Monday, April 13, 2015

Pay Down Your Mortgage or Invest?

The many arguments you can find online about whether it’s best to pay down your mortgage or invest tend to gloss over the most important considerations. The answer isn’t in detailed calculations of returns based on assumptions that are just guesses. The truth is that if your income remains stable, you’ll do fine with either approach. The real answer comes when considering problem scenarios.

All investment choices should balance two needs: (1) capturing wonderful returns through good times, and (2) surviving bad times. If you just average out the good and bad times and project future returns based on some middle-of-the-road assumptions, you might be taking on too much risk.

One possible future for you is that you will always have a job when you want one and enjoy ever-increasing pay until you choose to retire. Here is another possible scenario:

– The stock market crashes and stays low for 5 years.
– Shortly after the crash, you lose your job.
– It takes you 6 months to find another job.
– The new job pays only two-thirds of your former salary.
– Your salary never recovers to its previous inflation-adjusted level.

If you knew this was a possibility for your future, would you pay off your mortgage or invest? When I was younger, my response to this possibility was to buy a less expensive house than banks told me I could afford, and I maintained emergency savings. By having a lower mortgage, I would still have been able to afford my mortgage payments on a lower salary. The emergency savings would have supported me during a period of unemployment.

What should people do now if they already have a large mortgage? Well, when you consider the negative scenario above, one good response is to build some emergency savings. Another good response is to pay off the mortgage aggressively until the principal is down low enough that a smaller salary could handle the payments. Once the mortgage principal is down, you can start building retirement savings.

Personally, I think it’s better to rent or buy a less expensive house from the start so you can begin to invest right away. But if you’re already stuck with a huge mortgage, you have to consider a safer path. This safer path may result in smaller future savings if the bad scenario never happens, but that’s no reason to ignore bad possibilities.

In the end, each person needs to find his or her own balance between surviving bad times and reaping returns during good times. But my experience has been that most people just deny that bad scenarios are even a real possibility for them.

8 comments:

  1. You are advocating common sense. The problem when it comes to a house purchase is that flies out the window. Same with renovations. Before doing any renovation you need to make sure there is a solid return for it when you have to sell the home.

    I think all the Home buying/reno TV shows on the W network have warped the reality of what a house needs to be in order for a family to be secure and happy.

    Even extremely high earners make horrible financial choices - buy way too much house with a massive mortgage and have no savings. They never take it into consideration that their $200,000 a year job may turn into a $75,000 job in a recession or have some unforeseen health issue etc. Here you have a group of people that with just a few years of saving and investing, could make their own (back-up) retirement plan that would be comfortable to the vast majority of people. If they can't even control their wants vs. needs, how can we expect regular folk to do this on tight budgets? You are so bang on with your post today.

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    1. @Paul: Interesting points. I don't tend to watch the shows you're talking about, but no doubt they affect people. I've known many ex-Nortel people who have faced a permanent drop in salary.

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    2. @paul I also think people should generally save up for the reno and pay cash. Aside from an actually leaking roof or pipes etc I can't see why anyone should borrow money to improve their home. If it will "only" take 2 years to pay off the basement reno, then saving for 2 years will mean it could be paid in cash and save the interest payments to the bank.

      I'm not sure I agree renos have to be worth something to the next buyer. My parents are still in their first home and we've been in this one for over a decade. If we want the home to be improved to suit us, we're willing to pay even if it has 0 impact on our market value.

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  2. This is where my head is at: "By having a lower mortgage, I would still have been able to afford my mortgage payments on a lower salary."

    I find the same people who don't bother to pay down their mortgage are the same people who don't need any emergency fund. You can simply use a LOC.

    That's not us.

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    1. @Mark: Sounds like we're on the same page.

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  3. "Personally, I think it’s better to rent or buy a less expensive house from the start so you can begin to invest right away."

    This, 100%.

    It really is strange that the average Canadian mindset has no problem assuming a large amount of long-term debt/leverage (mortgage) to buy a depreciating, non-productive asset (house) under the assumption it is a riskless, yet ever-gaining investment (it is not), but the same mindset is hugely fearful of renting and assuming a large amount of long-term debt/leverage (investment loan) to buy appreciating, productive assets (stocks/companies) under the assumption it is a risky, yet ever-crashing investment (they are not).

    Might be a result of passing along deeply engrained generational beliefs and biases, cultural and societal status/stigma pressures, political cheerleading, and emotions. I highly doubt most people sit down and run a bunch of different investment models before going to a bunch of different open houses.

    I'm almost convinced a lot of mortgage payers aren't really sure i) what they actually want (home, wealth) and ii) what they actually have (house, assets).

    It's a shame there still is no wide-spread math-based financial education available to the public (e.g. in grade school) to dispel the many myths of home ownership, leverage, and investing. The best we get is free marketing and mis-information from the financial sector.

    My two bits.

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  4. I was thinking about the same question in terms of the investing portion including different options, what are people's thoughts on company matched rrsp up to x% vs tfsa vs mortgage payment.

    1. Maxing out RRSP, no TFSA

    2. Putting minimum into RRSP up to the matched amount to get the free money and invest the rest in TFSA Personal Limit

    3. Paying down mortgage and split between RRSP/TFSA

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    1. @Anonymous: The answer to your question depends on your personal circumstances.

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