This question was raised to me in response to my first article on why pre-paying your mortgage is not a good idea. It is also known as ” The Smith Manoeuvre”. The key idea behind this strategy is to deduct the interest paid on an investment loan from your income.

What are the steps for this strategy?

Assuming you have $10,000 saved up at the end of the year you would do the following:

1) You put the $10,000 into your mortgage to save on the mortgage interest
2) You then borrow the same $10,000 to invest
3) You invest the $10,000 into a diversified portfolio
4) You deduct the interest paid on your investment loan from your income

Since the investment return is the same as investing the $10,000 directly instead of paying off the mortgage first the only difference is in the borrowing rates and tax treatment. The idea is that the interest deduction will more than compensate you for the higher borrowing rate you will have to pay on an investment loan vs. your mortgage.

Why makes it difficult to determine whether this works? 

What makes this particular strategy difficult to assess is the fact that it’s profitability relies on an individuals marginal tax rate after all other deductions have been counted. In non-accountant speak it means it depends on your personal income and spending situation.

Gettin’ down and dirty with the math

I know this is everyone’s favorite part and believe me I’m excited! Nothing like poring over tax brackets and figures to make me jump around in joy. Yeah I’m weird like that.

Apples to apples

We are going to compare a variable rate mortgage versus a HELOC loan.

Why?

This is because the cheapest investment loan you are likely to get is a HELOC (home equity) loan. It also takes off the table any perceived benefit of not pledging your home as collateral since both loans are backed by the house. Since all HELOC loans are variable rate loans they must be compared against a variable rate mortgage.

It’s easier to compare a variable rate mortgage because comparing a fixed rate mortgage versus a variable rate HELOC would require the stripping out the rate benefit you get due to taking on the interest rate risk (just like you do when you get a variable rate mortgage versus a fixed mortgage). It’s easier to just compare apples to apples. Picking a fixed rate mortgage versus a fixed rate loan would not change the conclusion but I do invite you to do the math yourself and perhaps post your results in the comment section.

After-Tax Interest Rates

The next step is to make the interest rate on the mortgage comparable to the interest rate on the loan through reducing the investment loan rate by the tax benefit.

This is actually very easy to do as all you need to do is multiply the HELOC rate by (1 – your marginal tax rate). Here is a table based on a 3.35% HELOC rate which is the best rate available on RateHub.

Benefit versus a Mortgage

Once we have the table above it’s really easy to compare whether we could save any money by pre-paying our mortgage and borrowing to invest versus just investing the $10,000. Since the HELOC rate is already tax-benefit-adjusted we only need to compare it against the best variable rate mortgage on RateHub which today stands at 1.99%.

Therefore the benefits of the borrow-to-invest strategy per $10,000 for various individual income levels are as follows:

Does this mean there is a benefit to the strategy?

It would seem from the numbers above that there is a minor benefit if you make 90K+ in gross income (the first tax bracket level where the benefit from the strategy is larger than 0) and the benefit increases a little bit as you get into higher income brackets.

However, we need to not only consider the gross income but also other deductions available to reduce this income.

Why?

Because the interest rate deduction does not apply to any loans where money was contributed to either an RRSP or a TFSA.

The tax benefits of contributing to your RRSP or TFSA will far outweigh the very minor tax benefits derived from deducting the interest. (Note: while the TFSA contribution is not tax deductible the returns are completely tax free. In the long run this tax free return benefit will be far bigger than the interest deduction.)

Adjusting the chart to account for RRSP contributions having been made

In order to determine whether it still makes sense to follow the borrow-and-invest strategy there are some adjustments that need to be made. You will need to add the RRSP contribution room available to you at each income level to the income ranges in the chart above above.

Alternatively, and maybe more intuitively, you can also subtract the RRSP contribution room from your income and compare against the chart above.

These two calculations are equivalent but I’ll do the first one to give you one easy final chart that will show you whether the borrow-to-invest strategy could work for you.

The calculation in each tax bracket is as based on 18% of your income being contributed to an RRSP up to the maximum of $24,930 allowed by the CRA.

Once we have the adjusted tax brackets we just map them back to our previous benefit table to arrive at the benefits for each RRSP contribution adjusted tax bracket.

The adjustment for RRSP contributions increases the required individual personal income to approx. $106,000 (the first adjusted tax bracket where the benefit from the strategy is larger than 0). This means that the minimum gross income level where a salaried employee should even consider this option is $106,000.

The TFSA factor

Let’s say you are lucky enough to earn $106,000 in annual income, have enough savings to contribute the full allowable $19,080 to your RRSP, and still have money left over that you need to put to work. In that case the first place you should look to put that money to work is in your TFSA. The TFSA allows for $10,000 in annual contributions but the RRSP contribution will return a nice big chunk of your taxes to you that you can use for that purpose. In the case of a $106,000 income contributing $19,080 will yield approx. $8,000 in tax return leaving you only $2,000 short of the maximum. If you contribute the full $8,000 tax return + $2,000 extra in after-tax money to your TFSA and still have money left over you might want to consider pursuing the HELOC borrow back and invest strategy.

What if you are stuck in a high fixed rate mortgage? 

This is probably the only case in which it would actually be worth the effort to go out of your way and follow this strategy. However, lets understand why that is. It is not due to the interest rate tax deduction. The reason it works is because you are in fact re-mortgaging a portion of your house at a lower variable interest rate.

If you take $10,000 out of a 3% fixed rate mortgage by paying it down, and then borrow back at a HELOC 3.35% after-tax rate of less than 3% (again depends on your marginal tax rate, see chart above) you will see a benefit. However, please keep in mind that majority of the benefit is due to the refinance of a fixed rate to a variable rate. The moment you are able to refinance your entire mortgage at a lower rate you should do that because the savings from doing that will be far larger than the benefits from the HELOC borrow back and invest strategy.

Instead of doing the HELOC borrow back strategy a more profitable approach would be to reach out to mortgage lenders and see if they would be willing to pay your penalty fee to earn your business a bit earlier.

So, should I pay down my mortgage and borrow back the money to invest?

If you earn more than $106,000, have fully contributed to your RRSP, and have maxed out your TFSA, any additional money can be used to pay down your mortgage and borrow back the money for a minor tax benefit.

Would I suggest doing it?

Let’s just say it wouldn’t be at the top of my priority list. For the vast majority of the population making less $165,000 per year in individual personal income you can save far more money expanding your energy into making sure you invest in only the lowest cost investments, limiting your trading commissions, or even bringing your lunch to work one more day a week. We all have limited time, energy and resources and the return on this strategy is so low that I wouldn’t pursue it until I’ve made sure all my other bases are covered. Given that only approx. 10% of Canadians actually exhaust their TFSA contribution limit and plan to do so in the future I think the HELOC borrow-back strategy is more of a distraction than a help for the majority of the population.

We all want to believe that there is some complex way to make extraordinary profits and if we could just figure it out and put all our energy into it we would reap amazing rewards. We chase intricate tax saving strategies and look through screens of hundreds of stocks based on obscure detailed metrics to find the perfect investment. The truth as to what is important when it comes to retirement investing, is very different, and conflicts with the way we’ve evolved to think. The important things are dead simple and really do not require much intricate knowledge (maybe some knowledge of yourself), while the complex things usually just lead to lots of time spent and very little benefit.

So save yourself some time and money and forget that expensive book or paid financial adviser pushing the next great investment or tax strategy. Instead focus on the little things that work and have always worked for generations. In return I’ll promise I’ll concentrate my posts on more useful things in the future 😉

Question, concerns, want to yell at me about how wrong I am? I invite you to click the “Leave a Reply” link below or use one of the social networks to leave a comment.

In my last post I outlined why on average it’s better to invest your money than pay down your mortgage in an interest rate environment like the current one. However, since we only live once, we’re not so much concerned with average outcomes as we are with actual outcomes that affect our lives. This means we must consider worst case scenarios.

What if it happens to be a particularly bad year for the stock market?

There is no denying that stock markets have some very bad years. This means many people think of it a bit like a casino where you need luck in order to succeed and the odds are against you. The fact is that, unlike a casino, the odds are actually stacked towards you if you are a patient long term stock market investor. What you need to remember is that the goal of financial security and maybe independence is a long term one. This means year to year variations are not as important as building wealth over a longer period of time.

This may surprise you but the S&P500 has NEVER returned less than 5.9% per year compounded over any 25 year period. Not even if you were unlucky enough to start your investing in 1929 just prior to the great depression would you have made less than that. This means if you invested $10,000 in the worst case in the last 100 years you would have had $42,000 at the end of the 25 year investment period (1929 to 1954).

(See full list of returns here)

On average the S&P500 returns approx. 10% per year for any random 25 year period. This means that an investment of $10,000 is expected to be worth $108,347 after 25 years, which is significantly higher than the interest savings from paying down $10,000 of your mortgage.

Some of you at this point will be saying “I get it!” while others are probably saying “my head hurts from reading all these percentage! What does this mean??”. Let me give you a practical example of what happens to Jim and Amy over a time period of 17 years.

Jim pre-pays his mortgage instead of saving

Mortgage: $500,000
Term: 25 years
Mortgage Rate: 2.5%
Pre-payment: $10,000 per year

Jim will be completely mortgage free in 17 years but will have no savings. His net worth will be exactly the value of his house and not a penny more. For the sake of easy calculation lets say the value of his house went up 50% and his net worth is $750,000, thought changing that assumptions makes absolutely no difference to the analysis. This is because paying down your mortgage makes no difference to the value of your house.

Amy does not pre-pay her mortgage but invests $10,000 per year in the S&P500

Mortgage: $500,000
Term: 25 years
Mortgage Rate: 2.5%
Pre-payment: $0 per year

Amy will still owe $194,798.78 at the end of the same 17 years. However, she has invested $10,000 every year into the S&P500 and achieved the median 15 year annualized yearly return of 12.22%. (http://en.wikipedia.org/wiki/S%26P_500#Annual_returns).

Amy’s investing account after 17 years would be worth $560,085.80. This means she could now pay off her remaining mortgage of $194,798.78 and still be left with $365,287 worth of savings. Since the value of her house is exactly the same as Jims her net worth is $750,000 (house) + $365,287 (investments) = $1,115,287. This is 50% higher than Jims!

(You can verify all the mortgage calculations here)

What if Amy didn’t achieve the median return? Even in the worst case scenario of a 4.24% annualized return (the worst 15 year return in the last 40 years as per my previous post) she still comes out ahead of Jim (though by a smaller amount). Despite the complex calculations above the rule to determine whether to pre-pay a mortgage or to invest is very simple.

If your mortgage rate is higher than your expected investment return you should pre-pay

If your mortgage rate is lower than your expected investment return you should invest

Here is a chart of the results for your comparison:

Amy’s worst case scenario is still better than Jim’s while her best case scenario makes her more than twice as well off.

So how do you get a 100% guaranteed return on your stock market investments? The answer, like most important truths in life, is simple and boring. If you invest your money in a well diversified portfolio over a period of at least 15 years, then based on history, you are guaranteed a positive return.

If after reading this you still feel like you’d rather just pre-pay your mortgage then you should go ahead and do that.  In our society paying down your mortgage has evolved to be such a great and noble goal that many people feel a great sense of accomplishment and pride when they put down a large amount. I don’t want to play down the importance of that feeling, I just want to point out that it’s not a financially optimal decision. Also remember, if you invest your gratification may only be delayed, as one day you will have enough savings to put down that one gigantic payment and pay off the rest your mortgage in full.

This is not a subject I wanted to tackle in my first post! I find people hold very strong almost religious-like beliefs when it comes to housing and mortgages. However, as I was relaxing on my train ride to work a couple of days ago noticed and read the following article in TheGlobeandMail.

“Why paying off a mortgage beats investing”

The way to dispel an illusion is to take the argument, deconstruct it, and then disprove it point-by-point. In that way both of the blog posts linked to in the article are great starting points because they reflect widely held views on mortgages and money.

Interest savings and investment returns are two sides of the same coin

The author writes

“The tax deduction essentially gives you about 25% of your interest payment back. There are people out there that keep their mortgage to pay the bank $400 in order to get $100 back from the government. According to my math, that’s a $300 loss.”

Then he continues with…

““By paying off my entire mortgage in just over three years, I was forced to pay only $6,000 in interest payments instead of the $70,000 that I would have incurred by carrying my mortgage the full 30 years.”

Never pay off your mortgage unless you have no other debt left

Assuming the author means $400 in interest per month and assuming a 2.5% fixed mortgage rate this means the hypothetical person would need to pre-pay $192,000 of their mortgage to save $400 x 12 = $4,800 a year in interest. Therefore right away you can see saving $400 a month in mortgage interest is not very realistic for most people.

However, let’s say you have an extra $5,000 sitting around at the end of the year and want to decide where to put it.

If you put it in into your mortgage you will save approx.. $5,000 * 2.5% = $125 per year or $10.42 per month.

Sounds good? What if you instead pay off your credit cards?

If you pay of an 18% credit card you will save approx. $5,000 * 18% = $900 per year or $75 per month. That’s much better!

How much of your mortgage would you have to pay off to generate $75 per month in savings? It turns out it would take $36,000!

Therefore paying off $5,000 of credit card debt saves you the exact same amount of money as paying off $36,000 of your mortgage!

The same calculation can be done for car loans (and leases!), credit lines and virtually any other type of debt you may have. Mortgage debt is by far the cheapest type of debt so unless you own everything else out right it you should not consider pre-paying it at all.

Here is a chart comparing the approx. interest savings from pre-paying various types of debt:

If you have no other debt except a mortgage than what matters is the interest rate

The author of the article states

“ For example, the S&P 500 was worth $1,441.47 on January 7^th, 2000. Fifteen years later, the S&P 500 has risen to $2,025.90. It sounds like a pretty impressive increase doesn’t it? But, when factoring in the 15 year time-span, we soon understand that the average growth during this period was only 2.3% per year. That’s pretty crappy. I think many of us would have rather paid off our home mortgage.”

There are two mistakes in the above statement that show either the author does not have a good grasp on how investing in stocks actually works or he’s ignoring facts to prove his own point.

• He forgot to count the dividends!

Dividends are payments made to you when you hold a particular stock, or in the case of the S&P 500, it’s payments received from 500 different stocks. It’s a little like rent when you buy an investment property. The author considered only the price increase but not the rent you get from your tenants and concluded you haven’t done very well!

With dividends reinvested the annual per year return for that particular 15 year period was actually 4.24%.

• He cherry picked the investing time period to suit his point

If we consider last 10 years the per year average total return (including dividends) is 7.67% and if we consider last 20 years it’s 9.85%.

If we look at the 15 year period ending in the year 2009, just after the worst stock market collapse in modern history, the per year average return was still 8.04%!

Why does the particular 15 year period the author chose look so bad? It just happens that 15 years ago there was gigantic internet stock bubble which drove stock prices far above where they would otherwise be. If you had bought at the exact peak of that bubble then your return would in fact be 4.24% per year, the worst 15 year return of the last 45 years, but still 70% higher than your current 2.5% mortgage rate.

The historical median total one year return on the S&P500 since 1970 has been 15.79%.

Assuming the $5,000 in the previous example was invested in the S&P 500 over the course of an average year it would be worth $5,789.50 at the end of the year. That’s an extra $789.50 and significantly higher than the $125 you would have saved by pre-paying your mortgage.

(You can check the S&P 500 returns here http://en.wikipedia.org/wiki/S%26P_500#Annual_returns)

Here is the same chart as above except this time including the median one year return for the S&P500:

For most people I would recommend paying off the unsecured credit line and perhaps even the auto loan as the median S&P500 return is not guaranteed. However, the right action depends on more than I have time to explain in a single blog post. The bottom line though is I would never recommend them paying off their mortgage in the current rate environment.

In my next post: What if it happens to be a particularly bad year for the stock market? Isn’t it better to get a small guaranteed return from paying down my mortgage rather than risk money on investments?