Many Canadians who secured low mortgage rates during the pandemic are now facing higher monthly payments, as they renew at current elevated mortgage rates. At the same time, with the Bank of Canada reducing short-term rates, the previous environment of appealing low-risk returns — such as the 4-5% offered by short-term bonds, GICs or cash-like investments — no longer exists.
Homeowners contending with both higher mortgage costs and lower returns on less risky investments must decide whether to prioritize paying down their mortgage or explore other investment strategies. Each choice has its own set of advantages, but the right path depends on your individual situation, financial goals and risk tolerance.
Though we focus on mortgages as part of this commentary, a similar comparison can be made to other forms of debt.
The Appeal of Paying Down Your Mortgage Early
Paying down your mortgage early offers clear benefits, especially for homeowners who value lower debt and peace of mind.
- Risk-Free Return: The return from paying off your mortgage is equal to the interest rate you are paying. For example, if your mortgage rate is 5%, paying off your mortgage effectively “earns” you the equivalent of a 5% risk-free return by saving on interest costs.
- Debt-Free: Once your mortgage is paid off, you own your home outright. This can be incredibly comforting and lead to more disposable income each month as you no longer have to make mortgage payments.
- Credit Profile: Reducing your debt load can improve your credit score and lower your debt-to-income ratio. This may make it easier to qualify for future loans or credit at better terms.
- Flexibility when Moving: If you plan on moving in the near future, a lower mortgage may mean lower penalties when it comes time to move if you need to “break” your existing mortgage.
While there are many advantages to paying down a mortgage early, there are also certain drawbacks that need to be considered.
- Liquidity: Once you put money into your mortgage, it is effectively locked up in your home. Unlike investments, it can be difficult to access this cash in the future. Refinancing or taking out a home equity loan may be required, both of which could involve additional fees or other impacts.
- Concentration Risk: When you focus on paying down your mortgage early, you are placing a larger portion of your wealth into your home. This means your financial security becomes more heavily tied to the value of a single asset—your property.
- Prepayment Restrictions: Many mortgages have restrictions on how much you can pay down early without incurring penalties.
The Case for Investing in a TFSA or RRSP Instead
Investing can offer certain benefits compared to paying down a mortgage, particularly for those with a long-term timeframe. TFSAs and RRSPs provide tax-advantaged investment benefits and should be the primary alternative to mortgage prepayments.
- Potential for Higher Returns: Unlike your mortgage rate, many investments do not have a fixed return. If you can earn more from your investments than the interest rate on your mortgage, investing could lead to higher long-term growth.
- Liquidity: Investments in publicly trade securities are generally more liquid than home equity. This means you can more easily access your money when required, without having to go through refinancing or taking out loans.
- Diversification: By investing in a variety of assets, you reduce the financial risk tied to your home. A well-balanced portfolio can help spread your financial risk across different sectors, making less of your overall net-worth tied to the real estate market.
As with paying down a mortgage, certain drawbacks must be considered when investing.
- Market Risk: The value of your investments is subject to market fluctuations, meaning you could lose money, especially if you invest in riskier assets like stocks. If you need to withdraw from your investments, you may need to sell investments at an unfavourable time, locking in potential losses.
- No Immediate Debt Relief: Investing does not directly reduce your debt, meaning you will still be making monthly mortgage payments. If you are seeking more recurring disposable income or less financial stress, investing may not provide the immediate relief that paying down your mortgage does.
Return Expectations: Mortgage vs Investing
When deciding whether it is better to pay off the mortgage or invest, it is important to understand the expected rates of return for each option.
We can start by considering the scenario where your mortgage rate is equal to your investment return in a TFSA or RRSP. For example, if you have a mortgage rate of 5% and expect to earn a 5% return in your TFSA or RRSP, the financial outcomes of both strategies are essentially the same in terms of the overall benefit.
The difference, however, lies in how you expect to achieve the 5% return. In the current interest-rate environment, it is unlikely that a TFSA or RRSP could achieve a 5% return without higher-risk fixed income or equity (stock) exposure. This means that your TFSA or RRSP investments will likely have more risk than paying off your mortgage. This also means that your investments will tend to have more volatility and your return could be higher or lower than 5%.
If your return expectations for a TFSA or RRSP are higher than your mortgage rate, investing may be more appealing than paying down your mortgage – though higher return expectations typically mean higher-risk investments.
Additional RRSP Considerations
As shown in the table above, TFSA contributions and mortgage prepayments are made with after-tax dollars and are easy to compare. RRSP contributions are, in theory, made with pre-tax dollars so the amount initially contributed should be more and is subsequently reduced by taxes when withdrawn. In reality, most people make an RRSP contribution with after-tax dollars and expect a refund after filing their taxes. The refund would therefore need to be contributed to the RRSP as well to reflect the full pre-tax dollar contribution.
The after-tax return on the RRSP will also depend on the difference between your tax-rate when contributing – or more precisely when you claim the tax deduction from the RRSP contribution – and withdrawing the funds. If these tax rates are the same, the after-tax return will be the same as a TFSA or a mortgage prepayment (see table above). However, if your tax rate is lower at the time of withdrawal, there is the potential for a higher after-tax return, or vice versa, as shown below.
What If My TFSA and RRSP are Fully Contributed?
If you have already maximized your TFSA and RRSP contribution room, you may consider investing in a taxable account instead of paying down your mortgage. While a taxable account can also offer the potential for higher returns, better liquidity and diversification, the primary additional drawback when compared to an RRSP or TFSA is the tax considerations.
Any interest income, dividends, or realized capital gains will be taxed in the year they occur. The tax rates can be significant, especially on interest income, which is taxed as regular income at your marginal tax rate. This will lower your after-tax returns and therefore a higher return will be required to equate to paying down your mortgage.
Tax Deductions and Other Considerations
In certain circumstances, mortgage interest can be tax deductible, providing a unique opportunity for tax savings. If you are deducting mortgage interest, it is important to recognize that any prepayments applied to the mortgage will effectively have a lower after-tax benefit.
- Rental Property
If you own a rental property, the interest on your rental property mortgage may be tax-deductible. This can create an incentive to carry a mortgage on your rental property, as the interest expense can offset rental income, reducing your overall taxable income. - Use of Home for Business
If you use your home for your business, you may be able to deduct a portion of your mortgage interest as a business expense. The Canada Revenue Agency (CRA) may allow you to deduct a proportion of your mortgage interest equal to the percentage of your home used for business. For example, if your home office takes up 10% of your home’s square footage and you only use this space for business purposes, you may be able to deduct 10% of your mortgage interest.
In both cases, the potential tax savings could make carrying a mortgage more attractive than paying it down, as the cost of borrowing is effectively reduced. In this instance, your investment returns could be less than the mortgage rate but still equate to the after-tax return from paying down the mortgage.
Pay Off Mortgage or Invest?
So, is it better to pay off your mortgage or invest? Like with many things, there is no clear-cut answer and each situation is unique. In general, if your mortgage rate is equal to or higher than the expected return from your investments, we might recommend paying off your mortgage. This may also be more appealing if you want to reduce debt or have a pessimistic outlook on the financial markets. However, if you expect to make a large purchase in the near future, paying down your mortgage may not make sense.
Otherwise, if you are comfortable with market risk and want to take advantage of tax-free growth, investing in a TFSA can offer benefits over the long-term. If you expect to have a lower tax rate at retirement, an RRSP can be even more advantageous.
Ultimately, whether you pay off your mortgage or invest depends on your unique financial situation. For someone with a moderate risk profile, we believe that the current interest rate environment leans towards a 5% threshold. If your mortgage rate is close to or above 5%, it may be worth looking at directing some of your excess funds to paying down your mortgage. A blended approach, where you do both — pay down your mortgage while contributing to tax-advantaged accounts — may also be a balanced solution that helps to offset the pros and cons from each approach.
Disclaimer: This information is not intended to be comprehensive investment, tax or legal advice applicable to the individual circumstances of a potential investor and should not be considered as personal investment advice, an offer, or solicitation to buy and/or sell investment products. Every effort has been made to ensure accurate information has been provided at the time of publication, however accuracy cannot be guaranteed. Interest rates, market conditions, tax rules and other factors change frequently and past investment performance does not guarantee future results. The manager accepts no responsibility for individual decisions arising from the use or reliance on the information contained herein. Please consult a portfolio manager prior to making any investment decisions.