Monday, April 13, 2009

Pay Down the Mortgage or Invest?

A reader, PR, asked the following question:

“I am moving in a few months and I'm trying to work out whether it will be wiser to buy a house outright (I can do so with savings from my last house, sold in 2006) or incur a mortgage. I have read Ric Edelman's spiel about why it is always better to take a mortgage instead of pay outright. I can see why it would work out if I were planning to stay, but I know I will be selling the house in 3 years. What do you think?”

The first thing to realize is that whether you have a mortgage or not, you are exposed to the full volatility of the value of your house. The bank that gives you a mortgage isn’t your partner in your home investment. If your home’s value drops, the bank will still want all of their money back.

If you decide to take a mortgage, then your portfolio will consist of your house plus the investments you make with the money you have on the side. You would be using leverage to increase the size of any portfolio gains. Unfortunately, any losses would be magnified as well.

Throughout my life, I preferred the simplicity of paying down my mortgage fast and living without any debts. Others prefer to go for greater investment gains with the increased risk of using a mortgage for leverage. This is a personal decision about whether you’d be prepared to live with lower spending or trying to earn more income if your investments go south.

If PR chooses to take a mortgage, he should seek advice to structure the investments and debt so that the interest payments are tax-deductible. This is easy enough in the US, but can be tricky in Canada.

Although PR’s question is whether or not to take a mortgage, the fact that the stay in the house will be only 3 years makes me think that a third option is possible. Why not consider renting? This would eliminate many thousands of dollars in real estate and legal fees to buy a home and then sell it after only 3 years.

Renting would also eliminate the risk of fluctuating house prices. I was only a renter for a short period of time when I was young and didn’t like having a landlord, but I would consider renting again if I knew I’d only be staying in a city for 3 years.

In my usual style, I haven’t actually told PR what to do, but tried to give him some useful information in making his own decision. Hopefully PR will let us know what decision he makes.

3 comments:

  1. I think between a mortgage pre-payment and investing (even within a RRSP), a prepayment is a superior for most people. The reason is that most people don't seem to earn even market returns and maybe better off with the guaranteed, after-tax return provided by a prepayment.

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  2. CC: I agree. Even for those who hope to get investment returns beating their mortgage interest rate, the security of reducing debt may outweigh the potential of higher returns.

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  3. I'd like to vote for renting (which I hadn't considered until you mentioned it), unless there are some details that prohibit it, pets, family, or a spouse that refuses to rent.

    There's a chance that housing prices will drop, that selling will be difficult or unpleasant, or that the house will be a dud. Insurance costs and taxes are likely higher too. Also, if moving to a new city, one might make the mistake of buying in an undesirable neighbourhood.

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