Essential Knowledge Series
It's an age-old question...should I pay down my mortgage with extra savings or invest that money?
Although this is a tough question, there is a correct answer. But that correct answer will be different for everyone.
You will likely fall into one of two categories when looking to pay down your mortgage.
I have a low-interest rate - for example, 2.50%
I have a high-interest rate - for example, 5.00%
If you fall into the first category, you have a relatively low-interest rate compared to current market rates. Plus, if you factor inflation into the calculation, you're in negative interest territory because the loan value is decreasing with inflation. In other words, a $100,000 mortgage in 1980 seemed big. A $100,000 mortgage today seems small.
If you fall into the second category, you have a higher interest rate than the first scenario, but still relatively low compared to interest rates 25 years ago. Add inflation again, and you'll fall into the negative interest rate territory.
In order to answer the question for you individually, you have to do a bit of math. However, instead of making you complete various calculations, I've made it relatively easy for you by following the steps below.
Calculate how much interest you will pay over the lifetime of your loan (from the beginning) https://www.triedandtruemortgages.ca/mortgagecalculator
Determine the extra payments you would like to apply to your loan
Calculate the total interest paid on your mortgage while applying your extra payments https://www.scotiabank.com/static-tools/scotiabank/personal/mortgagecalculator_new/en/index.html
Calculate the interest saved by subtracting step 3 from step 1
Calculate the amount of money your investment would have made over the lifetime of the loan https://www.fncalculator.com/financialcalculator?type=interestCalculator
Calculate the investment return minus full interest paid
Calculate the difference between your investment return and the interest saved
Let's follow these steps for the two scenarios listed at the beginning.
General Scenario: $500,000 mortgage / 25-year amortization
Scenario 1 - 2.50% Interest Rate | Scenario 2 - 5.00% Interest Rate | |
1. Total Interest Paid (assuming no extra monthly payments) | $172,925.10 | $421,131.24 |
2. Extra Payments (11.88% average S&P 500 lifetime return) | $500 | $500 |
3. Total Interest Paid (assuming extra monthly payments) | $127,150.89 | $265,027.36 |
4. Interest Saved | $45,774.21 | $156,103.88 |
5. Investment Return | $835,052.00 | $835,052.00 |
6. Investment Return Minus Full Interest Paid | 612,454.31 | $364,248.17 |
7. Difference Between Investment and Interest Saved | $566,680.1 | $473,171.65 |
You'll notice that both scenarios end with a positive return by investing $500/month. In these scenarios, it makes good sense to invest the money instead of paying down your mortgage. However, you have to complete the numbers for your specific scenario. Different mortgage amounts, amortization, return on investment, and extra payments will change the numbers drastically.
Additionally, when I plan for the future of my investments, I try to make them as realistic as possible. For example, can I make 30% in the stock market? Yes. Is it probable? Not at all. I try to make sure I am reasonable with the return on investment because if not, you will have no margin of safety. In other words, when you're driving on the side of a cliff, you stay as far away from the edge as possible. This way, a slight error in movement will only get you close to the cliff and not over. As Warren Buffet always says, you need a margin of safety for every investment.
Think you're going to receive 20% per year? Cut that in half. 10%? Cut that in half too. I may be a good investor, but I can't predict the future. This is why it's important to anticipate lower returns to lower expectations.
I know what you're thinking, "Alex, it's not about the money. I like to pay off my debts as soon as possible". To this person, there is nothing I can say to change their mind. No amount of money will change that. The reason for this is that I know, along with many others, how satisfying it is to pay off debt. Mortgage or otherwise. If someone wants to pay off their mortgage in 10 years because they don't want to have the payments anymore, be my guest.
But, if you don't mind some risk, and monthly payments, investing can also be a good option.
Please note I am not a financial advisor. Please consult your financial advisor before starting any investments or deciding to invest or pay down your mortgage.
For a free copy of the spreadsheet I used to make this, please contact me at alex@empiremortgagegroup.ca, and I'll happily send you a copy.
I'll leave you with this quote by Warren Buffett, "The three most important words in investing are margin of safety.”
Questions/Comments?
Give us a shout in the comment section or find our contact details on the main page of our website at www.triedandtruemortgages.ca
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