Over the last 15 years this has been an easy question to answer. Unless it was credit card debt (or other high-interest debt) the answer was to invest and only make the required payments on your debt. Interest rates on mortgages were so low there was little financial benefit in paying them off early. With the rapid increase in interest rates over the last year the answer may not be quite so simple anymore.
In general, the best place to deploy excess cash is where it can get you the best long-term rate of return. This has usually been the stock market, for example the S&P 500 has an annual return of 9.0% since 1996 (source: McKinsey). Over that period, it would have been a better decision to invest excess cash rather than to make extra mortgage payments.
The Financial Impact
Let’s examine what happens if you used $5,000/year to make extra mortgage payments or invested over the 15 years from 2008 to 2022.
|Excess annual cash flow||$5,000||$5,000|
|Interest rate/rate of return||3.20%*||9.50%**|
|Number of years||15||15|
|Change in net worth||$94,400||$146,800|
You would be $50,000 better off at the end of the 15 years if you had invested the money instead of making extra debt payments. This is 50% more net worth on the same $5,000/year.
While the decision to invest was easy over the past 15 years, things have become more nuanced with the increased interest rates. A five-year fixed mortgage is now at 4.50% or higher (source: Ratehub) and at the same time the average home price in Canada fell 12% in 2022 (source: Canadian Real Estate Association).
- Risk-free return – The “return” from repaying debt is risk-free but the return from investing is not. If you make an extra debt payment you are guaranteed to pay less interest in the future but the return you get from investing can fluctuate and even be negative.
- Anxiety/Stress – Large amounts of debt can cause anxiety and stress. There is often great relief knowing that all your debts are paid off.
- Liquidity – If you have an emergency or opportunity, it is easier to liquidate your TFSA then to go and refinance your home.
- Diversification – If all your net worth is tied up in the value of your home you are exposed to a large amount of risk if the housing market declines in your area. Meanwhile having a diversified investment portfolio protects you from industry specific or asset class specific risks.
Investing and paying down debt are both good uses for excess cash. Paying off your high-interest debt, such as credit card debt, is the priority. Afterwards the decision becomes more nuanced and personal.
Consider your personal appetite for risk and your relationship with debt. If having a large mortgage causes you anxiety and repaying it aggressively brings you peace and confidence, then that may be the best option for you. If holding mortgage debt does not bother you then investing has almost always been the better option to maximize growth.
The decision also does not need to be either/or, in fact it may be best for you to do a bit of both at the same time.
* Average Canadian fixed mortgage rate from 2008 – 2022 (source: Ratehub)
**S&P 500 rate of return 2008 – 2022 (source: officialdata.org)
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