Every week I will share a post with you that was inspired by a PF blogger. There are so many talented PF bloggers that I follow, but every once in a while I stumble on a post that really gets my attention. In these posts I will expand on their ideas and findings, provide my perspective and two cents about the topic.
This post was inspired by Bridget’s recent post ‘Should You Save Money or Pay Extra on a Mortgage?’ I always enjoy reading Bridget’s post because as a fellow numbers geek, she loves to crunch numbers. She also provides well-researched and detailed information and breaks it down in a clear and concise manner. This week I particularly enjoyed her post on whether someone should save (invest) money or pay extra on a mortgage to pay it off quicker. She compares investing $5,000 annually in a tax free savings account (TFSA) for 25 years or using that $5,000 to put towards a mortgage and accelerate the payments. Her final analysis reveals that the person that invested the extra $5,000 would come ahead by $80,000 over 25 years earning an average 5% rate of return. The three major reasons she provides are: a) cash invested is generating you an income, debt paid off is not b) historically low interest rates on mortgages favor investing in the stock market because your money is working harder for you c) you cannot discount the importance of time and compound interest when investing.
To read her full post, click here.
I agree with her conclusion (because the math supports it), but as she concluded in her post, it is not that black and white. It comes down to what you value most. Here are my thoughts:
Point #1: Cash invested is generating an income, debt paid off is not. – If you are more of a spender and find saving/investing money difficult, putting extra money on your mortgage can be a form of ‘forced savings’. You may not get market returns when paying down your mortgage, but if the alternative is monies being frivolously spent, I think debt repayment is a good option. Alternatively, if you are like myself and like to save and invest and feel fairly disciplined in doing both, investing your money may be better.
So why did my husband and I spend 2.5 years aggressively paying off $120,000 of student loan debt? Why didn’t we just make the minimum payments and put the difference towards investments? Here are my reasons why:
- I do not think student debt is ‘good debt’. Do not get me wrong, I understand the importance of the student loan program as without it 70% North Americans (including myself) would not be able to attend post-secondary school. Student loans are a means to an end, but if you can avoid having one, you are ahead of many. Student debt becomes ‘good debt’ when you can translate that debt into equity in the form of gainful employment. Also, student debt unlike other debt like a mortgage has no underlying asset behind it. Lenders still see student loan debt as any other debt, but mortgage debt is seen more favorably because of the underlying asset (house) it holds.
- Comparable rates of return. At the time of our student loan repayments our interest rate on all the loans were 5.5%. As a moderately aggressive investor in a balanced portfolio, I can expect a return of 5%-6% (adjusted for inflation) over the long term. Whether we paid down the debt at 5.5% or invested the monies at an average 5%-6% rate of return, either approach provided similar returns. So, to settle this we went with the option that had the least volatility in the short-term, paying off our debts. Because we gave ourselves a 3 year timeline to pay it off, we knew this was the best option, all things considered.
- You can’t cut your losses and move on. The majority of people that buy a home find their purchase to be a good investment in the long term. As they pay down the debt and their equity grows, they start to build their net worth. However, there are unfortunate situations where people have purchased a home and it turned out to be a horrible investment. In either situations you can sell the asset (home) and move on. You may have sold it at a substantial loss, but you can move on to another chapter of your life. Student loans however are with you for life. You cannot ‘cut your losses’ and move on if you ‘invested’ in the wrong degree or graduated at the wrong time etc. The permanency of student loans scare me. The fact that for a majority of Americans the only way to get rid of them is to pay them off or die is telling.
Point #2: Historically low interest rates of mortgages favor investing in the stock market.
This is probably the biggest reason why I would not rush to pay off a mortgage and would invest instead. People buying homes in the 80’s and 90’s were motivated to pay off their homes because mortgage interest rates were astronomical. In Canada the mortgage interest rate in 1981 was 21% and in 1990 was 14.75%. Contrast that to the current mortgage rate of 2.70% in 2016 (Rate Hub). The United States saw a similar trend with rates at 18.53% in 1981, 10.02% in 1990 and 3.41% in 2016 (FRED). With mortgage interest rates this low it makes sense to put extra money in investments. It would not be difficult for a balanced portfolio to beat a 3% rate of return in the long-term.
Point #3: Time and compound interest.
Of course compound interest can work in your favour. When aggressively paying off debt compound interest reduces your principal and interest balance faster. When investing compound interest grows your investments quicker over time. The difference is with investing you are seeing how quickly you can stack your chips up. The more money you have invested, the quicker your money will grow. Also with investing you can continue to grow your money long after you have stopped contributing to the investment.
For example if you were to invest $5,000/year from age 30-40 (10 years) in a balanced portfolio and had an average rate of return of 5%, you would have $66,467 in investments at age 40. This is $16,467 of income generation ($66,467- $50,000). Leave the $66,467 invested for another 25 years (age 40-65) without adding any more money to the investments you would have $231,391 at age 65. With debt repayment once you stop making monetary contributions to pay down the debt, you stop realizing the financial benefits. This is why I like investing, it does the work even when you stop working on it.
So even though overall the math supports investing over paying off a mortgage quickly, I think there is more to it. Personal finance is personal because it affects people differently. Your decisions will vary whether you are a saver or a spender, risk adverse or risk tolerant and what your future long term goals are. Either way, it is nice to see how the numbers play a part in all of this.