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Paying off Your Mortgage May be Bad for Your Net Worth

Posted on Mar 17, 2014 in Mortgage Market Updates and News

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By Calum Ross
The Real Estate Insider

In a society where financial planning education and free financial resources are as readily available as fast food, it is unfortunate to know that most people actually do not understand how to use their cashflow and capital effectively. When determining many people’s top financial objectives, a large number of people select building their net worth and paying off their mortgage at the top of their list. While at face value these seem to be rational choices, what I will show you is not only why these goals may directly contradict one another, but also how being mortgage free could very well be a detriment to building your net worth.

With rates of returns in the global equity (stock) markets all over the map and many people facing lower than planned retirement savings, RRSP contributions and investments are once again hot topics. The challenge that this presents for most individuals is a clear one – with only a finite amount of income and financial capital, how does one allocate one’s capital to reach that often elusive net worth figure that brings him or her closer to the point of retirement? Keep in mind that retirement for the purposes of financial and real estate investment planning is not necessarily where you stop working, but rather where you no longer need to work.

The RRSP/invest versus pay down mortgage debate has for a long time been the source of much controversy. While there is no definitive answer, here are some clear cut rules that will enable you to make an informed decision. Some of the major factors influencing the choice of options are the mortgage interest rate versus the expected return on the investment, the investment time horizon versus the mortgage time horizon, the availability of RRSP contribution room, available investment opportunities, along with the important element – your risk tolerance. When you couple this with the confusion of after-tax cost of borrowing versus after-tax rates of return, it is no wonder people’s eyes glaze over.

When borrowing to invest – given an expected after-tax investment return equal to or greater than the after-tax mortgage interest rate, and when the investment time horizon is equal to or greater than the likely mortgage life, maximizing investment contributions generally maximizes net worth. Conversely, if the after-tax investment return is less than the after-tax mortgage interest rate and/or the investment time horizon is less than the life of the mortgage, it generally becomes more attractive to prepay the mortgage.

Generally speaking, if you borrow to invest (with the expectation of profit) then the interest borrowed on that money is tax deductible (please consult a competent mortgage advisor who is well versed in the basic concepts of personal tax and financial planning before considering this strategy and never do this without a letter of opinion from an accountant or a tax lawyer).

IMPORTANT NOTE – To determine the after-tax cost of borrowing (the real rate of interest to the person borrowing the money) subtract your marginal tax rate percentage from 1 and multiply by the interest rate on the money borrowed. For example, someone who borrows at a face rate of interest of 5% but who has a marginal tax rate of 40% has an after-tax cost of borrowing of [(1 – 0.40) x 5%] = 3%.

The next important consideration is to determine your after-tax rate of return. When investing outside of your RRSP, it is important to keep in mind that not all investment income/growth is treated equally for tax purposes and the difference will vary significantly based on your personal tax bracket. As a general rule, in order to optimize your after-tax rate of return, you should likely seek capital gains first, dividend income second, and interest income third.

On a separate note, it merits mentioning that there is a common misconception in society that wealthy people do not have mortgages. In reality, the odds are that if you know a wealthy person without a mortgage then they likely inherited their money, do not have a good financial advisor, or are highly risk averse. With interest rates at where they are today, paying off your mortgage is in all likelihood not a wise financial decision if your hope is to have the highest and best use of your capital. This is especially true for wealthy people who are in the top two marginal tax brackets.

Take some solace in this; the next time you are at a cocktail party or family function and someone smugly tells you that they have paid off their mortgage – odds are they know little about personal finance and will likely limit their personal net worth as a result. After all, who really worries about a mortgage of a couple of hundred thousand dollars when your investment portfolio is a couple of million dollars and could be used to retire your mortgage any day you choose? By deploying this strategy, what you are doing is using other peoples’ money to build your net worth.

In today’s market, the concept of a reasonable rate of return (one above inflation factoring in your tax) is all but absent in the market. It is for this reason that the forced savings mechanism of real estate investment, coupled with the deductibility of the interest, and the payments from renters, make it hard to beat. Factually, a real estate investor who puts 20% down, and uses a 25 year amortization period to pay off their mortgage will get a 400% return on their money over the 25 year period without factoring in additional cash flow or appreciation of the real estate asset.

At the end of the day, determining the correct balance of debt reduction versus investing comes down to your investment objectives, time frame, personal goals, and also your risk tolerance. It doesn’t take finance majors or an accountant to see that if your after-tax rate of return is greater than your after-tax cost of borrowing then you are getting rich with other people’s money (OPM). Furthermore, if your financial situation and cash flow allow you take advantage of the above strategies, then they can certainly play a huge role in helping you achieve greater net worth goals and allow you the flexibility to retire years earlier.

While the extra net worth won’t buy you any happiness, I am going to assume that all else being equal, you would rather be richer than poorer. Following these simple personal finance rules and acting on the advice of good advisors will help you achieve the bigger and longer term financial goals. 

Calum Ross was ranked as the top producing mortgage broker in the country by Canadian Mortgage Professional Magazine. He is regularly featured in the media as a mortgage expert including appearances on Canada AM, CTV, City TV and Inside Toronto Real Estate. He is the mortgage columnist for New Homes and Condos magazine and The Condo Guide and is regularly quoted in newspapers such as The National Post, The Globe and Mail and the Toronto Star. He holds both a B.Comm and MBA in finance and recently completed the Comprehensive Leadership Program at Harvard Business School.

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