Investing Versus Paying off the Mortgage

By PAIP Canada staff

It’s one of the most common questions asked by clients, and why shouldn’t it be? When a family receives a lumpsum, either from performance bonus or an inheritance, or for any reason for that matter, there’s a decision to make.

Since interest rates were so low for so long, it made a lot of sense to invest one’s excess savings instead of paying down the mortgage, but that may no longer be the case. Since interest rates have steadily increased over the past year, a mortgage with an interest rate of 5% is not uncommon.

Making a lumpsum repayment of any amount translates to a return of 5% on a post-tax basis! It’s a pretty good deal.

On the other side of the coin, if a person wanted to assume more risk and invest their additional dollars, they would require a return of more than 5% to break even. Assuming the entire return is fully taxed, the formula to determine the breakeven return is one’s mortgage rate divided by one minus their marginal rate of tax (MRT), as follows:

Mortgage Rate / (1 – MRT)

Assuming a salary of $100,000, in most Canadian provinces, one’s MRT would be between 30% and 35%. From this, we can calculate that for one to “beat” the return on their mortgage, they would have to earn a pre-tax return of 7.14%, calculated as: [5% / (1 – 0.3)]. Not an easy task when companies are also facing higher borrowing costs.

Of course, those who can make additional deposits to their Tax-Free Savings Account (TFSA) don’t face this additional hurdle. Returns inside of TFSAs require no more than a 5% rate of return, and it could come in any character (interest income, dividend income, or capital gains).

When a return is taxed as a dividend, then the hurdle rate moves lower than the previously calculated 7.14%, and even lower still, for those whose returns come in the form of capital gains. Additional risk goes hand-in-hand with lower taxes. Since interest income is generally guaranteed, the entire return is subject to tax at one’s MRT, whereas capital gains (which are not guaranteed) are subject to an inclusion rate of 50% only.

But the decision isn’t just about the numbers.

Since mortgages are amortizing loans, once a repayment is made, the money cannot easily be accessed by the borrower. It’s gone into the mortgage, which must be renegotiated (at a financial cost) in order for the borrower to access additional amounts.

Liquidity and access to capital are critical parts of the decision-making process.

For those who do not have an emergency fund, then saving money in a high-interest savings account may be the best approach. Once a family has sufficient access to cash (should an unforeseen expense occur), then it becomes possible to better plan one’s financial affairs. Until that time, it’s safety first, and then we get to crunch the numbers.