If you have cash on hand, the question of paying your mortgage versus investing the money will depend on many factors. This article will look at the factors to consider and what assumptions are implicit in the process.
The situation is that the mortgage is for $300,000, with an interest rate of 3%, which is due in 3 years. Current monthly payments are $1500 per month. There is an amount of $200,000 USD that is available to pay down debt or invest. There is no other debt to speak of, and the mortgage is 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 is now down to $40,000 and the income used to come from a full time job and is now self-employment income. It is assumed that there are no other sources of income.
Criteria #1
Is there an aversion to borrowing? If the number one priority is debt reduction or elimination, cash should be managed conservatively and debt should be paid in lump sum payments where possible or as one large payment at the end of the 3-year period when the mortgage This expired. renewal.
Criteria #2
What is your comfort level with taking risks? Another way of saying this is: if I lose a large percentage of the money I’ve 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 able to 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 the worst case figure. Where does this worst case figure come from? The number comes from a typical stock market crash scenario or the worst decline in investment value you can imagine happening. How long do investments take to recover? The typical figure is at least 5 years old. 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 decline in another market can also be used, but the equity market is the most common exposure.
Criteria #3
How competent am I as an investor? A related way of expressing 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 down debt because it is likely to be the best outcome. If you want to learn more about investing or gain conviction on how to make money, you may want to consider alternatives to paying down debt.
Criteria #4
Income generation from cash can be compared using an allocation of equity/fixed income investments versus interest costs on debt. after fees and taxes. Why? Debt interest costs are paid after taxes, while investment income is typically generated before fees and taxes. Regarding criteria #2 and #3, what is the best return I would get on my investments? If you think you can generate some return, use the equation: Profitability Profitability generated less investment expenses and taxes compared to interest rate on the debt you are currently paying.
Let’s say you plan to invest 50% in equities 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 any registered accounts where I can deposit money that could change my tax rate? 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. The 3% earned on investments less management fees of 0.25% per annum less taxes of 20% * 2.75% = 0.55%. The net return on your investments after taxes is 3% – 0.25% – 0.55% = 2.2%. The interest rate on the debt is 3%. If you think the capital gains on your investments will make this worthwhile, you can assume a return for the capital gains portion of the investment and add it to the return. The capital gains tax is usually half of your tax rate, in this case, 10%.
Within the rate of return on investment in this case is the currency exchange rate from US dollars (USD) to Canadian dollars (CAD). This would be another factor to consider as well.
Criteria #5
Will the future interest rate change by the time I renew my mortgage? If the return on 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, debt settlement looks more promising. If the interest rate drops when the mortgage is renewed, the return on investment looks more promising. This decision involves predicting the future, which is not easy to do. If it is obvious which way the interest rate will go, the decision will be clearer.
Other criteria
Other criteria could be whether the prospects for the investment’s rate of return improve, for example, after a market correction. You may have better conviction in a specific market compared to the average, which would make investments more attractive. Your income may 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 making 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 time.
