It’s Thursday, so it’s your regular addition of the other guy who writes here. His name is Eddie, and he’s delightfully mean. We’re BFFs. He blogs here.
Personal finance fallacy number 4 is about to be challenged.
Here are the first three, if you’d like to read back:
- How choosing the right credit card barely matters
- Why you should go into, not out of, debt
- Why index investing is for suckers
This is another in a series questioning the wisdom of PF writers before I begin to write about more advanced concepts that will benefit readers.
Oft written on many PF blogs is urging readers to pay off their mortgage as quickly as possible. Some more ‘advanced’ writers introduce a bit of tax strategy by using excess cash flow throughout the year to contribute to their RRSPs, then use the tax refund to pay off their mortgage. It’s a straightforward concept that has some logic, but it is far from optimal.
Other writers justify paying off their mortgage by stating that they are getting a return from paying it off and offering their current mortgage interest rate as their ‘return’. Paying off your mortgage sooner offers no return whatsoever, it merely lowers your cost of borrowing. A return is only generated on an asset such as your home through payment of a dividend/income or a capital gain (selling it for more than you paid for it). Reducing your cost of borrowing by an additional mortgage payment does not fulfill this standard.
The semantics of returns aside, paying off your mortgage more quickly as a savvy financial move ignores opportunity cost. In other words, there are more important or lucrative things you can invest in other than lowering the cost of borrowing on your house.
A mortgage is likely the lowest cost of borrowing you will ever have because it is secured debt. Similarly, a home-equity line of credit traditionally has lower rates than unsecured debt (a loan with no collateral) because the balance of the loan the bank makes to you is supported by the equity in your home (pardon the truism). If you were to ever default, the bank could repossess the home and get its money back (although it’s a pain).
Pretend for an instance that you recognized that there are other options out there than putting money against your mortgage or in a RRSP or TFSA. Examples include investing in real estate or an existing business such as a franchise. These alternative investments will likely be funded through a mixture of equity (money that you put up) and debt (money that you borrow). To obtain the debt financing required to fund the purchase price, the bank and/or business and property that you wish to acquire will insist on equity financing. Since saving for this equity is likely the largest obstacle to realizing the returns from investment properties or a franchise, the accumulation of capital through personal cash flow is paramount.
The greater the cash flow you can generate, the quicker you can overcome the barriers to entry that real estate investing and franchises exhibit and the much higher returns can be had. This is certainly not worth lowering your cost of borrowing and ending your mortgage payments in 12 years instead of 13 years.
I can certainly understand the logic to paying off your mortgage sooner. It is usually the play for very risk averse people or those that lack the outlook or sophistication to invest in other assets or businesses. If a more conservative approach is right for you, fill your boots; you will get no criticism from me provided it’s an informed decision. However, do not delude yourself into thinking it’s about returns. There are much more profitable ventures out there that generate higher returns without much more risk. Paying off your mortgage can seriously impede the cash flows required to enter these markets and should be factored into any decision.