Why Paying Down Your Mortgage Early is Not Always the Best Idea

Craig Sebastiano
by Craig Sebastiano October 15, 2018 / 1 Comment

No one likes debt, especially when they’re carrying hundreds of thousands of dollars of debt in the form of a mortgage. Most financial pundits will argue that you should pay it down as quickly as possible. Some people have even managed to pay it off in just a few years. But is it the right decision?

Many Canadians try to pay their mortgages down faster to get out of debt and then focus on saving for retirement. It’s a commendable goal, but they’ve probably never actually sat down and figured out whether it’s a smart move.

Let’s assume you, a first time homebuyer in Ontario, buy a $500,000 home and put 20% down. Assuming you have a fixed-rate mortgage were able to get the best Ontario mortgage rate of 3.13% (as of Oct. 8, 2018) with a five-year term, Ratehub.ca’s mortgage approval calculator says your monthly mortgage payment on a $400,000 mortgage with a 25-year amortization will be $1,920 a month.

If mortgage rates are the same when you renew your mortgage each time (we know they won’t be, but for simplicity’s sake we’ll make this assumption), you’ll end up making total payments of about $576,000 ($1,920 a month x 12 months x 25 years).

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We’ll also assume you’re able to save $863 a month and your return on investment is a 7% a year. You put all of your money into a registered account (either an RRSP or TFSA, or both) to avoid paying additional income tax and maximize your tax savings. After 25 years, you’ll end up with $675,765.14 in savings.

But say you decide that you want to pay less interest and be debt-free sooner. You will save a little less until the mortgage is paid off in full and choose a 20-year amortization period.

In this scenario, your payments jump up to $2,240 a month. Over 20 years, you’ll make total payments of $537,600 ($2,240 a month x 12 months x 20 years) and pay about $38,400 less in interest.

For the first 20 years, you’ll only be able to save about $543 a month. But once the mortgage is paid off, you’ll be able to save $2,783 a month. After 25 years, you’ll end up with $584,670.11 in savings, assuming an annual return on investment of 7% and assuming you don’t blow the extra money in your pocket every month.

Say you’re not satisfied with being debt-free in 20 years. Instead, you don’t want to have a mortgage 15 years from now. Your payments jump up to $2,783 a month and you make total payments of $500,940 ($2,783 x 12 months x 15 years).

Once you’ve finished paying off your mortgage, you invest $2,783 a month every year for the next 10 years. Assuming a 7% annual rate of return, you’ll end up with $476,036.97.

You may have noticed you end up with a lot less saved than what you would have had you decided to save more and pay down your mortgage at a slower rate.

If you pay off your mortgage over 15 years, your total payments will be about $38,400 less than had you paid off your mortgage over 20 years. However, you’ll also have $108,633.14 more invested. When you save more right from the start and pay off your mortgage over 25 years, your total payments are $75,060 less and you have $199,728.17 more invested.

What gives? By saving and investing earlier, you can still end up with a lot more money even though you’ve put less money away. That’s the power of compounding. In the first example, you save $863 a month for a total of $258,900 over 25 years. In the second example, you save $543 a month for 20 years and $2,783 a month for five years for a total of $297,3000. And in the third example, you save $2,783 a month for 10 years for a total of $333,960. The lesson? Save and invest early so you’ll come out ahead.

The bottom line

While it may make sense to pay off your mortgage early, it’s actually not always a good idea. Even though interest rates are rising, they’re still quite low historically. The key, though, is to invest the money in a higher-risk investment that’s held in a registered account. If you invest in a GIC with an interest rate lower than the rate on your mortgage, paying down your mortgage early will be the better option.

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  • drpipeto

    All of this works when you find an average rate of return of 7% per year. The only place to find is in stock market, which means there is an additional risk that when you need to withdraw your money your savings will be way less if the market is in downturn. Let’s also not forget that when you withdraw money from RRSP you will need to pay tax, so savings in that account need to be calculated differently from TFSA and that both RRSP/TFSAs have a limited contribution room each year, which means you might not be able to put as much away as paying down the mortgage.