If you have cash on hand, the question of paying your mortgage versus investing the money will depend on many factors. This article will analyze 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%, due in 3 years. Current monthly payments are $1500 per month. There is an amount of $200,000 USD that is available to pay off 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 mortgage holder’s income was $80,000 per year and has now been reduced to $40,000 and the income used to be from full-time employment and is now self-employment income. It is assumed that there are no other sources of income.
Criterion #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 off in lump sum payments when possible or as one large payment at the end of the 3-year period when the mortgage This expired. renewal.
Criterion #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 “big 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 drop in investment value you can imagine happening. How long does it take to recover the investments? 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 dip is long-lasting. The assumptions here use an equity correction. A real estate correction or a drop in another market can also be used, but the stock market is the most common exposure.
Criterion #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 down the debt because it is likely to be the best outcome. If you want more information on investing or conviction on how to make money, you may want to consider alternatives to paying down debt.
Criterion #4
Income generation from cash can be compared using a fixed income/equity investment allowance 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 from my investments? If you think you can generate some return, use the equation: Profitability Profitability generated minus 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 current tax rate on my income? Do I have an account on file that I can deposit money into 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 available registered accounts. The 3% obtained on the investments less the management expenses of 0.25% per year less the 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 from 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. Capital gain tax is generally half 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.
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, debt settlement looks more promising. If the interest rate falls 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 rate of return on investment 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 where paying your mortgage becomes 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 progress through the process, the answer to your situation becomes clearer and more applicable to where you are at any given time.