Is Paying Down Your Mortgage Really the Fastest Way to Pay Down Your Mortgage?
No, that title isn’t a typo, though it admittedly was meant to catch your attention, which evidently worked. Now, if you’re still with us, we will talk about a way to potentially pay off 20% more of your mortgage in the first 5 years without having to put aside any more money.
You can’t open your internet browser without seeing a news article, or comments from the Bank of Canada regarding Canadian household debt. Most of this increase, however, has come from mortgage debt. Mortgage debt is the most stable and safe form of household debt and can be a great way to consolidate your debt and improve your finances.
At the same time though, many Canadian homeowners are making the financially prudent choice to make accelerated or lump-sum payments in order to pay down their mortgage faster. Paying down your debt faster is a great idea, but accelerated payments aren’t necessarily the best way to go about. There are other options to consider, though they do carry more risk.
What Else Can You Do to Pay Down Your Mortgage Faster?
First, a few important things to keep in mind:
- Making accelerated payments now will not lower your current minimum mortgage payments, as they are set out when you sign or renew your mortgage. What it will do is lower the amount owing for when you renew
- As such, your current interest rate is largely irrelevant and should not be taken into account when deciding whether or not to make accelerated or lump sum payments
- Rather, you should look at the rate you expect to pay at the time of your renewal. Every dollar you manage to pay down before that time will not have that future interest rate applied to it and that is where the savings come from .
Now, let’s set out a situation and a goal, then we can compare alternative methods for achieving that goal:
- Let’s say you have an additional $100 every month that you did not previously have
- Now let’s assume that your goal is to have paid down as much of your mortgage as possible by the time you renew (let’s assume the full 5 years).
You have two options: you can make lump sum payments onto your principal, OR, you can put that $100 into a savings account and then make one large lump sum payment at the end of 5 years. The chart below illustrates the difference:
- Option one: you diligently put $100 directly onto your mortgage every month, or at the end of the year. By the end of 5 years, you would have put down $6,000 directly onto your principal – not too shabby.
- Option two: you invest your $100 into a savings account every month. In the example below, we use the iShares TSX index, which replicates broad movements in the TSX and includes dividend payouts. Essentially, it is a simple investment vehicle that does not require much financial knowledge (alternative investment vehicles could have been used in this analysis, but we had to pick something)
- The key difference here is that your $100 is now earning interest. Had you begun this process in August 2010, your investments would be worth $7,249 (21% more than the first option).
- Importantly, this can be done through a TFSA, avoiding capital gains taxes and includes the recent financial downturn, which means we are not overly embellishing the numbers.
What is of further note is that this does include the effect of your lower mortgage payments stemming from a reduced principal:
- Shaving another $1,249 off of your principal on 5 year fixed mortgage with a 3.5% interest rate and a 20 year amortization would save you $7.49 a month.
- This isn’t much, but it allows you to pay down your mortgage by $107.50 a month, rather than $100
- If you were to do so and if you were to garner similar investment gains, you would have paid down your principal by $17,555 by the end of the first 10 years, compared to just $12,000 (a difference of 46%)
At the end of the day, paying down your debts is a great idea and even if you are not doing it in the most effective manner, we still encourage you to do so. Investing your funds and using the returns to pay down your principal can be a great way to get out of your mortgage sooner. It does carry risks, however, so it's up to you to decide whether or not you are comfortable with the option.