Get the best bang for your buck

Question

I have $1,000 per month available to either invest or put towards my mortgage. I currently pay $4,500 a month on my $800,000 mortgage, which is financed at 3.75%. I’m on track to pay it off in 22 years, but if I put the extra $1,000 into the mortgage I can pay it off in 17 years. Alternatively, I could invest the additional money in the hope of getting a guaranteed 3.75% annual return to offset the mortgage rate. Which is the better option?

Answer

If this was the early 80s and Rick Springfield was topping the charts with “Jessie’s Girl,” the answer to your question would be immediately clear. Back in Rick’s heyday in 1981, mortgage rates hovered above 21%, well exceeding the performance of the markets. Any extra cash you had would go into paying down the mortgage to ease the sting of those outrageous interest payments.

But today, mortgage rates are near historic lows. And while equity and fixed income performance hasn’t exactly received a standing ovation from investors, it has been holding its own over the past year, making the question tougher to answer.

I asked Matthew Ardrey, a CFP with fee-only firm T.E. Wealth, to take a closer look at the math. He used your assumptions to develop two scenarios. Speaking of math Ardrey suggests looking at your numbers again—specifically the rate of return you’d need to offset the interest on your mortgage. As Ardrey points out, you assume that the rate of return will be equal to the mortgage rate to break even, but that’s not the case. Your mortgage payments are made from after-tax income, whereas your investment gains will be subject to tax. What that means is you would need a pre-tax investment return of 5.36% to equal an after-tax gain of 3.75%.

Of course, finding a guaranteed return in excess of 5% is going to be tough. More importantly, it’s highly unlikely that you will have a mortgage rate of 3.75% for the life of your mortgage, says Ardrey. “Unless we continue to have disastrous economic results for the next two decades, rates are going to increase.”

Scenario A – Invest the money

For argument sake, let’s say you were able to invest $1,000 per month for the 22 years left in your mortgage and earn a constant rate of return of 5.36%. In that case, Ardrey says after-tax you’d have about $339,000 in assets, of which $228,000 would be capital and $111,000 would be the after-tax return on investment. Meanwhile, the total interest you would pay on your mortgage during this period would be $316,807.

Scenario B – Pay down the mortgage

If you were to plough that extra $1,000 into your mortgage you would shave more than four years off your term and save $77,892 in interest. In 17 years when your mortgage paid off you’d have $5,500 to invest—the $4,500 you no longer need for your mortgage and the $1,000 extra you had all along. If you were to invest that cash for four years—to match 22-year amortization period in the first scenario—you’d have investments worth $306,000, including an after-tax return of $25,500, again assuming a return of 5.36%.

Pay down your house is “guaranteed”

The bottom line, says Ardrey, is that it’s unlikely you’ll be able to find a “guaranteed” return equal to your mortgage. Ardrey says that you could find returns that would equal it, or possibly even better it using dividend stocks for example. But you have to be prepared to take on the risk that comes with that return. “The risk adjusted return is more favourable on your mortgage than an outside investment,” he says. “I would recommend that he put his additional savings there if he wants his return to be guaranteed.”

Bottom line: In your case it makes sense to pay down your house, and tune in to some 80s rock while you’re at it.

About Bruce Sellery

Bruce Sellery is the CEO of Credit Canada, the country’s longest-standing non-profit credit counselling agency. He is a former MoneySense columnist.