Should you pay off your mortgage early?

THINK OUTSIDE THE BOX:  It’s important to come up with both a short-term and a long-term plan for your mortgage, and decide how it fits into your overall financial plan.

On the surface, it’s a no-brainer to pay off your mortgage early. After all, a mortgage is the biggest debt that most people will ever have, so it makes sense to want to eliminate it as early as possible. But how much financial sense does it make to do so?

Saving money in interest

One of the biggest considerations to take into account when deciding whether or not to pay off your mortgage is how much you’ll pay in interest over the amortization period, which is the life of your mortgage. With almost every loan, there are two parts: the principal and the interest. The principal is the amount of money that you actually want to borrow. So if you buy a home that’s $350,000 and you have a 10 per cent down payment of $35,000, you’d need a mortgage of $315,000 from your lender. But if you get a mortgage with a 25-year amortization period, that doesn’t mean that you’ll pay off $315,000 over the course of 25 years. That would be too easy – and not be of any benefit to the lender! So, as with most loans, you pay interest, which is essentially paying for the privilege of borrowing money. This is where the importance of interest rates come into play.

Using a mortgage payment calculator with a 2.8 per cent interest rate, your monthly payments will be $1,461.20. But if you take a look in the second column, you’ll see that the amount of money that you’ll pay in interest over the life of the loan is $123,360. So your $315,000 loan is really costing you $438,360.

There are two schools of thought when it comes to paying off your mortgage as soon as possible. The first is the more common reaction: you’re paying an extra $123,360 on top of the mortgage itself, which works out to almost an extra $5,000 each year, and no one wants to pay more money than necessary. There are ways to lower this number, such as making accelerated payments or lump sum payments, which allow you to pay more money than required, which goes toward the principal and shortens the length of time required to pay off the loan. And the less time it takes to pay off the mortgage and the lower the principal amount of the loan, the less you’ll pay in interest overall.

Not so fast

But Rachael Beemer, mortgage broker and owner of My Better Mortgage™ in Barrie, Ontario, says that while there are times when paying off your mortgage is a fantastic idea, there are also times where it will not help you.

“In the case of being self-employed and having a home-based business, it’s not beneficial to pay the mortgage off early,” she says. “When you’re self-employed and have a home-based business, the interest on the mortgage is tax deductible and so you would actually be bringing down your taxable income by having that write-off. The same would apply if you’re an investor, so having a rental property that’s free and clear but paying a mortgage on your own home is actually backwards; I tell my clients to do it the other way. So if you’re an investor, it’s beneficial for you to have your owner-occupied home paid off but you want to have your rental properties mortgaged because again, that’s where the tax deductions come from.”

Investing instead

Another school of thought about paying off your mortgage early is that you don’t; rather than putting every spare penny you have into paying off your mortgage, you invest it instead. Low interest rates, while good for your mortgage, aren’t great when it comes to saving your money. Vehicles like high interest savings accounts aren’t an effective way to hold onto cash, and depending on the interest rate of the account itself, may actually be losing money when you take inflation into account. Investing it can give you better returns on that money. With a $315,000 mortgage, sure you’ll pay that $123,360 in interest, but you could also end up with more than that at the end of 25 years if it’s invested wisely.

One way to invest is through the Smith Manoeuver, which makes your mortgage tax deductible. Many of her financial advisor clients participate in this arrangement, whereby your mortgage is set up with a line of credit behind it. As you make a mortgage payment, the line of credit is readvanced by the amount of principal decreased. For example, if you made a mortgage payment and your principal decreases by $1,000, then your line of credit increases by $1,000, and that money is then advanced and goes into an investment product.

“That product and that setup is not right for everybody,” Beemer warns. “You need to know what you’re doing because if you’re investing into something that isn’t giving you a return higher than the line of credit, you’re obviously going in the wrong direction.”

Leave your options open

When you get your first mortgage, it’s hard for many people to focus on the end game, especially given that so many people put so much effort into saving up the minimum down payment, or even making use of grants or various cash-back programs that some lenders offer. But it’s important that you keep all of your options on the table so that when you’re ready to focus on your long-term strategy, your mortgage allows you to take action, whatever that may be.

“We always make sure that when we put somebody into a mortgage product, they have the ability to increase their payment or double up their payment,” Beemer says, “but first-time homebuyers typically don’t come in saying, ‘I have a plan to pay this off in five years.’”

In fact, she says, many buyers overlook what their plan is going to be for the next five years, thinking that their lives are going to stay exactly the same as they are at the moment, and what they’re paying in rent will easily translate into what they’ll get when paying a mortgage on a home, and it’s not the same.

“They’re not taking into account a new vehicle, or possibly expanding their family, and all those things put pressure on household finances, and then we see that they’re using credit.”

It’s important to come up with both a short-term and a long-term plan for your mortgage, and decide how it fits into your overall financial plan. When it comes down to it, you have to ask yourself: what is it worth to you to live debt-free?

“I come from the thinking that your money stays in your bank account and you don’t carry debt,” Beemer says. “And I agree with that – except in those situations where you are self-employed and run a home-based business or if you’re an investor. Then I think you’re not making the best use of your money.”

You might be the kind of homeowner who will always be thinking about the money you “lost” by not investing it somewhere that may have gotten bigger returns. Or you may be the kind of homeowner who, regardless of what the returns that you might have missed out on, value the freedom that comes with truly owning a home, and not having a large debt looming over you. Sure, you’ll still have to pay for property taxes, and you’ll want to continue paying for home insurance, but with hundreds, sometimes thousands of dollars freed up each month, you’ll be able to take that money and invest as aggressively as you would like, without worrying about the bank taking your home, ruining your credit, and you not having a place to live if the going gets tough.

Kimberly Greene      WhichMortgage      December 14, 2016

No Comments

No comments yet.

RSS feed for comments on this post.

Sorry, the comment form is closed at this time.