If you have cash on hand, the question of paying your mortgage instead of investing the money will depend on many factors. This article will discuss the factors to consider and what assumptions are involved in the process.
The situation is that the mortgage is $ 300,000, with an interest rate of 3%, maturing in 3 years. Current monthly payments are $ 1500 per month. There is an amount of $ 200,000 USD that is available to pay off debts or invest. There is no other debt to speak of, and the mortgage is being held against a home valued at $ 700,000 that generates rental income of $ 20,000 per year. The income of the person who had the mortgage was $ 80,000 per year and now it has been reduced to $ 40,000 and the income used to be from a full time job and now it is self-employment income. It is assumed that there are no other sources of income.
Criterion no. 1
Is there aversion to having debts? If debt reduction or elimination is the number one priority, cash should be managed conservatively and debt should be settled either in lump sum payments when possible or as a large payment at the end of the 3-year period when the mortgage is current. renewal.
Criterion no. 2
What is the comfort level when taking risks? Another way of saying this is: if I lose a large percentage of the money I have invested, will I panic and lose sleep? Another version of this question is: if I lose a large percentage of my investment, am I willing and can I wait for the investments to recover? How much is a “large percentage”? The typical number I use is 1/3 or 33%. Instead, you can insert your worst-case figure. Where does this worst-case figure come from? The number comes from a typical stock market crash scenario or the worst drop in investment value you can imagine. How long do investments take to recover? The typical figure is at least 5 years. If you want a lot of certainty in your income, 10 years is more realistic if the downturn is long-lasting. The assumptions here use an equity correction. A real estate correction or a fall in another market can also be used, but the equity market is the most common exposure.
Criterion no. 3
How competent am I as an investor? A related way of putting this is: Do I have an alternative way to use my money to generate higher returns? If you are a new or novice investor, it would be preferable to pay off the debt because that is likely to be the best outcome. If you want more information on how to invest or if you are convinced about how to make money, then you can consider alternatives to debt repayment.
Criterion no. 4
Income generation from cash can be compared using a fixed income / equity allocation of investments compared to borrowing costs. after taxes and fees. Why? Interest costs on debt are paid after taxes, while investment income is generally generated before fees and taxes. By observing criteria n. 2 and n. 3, what is the best return on my investments? If you think you can generate any returns, use the equation: Return on income generated less investment fees and taxes in comparison with interest rate on the debt you are currently paying.
Let’s say you plan to invest 50% in stocks and 50% in fixed income. The dividend yield on stocks is 4% and the interest yield on fixed income is 2%. The average rate of return is 3%. For taxes, there are some additional questions. What is my tax rate right now on my income? Do I have a registered account where I can deposit money that could change my tax rate? The assumptions so far ignore capital gains because they are unpredictable in the short term. Let’s say your tax rate is 20% and you have no registered accounts available. 3% accrued by investments minus management fees of 0.25% per annum less taxes of 20% * 2.75% = 0.55%. The net return on your investments after tax is 3% – 0.25% – 0.55% = 2.2%. The interest rate on the debt is 3%. If you think the capital gains from your investments will make this worthwhile, you can take a return on the capital gains portion of the investment and add it to the return. The capital gain tax is generally half your tax rate, in this case 10%.
Within the investment rate of return in this case is the exchange rate from US dollars (USD) to Canadian dollars (CAD). This would be another factor to consider as well.
Criterion # 5
Will the future interest rate change when I renew my mortgage? If the return on the investment exceeds the return on the mortgage, but the future rate in 3 years will increase to 6%, is the investment still viable? If not, paying off the debt looks more promising. If the interest rate falls when the mortgage is renewed, the return on the investment looks more promising. This decision involves predicting the future, which is not easy to do. If it is obvious in which direction the interest rate will go, the decision will be clearer.
Other criteria could be whether the outlook for the rate of return on the investment improves, for example after a market correction. You may have a better conviction in a specific market compared to the average, which would make investments more attractive. Your income can increase to the point that paying your mortgage is easier and faster, or vice versa. The equity in your home can go up or down, which can also change the decision.
This article is intended to examine the thought process of how to make a decision with many unknowns. As you go through the process, the answer to your situation becomes clearer and more applicable to where you are at any given moment.