enough on my investments to make significant contributions to my mortgage. The key to knowing whether one is “better” than the other is completely dependent on the return on the investments and the rate of interest on the mortgage.

    Well done!

  • I’m with Kevin on this, re: “at the same time, I would not dump everything on the mortgage and I would still invest at the same time.” A bit of column A and a bit of column B is our approach, and it works for us anyhow.

    Another good post Mich, you made some excellent points.

  • Mich

    @Doc, Great job on using your investments to pay off the mortgage. My DIY portfolio would not be able to sustain such payments at this time, I would need an extra 0 in my ROI :)

    However, the ROI is not the only variable that makes one decision better than the other, you have to take into account a person’s risk tolerance.

    @FC, I agree with you that investing should not be totally ignored. I still invest monthly in my RRSP but the bulk of my free cash flow is directed to the mortgage.

  • It sounds like you’re able to save a lot of your income. That’s fantastic. You did a nice job of showing how the math works too. It’s even more potent to make those prepayments earlier in your amortization period.

    Looking at mortgage calculators is actually what got me addicted to paying down our mortgage. We will have it paid off before the 10 year mark, but will still have paid over $50 000 in interest because we didn’t get really serious about prepayments until somewhere around year 5.

    Great post! :)

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  • Mich

    @Balance, You are right, to optimize your savings you need to start prepayment at the first year if possible. In your case, better late than never!

    I run a tight budget at home in order to achieve our financial goals which not only include mortgage prepayments, we like to take a trip once a year. I committed to finishing the mortgage before 2015, all in all it would have taken me ~6-7 years.

  • Most people don’t systematically prepay their mortgages, so I’m so happy that you are the exception. Additionally, you are banking 11% of your income too, which speaks to just how diligent you are! I enjoyed seeing how the math worked out too!

  • Mich

    @Roshawn, I wish more people automatically saved a small % of their income, settled for enough house, 1 trip a year or 1 car per household. Many would have avoided drowning at the first hiccup they encountered!

    Thanks for the comment.

  • I agree with InvestItWisely. For me, doing both is the right approach. Making extra payments, lump sum payments, or signing up for an accellerated program like bimonthly payments is good. Being less in debt is very good. Being debt-free is fantastic.

  • And the peace of mind from paying off the mortgage is something that cannot be measured. The best personal finance decision is the one that fits YOU.

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  • Mich

    @101, I cannot disagree with you on the feeling of being debt-free!

    @Barb, you pretty much summed it up by affirming that the best personal finance decision is the one that fits YOU.

    In my case, I’ll tick to the peace of mind being a superior return than any other investment vehicle out there~

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  • Alex

    I am really new to mortgages.
    Is the lump sum pre-tax or post-tax?

    Thank you!

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  • Mich

    @Alex,

    The lump sum is after-tax money. If you have further questions, please do not hesitate to ask!

  • Great post. You will have your mortgage paid off in no time. Quick question…why does the bank cap the amount that you can pay on your mortgage annually?

  • Alex

    @Mich thanks a lot.

    @Mark I only assume it’s because of the same reason my bank doesn’t allow me to pay my car loan in one year: they won’t get that much interest!

  • Great post Mich!

    This I think would ring even more true here in Vancouver where the average home owner takes MORE mortgage (and can’t help but do so).

    I am planning to do the same thing too, though at the same time invest. What kevin suggested of using 50/50 or 75/25 of extra money is a good idea.

    I plan to keep what I have in my investment account and let it grow by itself from there. If I have extra money I am planning to sock it away into the mortgage to pay it off faster.

  • Mich

    @Mark, I never got a satisfying answer, it’s a limitation in the contract and its different from one bank to the other. I think just like Alex said, they need to make sure they profit off you!

    @YT, If 50/50 makes you comfortable then go for it! The right answer will be different for each person. In my case I am not ignoring investing just putting most of the weight on the mortgage. I’m looking at closing off the mortgage in the next 5 years, i would be 38 by then! That would be the first step towards financial freedom :)

  • We’re doing some of both. We’re putting a bunch away in tax-advantaged saving (retirement, college) and prepaying the mortgage. If the investment environment were to get more stable or safe interest rates to go way up again we’d probably invest more and prepay the mortgage less.

    I sure am glad we don’t have any prepayment penalties.

  • Yay I’m very excited for you! Paying off the mortgage is definitely very freeing. amazing that you’d have paid off your mortgage by 38! Forget Freedom 55, it’ll be Freedom 38 for you! :)

  • Mich

    @Nicole, this is a great approach and your point on the market makes a lot of sense. When you invest in your mortgage you get to sleep much better at night than if you were putting your money on the line in these unusually uncertain times!

    @YT, no Freedom 38 unfortunately as I would not have a passive income that would replace my job :(
    But I’m trying to get there!

  • Good post. We paid off our mortgage first, then started investing. A very important aspect of investing is building up an equity position and large credit facilities, which we’ve been able to do with our HELOC. I noticed that you also mentioned your HELOC in another post, and so it is clear that you are doing something similar–i.e., you can pay down your mortgage and invest using leverage.

  • Mich

    @PW, must be a great feeling to be mortgage free! my HELOC strategy is on a small scale since my portfolio is risky by all standards :)

  • We do both, but after I lost my shirt during the crash, I realized that I needed to change the ratio a bit.

    Now much much more goes towards the mortgages and despite the great recovery of the market during that time, I do not regret my approach.

    The reality is that with 2 kids and 2 FT jobs, it’s hard to watch the market and try to time when to cash out and put it towards your principal. I like the sure thing approach.

  • Mich

    @FGA, that is the sensible approach my friend. If you don’t have the time to watch the market, there’s no point in playing the picking game, you go with the index and forget it.

    Like you, my ratio highly favors the mortgage as well, the market is not going anywhere.

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  • jay

    100% of my savings goes into paying the mortgage… I both double my payments and then try to pay as much of the 10% lump payments as I can while reserving a 6 month cash pile – sometimes it was the full amount, sometimes only 5%. I have a pension that is also contributed to, so in that sense I’m lucky.

    Doubling payments may be the way to go, at least at the beginning of the mortgage term. If you get in trouble, you can often skip the number of payments that you doubled, at least with my bank (RBC). I don’t know if that applies to lump payments.

    For me, the goal is not so much to build investments as to reduce costs. The mortgage will be done in March after only one five year term. I can then live on roughly $15000/year, if I have to. Yes, that’s taking “conservative” to a whole new level. But if I don’t have to, I won’t!

  • Mich

    2Jay, congrats on your discipline in paying off your mortgage on a regular basis. Few are those who can keep the focus on an objective that is often several years in length to attain.

    I am on the same track as yourself in finishing my mortgage by the 5th year. For 2010 I reached my 130k milestone and targeting 100k mortgage level in 2011, a 50% reduction in less than 3 years.

    Your lifestyle security is the best ROI one can obtain.

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  • Melanie S

    I’ve thought about paying extra on the mortgage, but the interest on the student loans is so much higher, so we’re putting all our efforts towards that first.

  • Mich

    @Melanie, You’re doing the right thing by focusing on the higher interest debt.Keep that discipline once you scratch off the student debt and move on to the next one on the list.

  • Mark

    I’m looking at buying a condo (in the 300k range) in Toronto Canada. I have about 90k I could put down but I’m thinking of only putting down about 5% (15k) and investing the rest in diversified index funds. I figure over the next decade or or so I can probably make at least 7% whereas the mortgage will only cost me about 3% Yes I’m aware that mortgage rates will go up eventually but I’ll be fixed for about 5yrs at which point I can decide if I want to continue on this path or just take the money out of the market and put it in the condo.

    Also I will be using some of this invested money to supplement my monthly condo payments, so the invested money will not last forever (but it will all eventually end up in the condo).

    Seeing as the market just crashed, I’m not too concerned that this is a risky strategy. Anyone think I’m crazy or does this plan sound reasonable?

  • Mich

    @Mark, Are your nerves solid enough to look at a negative portfolio? can you go through a second crash? we’re not out of the woods yet and 2011 will have its fair share of volatility. When you hug the index, you will ride it up and down and you know how human psych works in a correction, the doomsday articles appear!

    If you have the psychology, it *might* be a good plan. Keep in mind that there are risks associated, consider a worst case scenario as there are other variables in play here. What if you lose your job going through a double dip and you need the money: can you afford to sell at a significant loss?

    I cannot recommend to you what to do, I can just ask you to make sure you’ve considered it from all angles before acting as you are the one who has all the numbers.

  • jay

    @Mark: Your investments would indeed have to do well. If you only put 5% down on a 300k house in Toronto, you will pay around 10k in CMHC insurance and HST on that insurance.

    You’ll never see that again… you’ll need to make that back on your investments above and beyond the 3% mortagage.

    If you put down 20%, about 60k, you’ll pay NO CMHC insurance.

  • Mich

    @Jay, thanks for pointing out the CMHC insurance costs to Mark, it completely escaped me!

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  • Interesting points. I love the idea of paying off my mortgage early, I am just starting to get to the stage where it feels like a viable option… Very exciting.

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