Paying off mortgage safer than investing the cash

Study after study suggests that Canadians are having a tough time paying off their mortgages, as debt levels continue to hit record levels year after year. Why?

Could it be that there are more opportunities to spend? Could it be that some people don't want to pay off their mortgages faster?

Or are some professionals advising alternate investment strategies, suggesting that paying off the mortgage is not the best financial strategy?

BIG MORTGAGES AFFECT RETIREMENT

Rebecca and Darcy are in their mid-50s and are starting to think about retirement planning; they would like to retire in the next five years.

One of their biggest hurdles is a $225,000 mortgage. Currently, their $2,200 monthly payment would have the mortgage paid off in 10 years.

Rebecca and Darcy recently both received increases in pay at work, allowing them to increase their mortgage payments by $1,000 per month and pay off their mortgage in just under seven years.

Just as they were working with the banker to renew their mortgage, Darcy also got news that he is going to receive a significant inheritance, which he could use to pay off the mortgage all at once. When they asked the banker what they should do, the advice concerned them.

ADVICE FROM THE BANK

The banker suggested that in a low-interest-rate environment, paying off the mortgage might not be the best thing to do with the $225,000 inheritance.

Instead, they could invest it into a mutual fund that made over six per cent over the past year and over five per cent compounded over the last five years. With mortgage rates at 2.5 to three per cent, higher investment returns would mean more money in their pocket.

The banker put together a nice graph showing Rebecca and Darcy that investing the $225,000 would give them over $315,000 in seven years at five per cent, and that their $3,000 monthly payment would mean the mortgage would be paid off at the same time.

The bank's conclusion? Keep the mortgage and invest the lump sum for a higher return.

WHAT WOULD YOU DO?

The banker is mathematically correct, but the big "if" lies in the rate of return, which cannot be controlled or predicted. The five-per-cent return is not guaranteed; what if the next five years aren't as generous?

I ran some numbers at two per cent for the couple, and in that scenario, $225,000 would only grow to $258,000 after seven years. Alternatively, paying off the mortgage and investing the $3,000 per month mortgage payment at the same two per cent would give them $274,000 after the same period.

Basically, if the return on investment is greater than the interest cost on the mortgage, then the math would tip toward investing money. If the return on the investment is lower than the interest rate on the mortgage, then the math would tip toward paying off the mortgage.

We could complicate the calculation with after-tax returns, but we'll keep things simple for this column.

The bottom line is paying down the debt is a more conservative option. It puts more control, flexibility and security in the hands of Rebecca and Darcy. Investing is always great when the returns come, but a good return is not guaranteed.

The banks make money when you keep a mortgage and they also make money when you invest in their mutual funds. Could that have any influence over the banker's advice here?

There is no right or wrong solution here. Both investing and paying down a mortgage are financially responsible.

I tend to err on the conservative side, so if I were in Rebecca and Darcy's shoes, I would pay off the mortgage, then invest the $3,000 per month for retirement. What would you do?

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