Have you recently earned some bonus income from your employer for a job well done? If so, congratulations on your efforts, and the windfall!
You may be wondering about the most sensible thing to do with that extra cash. Should it go towards your mortgage, giving you a break from interest charges on a (typically) hefty debt? Or are you better off investing the money and using it to generate more wealth?
The correct answer depends on your personal circumstances, notably the amount of money still owing on your mortgage, and the interest rate.
Likewise, no decision on investing should be made without a deeper understanding of the potential outcomes, both good and bad, as well as the expected rate of return.
Even so, it doesn’t take a financial genius to see that interest rates, while rising, are still below the historical average. Not only that, but they’re also lower than the typical rate of return available from investing in stocks.
What does that mean? Well, you may be paying five or even six per cent interest on your mortgage, but that pales in comparison to market performance: the TSX composite index has grown more than 20 per cent over the past five years, while the Dow Jones has climbed almost 40 per cent in the same time frame.
Of course, personal situations and needs always vary, so there may be a good reason to make your mortgage the priority. Here’s a look at a few things that might make up your mind.
Save on interest
Paying down (or paying off) a mortgage, even one with a low interest rate, can save tens of thousands of dollars in interest charges over the lifetime of the loan. If you’ve got a mortgage with a high interest rate, you can generate instant savings and budget flexibility by paying down the debt. No matter what your rate is, you’re guaranteed to save something when you reduce the principal with a prepayment.
Build more equity
Paying down your mortgage also gives you a bigger equity stake in your home, which you can use to borrow against. You might borrow money to pay for a home renovation project (thereby increasing the home’s resale value), or to pay off another debt. Having more equity in your home may also help you get a better rate when your mortgage comes up for renewal.
Reduced risk/Peace of mind
Stock market investments don’t always go up in value, but there’s no such risk associated with paying off debt. If you don’t like the riskier aspects of investing money in stocks and equities, or if you just don’t like having a large debt hanging over you, paying down your mortgage is a perfectly reasonable thing to do. Once the mortgage is gone, you can start diverting more money to other things, including suitable investments.
On the flip side, if your mortgage rate is low, you don’t have much left owing, or both, you might consider investing instead. Here are a few things that might tip the scales in that direction.
Equity in your home has its advantages, but it’s not very liquid (meaning it’s difficult to access without borrowing through a line of credit, or selling the property). If you have to deal with a financial emergency, or need cash quickly to take advantage of an opportunity, it’s easier to turn investments into cash than it is to cash out on your home.
As we discussed earlier, the stock market tends to generate higher rates of return than the interest rate you’re paying on your mortgage, meaning you’re likely to make more money over the long term by investing than paying down your housing debt. Remember, however, that tax implications will eat into the value of your investment earnings, so make sure to factor that in when deciding.
Potential tax advantages
If you choose to invest your money into an RRSP or a TFSA, you’ll be able to take advantage of tax breaks that make your investment dollar go further. With a RRSP, the contribution amount is deducted from your taxable income, lowering your tax bill and freeing up money for other things (such as paying down the mortgage). When you contribute to a TFSA, you don’t have to pay tax on any income generated by the investment, meaning you’ll end up keeping more of your earnings.