The instinct to pay off debt as quickly as possible is one of the strongest financial urges we have. It makes sense, since debt can drain your resources and prevent you from making other, more beneficial, financial moves. But do you really need to pay off your mortgage early if you want to embrace a smart debt strategy?
“We bought a house right after university, and I remember seeing that large sum leaving the account every two weeks,” says Kornel Szrejber, the found of Build Wealth Canada. “I started fantasizing about all the things we could do once we weren’t spending all that money on the mortgage. I decided to make it my mission to pay off the mortgage as quickly as possible.”
Szrejber did just that, paying off his mortgage in about six years. However, once he finished, he decided that he had made a mistake. “Back then it sounded like a wise thing to do,” he says. “On top of that, this was around the 2008 meltdown, so after seeing all the money my colleagues were losing in the stock market, real estate seemed like a much “safer” investment at the time.”
He’s quick to point out that Canada didn’t see the same housing meltdown that the United States did (although some argue that Canadian housing is still in a bubble that could burst), so it seemed even smarter to put his resources into paying down his mortgage debt. Looking back, though, and after learning more about how investing works, Szrejber wishes he’d done things differently.
Could you see better long-term returns by keeping the mortgage?
Mortgage rates are near historic lows right now. As a result, paying off your mortgage early means a “guaranteed return” of about 4% a year. However, historically, the S&P 500 returns about 9% on an annualized basis. Add in the tax benefits associated with using a retirement account and the tax deduction for mortgage interest, and your “real return” for paying off your mortgage early starts to look even smaller.
If he had to do it again, Szrejber would have taken all of his extra payments and put them in a tax-advantaged investment account. In Canada, where Szrejber lives, that means putting the money in his RRSP and TFSA accounts. In the United States, that money could be put in 401(k) and IRA accounts.
“If you’re in a higher tax bracket, you can use tools like the 401(k) or Traditional IRA to lower your taxes significantly and invest with pre-tax dollars, which can make a huge difference to your net worth over the long term,” says Szrejber. “If you’re paying off your mortgage with accelerated payments and are in a high tax bracket, you are getting demolished by your high tax rate and using what is left over to pay off your mortgage.”
It’s not just high earners that can benefit from keeping a mortgage to its full term. “If you’re not a high income earner, you could use that money in a Roth IRA to invest so that you can take the money out tax-free, after it’s grown.” Plus, if you itemize, you can receive a tax deduction for the mortgage interest that you do pay. It’s not a huge advantage, but it does make putting your money into something with higher returns even more attractive.
Many homeowners choose to pay down the mortgage quickly as a way to build equity in their homes, and because it’s considered “safer” than risking the money in the stock market. However, what happens if you pay down your mortgage early, but end up with the need to sell at the bottom of the real estate market? All of your early payments might be lost unless you hold onto the home and rent it out until the housing market recovers. The risk of loss is still there.
Szrejber points out that 2008 “was scary, but as you know the market really bounced back. If I had invested instead of paying down the mortgage early, our net worth would be a lot higher right now.”
When to pay off your mortgage early
Even though Szrejber would have done things differently if given another chance, he does acknowledge that some people are better off paying off the mortgage early. Homeowners who want to pay off debt for personal reasons of security and confidence, and a desire to be truly debt-free, can benefit. “It’s not worth the higher net worth if you’re stressed, losing sleep and getting higher blood pressure because somebody told you to invest in a way too aggressive for your comfort level,” he points out.
Paying off your mortgage early might help you reach your goal of financial independence earlier, and help you feel better about your situation. Szrejber warns that you still need to be careful. Once your mortgage is paid off, you might discover that you are behind in your retirement savings because that money has gone into the house. He suggests preparing to play “catch up” with your retirement contributions once the home is paid off.
Watch out for the temptation to “upgrade” to a bigger home as well. Continuous upgrades — along with paying off each mortgage early — could be disastrous in the long run. “If you keep doing this, you could end up with little to no money saved for your retirement day-to-day expenses,” says Szrejber. “You’re also extremely un-diversified, which can be catastrophic if there is ever a correction in the housing market.”
As always, it comes down to personal preference and your own goals. “The accelerated mortgage paydown strategy is a good option for some people, and it is the safer option,” says Szrejber. “But you definitely pay for that increased safety in the form of lower net worth in the long term.”