## It’s Better to Invest than to pay down Mortgage debt

Many financial gurus will advise home owners to make lump sum payments on their mortgages and pay them down sooner rather than later. However I worry people may be under estimating the power of opportunity cost. Let’s work through the numbers and look at some facts instead of listening to main stream opinions.

Let’s say we won the lottery and became \$100,000 richer! Let’s decide if we want to put this money towards the down payment for a house in order to have a smaller mortgage, OR, invest all our winnings in the stock market index and take on a bigger mortgage. Which option will likely make us richer in the end?

First we must find out what is the cost of borrowing \$100,000. Assuming our mortgage rate was 7% every year, by the time we pay off a \$100,000 mortgage over 25 years, we would have paid a total of about \$210,000 (according to RBC’s calculator). Which means we will be paying \$110,000 in interest alone. So if we increase our down payment by \$100,000, we save \$110,000 on interest in the long run.

But now let’s see what happens if we invest all of that \$100,000 into the stock market index instead. Let’s say over 25 years we make an average of 6% a year. In the end our \$100,000 would turn into roughly \$429,000. But since we invested our \$100,000 instead of adding it to our down payment, we have to borrow \$100,000 more for our mortgage. From the last paragraph we know the cost of taking on an additional \$100,000 mortgage loan will cost us \$210,000 total (including interest) over 25 years. So if we then take our stock investments after 25 years (\$429,000), and paid off the extra cost of having a bigger mortgage (\$210,000), we would still walk away with a \$219,000 profit, in addition to paying off our mortgage as planned! Hey-Ooh! Below is a chart of our investment returns.

In the first example we left extra capital sitting in our house doing absolutely nothing, except to save us 110% in interest over 25 years. In the second example, we invested that capital instead. Even though we had to pay the 110% interest over 25 years, we also made 429% on our investments during the same time using the same capital. So it’s pretty clear which choice is the clear winner.

## The Simple Concept Behind Leverage

But wait a minute. What accounting sorcery is at play here? How does a 6% investment return dramatically outperform a 7% mortgage rate? Well maybe you’ve figure it out by now. Each time we make a mortgage payment, our principle decreases. It’s the opposite of compound interest, because we pay less interest each time (not more) until eventually the entire loan is paid off. But investment returns on the other hand are the exact opposite and actually compound and grow, giving us higher returns year after year (not less.) Annual Compounding x 25 years = major win.

## Interest Rates Are Super Low

Our mortgage calculations are based on a 7% interest rate which is higher than average, even compared with long term historical rates. Not to mention rates are super low today. My current mortgage rate is just 2.6% as of 2014. So chances are we’ll probably end up paying a lower rate than 7% on average over the span of our mortgages. A cheaper borrowing cost means we’ll end up even further ahead.

## Favorable Market Returns

We also used 6% for our investment returns to be on the conservative side. But North American equity markets have historically returned about 8% to 10% annually, and bonds average about 7% to 8% annually. Market returns are not guaranteed, but as long as we can average more than 3.1% return per year for our investments (since that will give us \$210,000 which is equal to the cost of the mortgage) then we’ll be better off investing all of our extra cash, than trying to pay down the mortgage. The worst total return ever for any 20 year period in the history of the stock market is still a positive 3.1%, which was around the Great Depression years.

What do you think are the chances of a balanced portfolio averaging less than 3.1% annual return over the next 25 years when that has never happened in the history of North American stock markets before? And are you willing to miss out on such a great risk to reward opportunity.

## Tax Benefits of Debt

It gets even better. The interest paid on the \$100,000 mortgage loan can be made completely tax deductible. Just use the \$100,000 as part of the initial down payment first. Then take that \$100,000 out as a home equity loan to invest in stocks, and now the interest on the loan can be claimed for earning investment income proposes. So if your marginal tax rate in the 30% tax bracket like me then that 7% mortgage rate has just automagically dropped down to 4.9%. Meanwhile, our investment returns from capital gains and dividends receive preferential tax treatment (less than 30%) because they are not earned income. What a bargain! Even the tax man is giving us an incentive to invest because the interest we pay on a loan for investment purposes is tax deductible.

## Inflation Helps Debtors

The rising cost of living can be a pain, but it can also be a blessing to people who have mortgage debt. If you owe the bank \$100 for example, then by next year if you haven’t touched the principle, that \$100 balance you owe will only have \$98 of purchasing power (assuming a 2% inflation rate.) This means that \$100 is now worth less, and it’s EASIER for you to pay it back. So a \$100,000 mortgage, assuming a 2% inflation rate again, will only be worth \$98,000 by next year. Wow, we just increased our wealth by \$2,000 in REAL terms by simply sitting on a mortgage. 😀 Thank you inflation!

The more debt we have the more we’ll benefit from the devaluing affects of currency. The U.S. has over \$16 trillion of national debt. And its growing by billions of dollars every day because its government continues to spend more than they take in. Inflation is a method used by many central banks around the world to deal with their nation’s debts. They print money so their currency won’t be worth as much. Inflation will slowly chip away at debt, which will decrease the debt’s real value over time making it easier to pay back 🙂 Debt is a depreciating liability, but real estate is an appreciating asset, so buying a home using debt is a double win!

## Investing in Stocks While Having a Mortgage Reduces Financial Risk

A Pew research center study found that between 2009 and 2011, most American households experienced a decrease in their net worths. However 7% of households saw their wealth grow. 😀 What was the secret of these successful households? The study points out that the these 7% of households have most of their wealth held in stocks, bonds, and retirement accounts. But the other 93% of Americans have on average just 33% of their wealth in the markets, while half their net worth comes from their homes. We all know that between 2009 to 2011, stocks rebounded from the recession, however U.S. housing prices remained flat to negative. So if we make extra payments on our mortgages then we risk over exposing ourselves to the real estate market and deny ourselves the opportunity to properly diversify our investments. And diversification, as the study points out, was how the top 7% got wealthier.

If we want to become wealthy too we have to invest in stocks and bonds like the rich do. Some people may argue it’s risky to invest while still in debt, but they don’t realize that it’s also risky to aggressively pay down a mortgage and not diversify their asset portfolio. (^_-) If we only focus on paying down our mortgage with any savings we have then by the time our mortgage is paid off we’d have 100% of our money in a single asset class. It’s certainly not prudent to have all our eggs in one basket.

This is why we have to be diversified. If Canada’s home prices have a major correction in the future, at least we would have other financial assets to cushion the blow to our wealth. But here’s the brilliant part – even if real estate prices continue to increase we would still benefit because our homes will be worth more money! So it doesn’t matter if home prices rise or fall. We win no matter what direction the real estate market goes in 😀 Regardless of how aggressive we pay down our mortgage it will not affect the future market value of our home.

However, whether or not we invest in the stock markets today WILL have a direct impact on the future profits of our stock portfolio. If we miss an opportunity now to capitalize on the financial markets then that potential profit is lost forever. But if as long as we have a home, then 100% of it’s future market gains goes directly to us whether we have a huge mortgage on it or if it’s been completely paid off. This is why we shouldn’t underestimate opportunity cost. Besides, even by simply making the minimum mortgage payments, we are STILL adding equity to our homes anyway. So even if we allocate 100% of our savings to invest in the financial markets the real estate portion of our asset allocation will still be growing in dollar terms 😉

## Take Advantage of Longer Amortization Periods

Finally, we used a 25 year amortization period. But think about how much more our investment returns can grow if we gave it 30 years to compound instead. A longer time horizon will also decrease our investment risk. For the record, my current mortgage is amortized for 35 years. The longer we spread it out the better our returns will be.

So when people say they want to increase their mortgage payments by \$500 a month, or make a lump sum payment of \$10,000, or aim to pay off their mortgage 10 years in advance, it all sounds good on paper, but I hope they understand just how much money they’re potentially NOT making, and how much asset allocation risk they’re taking on, by being overweight in real estate. 🙁

My mortgage in 2009 when I bought my condo was \$215,000. Today, in 2014, the balance is only down to \$200,000. So I’ve paid on average just \$3,000 a year towards the principle which I made sure was the least amount possible. 🙂 I could have easily shortened my amortization period, doubled-up my payments, etc, to have a principle balance of just \$150,000 today. But instead of doing that I invested every spare penny I saved. My condo is now worth \$50,000 more than my purchase price. And I have over \$100,000 in the financial markets thanks to the last several years of better than average stock market performance. My net worth would not be nearly as high today if I had aggressively tried to pay down my mortgage.

That being said, borrowing money from a home, or investing rather than paying down debt, could increase your financial risk. We are talking about leverage after all, which is what a mortgage is. So if you don’t want to risk losing your home, or not being able to finance the extra debt, then please pay off your house as soon as you can. But if you want to live dangerously like me and don’t mind the risk, then invest your extra cash instead of leaving it tied up in your home. Focus on investing and only make the minimum payments on your mortgage, and by the time you retire there’s a pretty good chance that you’ll be much better off than other home owners who only prioritize on paying off their mortgages. 😀 Good luck!

• stock market index – A weighted average of some of the largest and most popular stocks. An ETF that one can buy to track this performance would be the IVV for example.
• capital – Money which can be put to good use
• 30% tax bracket – In Canada, if your annual income is between \$40K and \$70K then there’s a good chance your marginal tax rate is around 30%.
•  leverage – Borrowing money to buy an investment

My bank’s checking account has a \$3.95 monthly fee. However this fee is dropped if I have at least \$1,500 in that account for the entire month. Typical right? Just about every bank does this. Keep a minimum balance in your account, and the account fee is waived! I used to maintain the minimum balance to avoid paying fees. But I wasn’t too happy about it because I was essentially lending the bank my money, interest free.

But recently I have removed the minimum balance out of my account and started to actually pay \$3.95 every month. But why would I choose to pay more fees when I don’t have to?  Answer: *Opportunity Cost (^_^)
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It’s true that by keeping a minimum balance of \$1,500, I save \$47.40 a year on checking account fees. But if I can make more than \$47.40 a year by investing \$1,500 then I would be better off investing that money instead of keeping it tied up in the bank right? So that’s why I transferred the money from my checking account into my brokerage account, and used all that money to buy my bank’s own common shares.  In other words, I purchased \$1,500 worth of TD Bank stocks. That’s because the stock’s dividend was more than enough to cover my checking account fees. Even today, according to google finance, TD Bank currently has a dividend yield of 3.46%. This means if you invest \$1,500 into TD shares today, TD will pay you \$51.90 every year in dividends. If you live in BC and make between \$43K and \$74K of income per year like me, then you will only have to pay a *few dollars of tax on that amount and pocket \$48.38. Not too shabby (^o^)
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To review, I am now paying the bank \$47.40 in fees every year. Meanwhile the bank pays me \$48.38 (after tax) for being a shareholder. Basically this means I get to use the bank’s chequing account service for free, AND make a tiny profit to boot. But it gets better! TD has grown it’s dividends 11 times in the last 12 years （ ﾟдﾟ）So this year I may receive \$48.38 like we’ve calculated, but next year, I wouldn’t be surprised if TD pays me \$50 or more because those dividends keep going up. But it gets even better! The *payout ratio for TD is under 50%!  This strategy also protects me from higher banking fees in the future because once I became a shareholder, every dollar of profit the bank makes from charging their customers higher fees will only add value to my stocks.

Of course not everyone banks with TD. But this strategy is transferable. Here’s some basic information on a few other banks below.

BMO Practical Plan Chq Acct: Fee = \$4.00/month. Waived with \$1,000. BMO’s stock dividend yields 4.80%
CIBC Everday Chq Acct: Fee = \$3.90/month. Waived with \$1,000. CIBC yields 4.69%
Scotiabank Powerchequing Acct: Fee = \$3.95/month. Waived with \$1,000. Bank of Nova Scotia yields 3.96%

But I can see why this may not be a good idea for some people. This strategy does come with risks after all. You risk the banks cutting their dividends in the future, even though they all have a solid history of growing them. You also risk losing some of your initial investment if their share prices drop and never recover, even though banks are the oldest and largest companies in Canada and the backbone to our whole economy. For short term investors and those who want to play it safe, keep your balance in the bank to save yourself some money. But if you want to live on the edge like me, then don’t let your bank hold your money to only benefit their own interests. Buy a piece of your bank instead and profit with them, and by the time you retire maybe you’ll be a little wealthier than if you hadn’t. (^_~)

*Opportunity Cost – Losing the opportunity to profit from a choice, because another choice was taken. Go ask an economist for a better explanation (>_<)
*few dollars of taxThe dividend tax credit makes dividend income very tax friendly. Depending on your location and other income, you may not have to pay any taxes on dividends at all.
*payout ratioTo be explained in a future post.

I’ve mentioned in an earlier post that most of the big 5 banks in Canada are raising banking fees this year. But there is a silver lining. See if you can follow along with this plan.

The minimum balance required to wave the \$3.95 monthly fee on my TD bank account used to be \$1000. So for that reason I’ve always held at least the minimum in my account before. I basically save \$47.40 a year. In other words, if I could make more than \$47.40 a year (after tax) with that \$1000 (or 4.74%), then I would be better off investing that money in the financial markets and just pay the monthly service fee.

However, starting this month, the minimum requirement to waive the fee has gone up to \$1500, but the fee itself remains unchanged at \$3.95/month. I now have \$500 more capital at my disposal if I choose to invest it. \$47.40 from \$1500 means I only need to make a 3.16% total return (after tax) in order to cover my bank account fees. Making 3.16% per year for the foreseeable future sounds a lot more doable than 4.74%. So from now on I’ll put the \$1500 (that would’ve been tied up in my checking account) into buying common shares of TD Bank, and just pay the \$3.95 monthly fee. Here’s why.

TD shares currently pay a healthy dividend of 3.50%, at less than 50% payout ratio (very safe,) which means the dividend alone paid to me, even after tax, which ends up being about 3.3%, is enough to cover the 3.16% return I need, to break even. Not to mention the future potential for dividend growth and capital appreciation. Plus, many people who kept \$1000 in their accounts before to avoid the monthly fee will just top-off to \$1500 starting now, which will give TD more capital to grow its business boosting value for its shareholders (me.)

In the end, this method is a little risky but if the banks are going to grow and make money at the expense of their customers, then it’s like that saying if you can’t beat them, join them. Of course only time will tell how this will play out. Don’t try anything on this blog without consulting with a financial advisor first.