May 28th, 2010 | 
Category: I was just reminded again recently when commenting on a post at The Financial Blogger at how investors with a mortgage struggle with the decision of investing or paying off your mortgage. It is a very good dilemma to be in, since it implies your have extra money.
In my book (figuratively speaking), both ways should be considered an investment.
- Paying down your mortgage saves you money. You can easily identify what the return on investment (ROI) is on your extra payment through the amortization reduction on your mortgage.
- Investing your extra money in a sound investment should provide a return and hopefully a compound growth.
The question is: Which one is better? It depends on your situation and this is where you need to do the math. Every situation is different.
Understanding Mortgage Interest Calculation
If you look at your payments summary in the year, you will notice that early in your mortgage term, the interest payments are much higher than the principal payments (Assuming a standard 25 year mortgage term). The lender is pretty much paying itself first and then reducing your principal. The interest is based on the principal and the compounding factor of the interest on the principal borrowed. The longer the term, the more significant the compounding factor is. This is why when you first take a 25 year mortgage, you can easily reduce it to 21.6 years by making bi-weekly payments rather than monthly. If your payment is 1000$ / month, this is how it looks:
- Monthly : 12 x $1,000 = $12,000
- Bi-Weekly : 26 x 500$ = $13,000
- Weekly : 52 x 250$ = $13,000 (Same total but further reduction since there is another extra payment within the 6 month window where interest is calculated.)
Doing a bi-weekly payment, or investment if you want to look at it that way, saves you nearly 4 years. That’s just under $48,000 in savings or ROI when you look at it as an investment. (I have rounded to 4 years for simple math) In this scenario, the extra payments also have interest payments on them. Imagine the compounding factor when you put extra money towards the principal only …
Invest or Pay Down the Mortgage?
A good mortgage calculator should help you assess your return on investment. The simplest way is to see how many months in amortization you save and multiply that by your monthly payment.
You also need to evaluate the investment you would do if you weren’t going to accelerate your payments. One important factor to keep in mind is that your mortgage isn’t impacted by market fluctuation.
My Take
If you are early in your mortgage, accelerate it until you reach the 10 to 15 year amortization length. Then re-evaluate your situation and goals. By that time, the compounding factor is reduced and more of your payments go toward your principal.
Early in a mortgage, the interest rate of a mortgage cannot be compared with other potential investments like apple to apple. There are too many factors in play;
- Interest / Principal ratio of mortgage payment
- Compounding factor on the term length
- Market fluctuation of potential investment (stock, mutual funds and such)
I am not saying to not invest but rather to consider a mortgage prepayment/acceleration as an investment and to give it the same due diligence you would other investments. I do both; accelerate my mortgage and invest.
Take your Time with HBP
Home Buyers’ Plan (HBP) is an example where you want to simply pay the minimum every year. There is no interest on this loan since it’s from yourself (from your RRSP). There is no financial benefit in accelerating the payments.
[...] Is paying off your mortgage a good investment? [...]
[...] actually much better to re-invest it The age old dilema is whether you invest it (TFSA anyone?) or pay down your mortgage. Both options can offer the power of compound growth. My personal take is if you are early in your [...]