Sept. 24, 2018
Question from Trevor: I have a question about paying down my mortgage versus investing in my tax-free savings account. My wife and I just turned 30 and we have a mortgage of $370,000, currently on a three-year fixed at 2.36 per cent. We won’t have to renegotiate for another two years, but the rising interest-rate environment has me thinking about the future.
I’ve maxed out my TFSA and it is currently invested in a diversified portfolio of broad market exchange-traded funds. My question is: At what point do I prioritize paying down my mortgage over investing in my TFSA? Further, is there an interest rate at which it might make sense for me to sell my TFSA investments to make lump sum payments on my mortgage?
For now, my strategy is to max out my RRSP and use tax refunds as lump sum payments against my mortgage. But I’ve started to think maybe I use extra funds in 2019 against the mortgage instead of topping up my TFSA.
Answer: It sounds like you are in a good situation. I agree that it is sensible to max out your RRSP using pre-tax dollars, assuming that you are in a higher tax bracket now than you expect to be in the future. You are right to be questioning the use of your after-tax dollars – it is not always obvious whether you should be paying down your mortgage or investing.
The answer to your question comes down to your asset allocation, or your mix between equity (stocks) and fixed income (bonds). If your ETF portfolio has a target 100-per-cent equity allocation, I would add your extra after-tax dollars to your TFSA. If you are targeting a less-than-100-per-cent equity allocation, I would use some of those after-tax dollars to pay down the mortgage.
Let me explain. Bonds are debt instruments. When you buy a bond, the company or government that you have purchased it from owes you money; a bond is debt that you own. When you take on a mortgage, you have effectively sold a bond to the bank; a mortgage is debt that you owe. I know this is not the easiest concept to wrap your mind around, so let me give you an example with some straight forward numbers before addressing your exact situation.
Imagine for a moment that you have a $100,000 mortgage and a $200,000 investment portfolio consisting of 50-per-cent stocks and 50-per-cent bonds. Let’s assume that stocks have an expected return of 6-per-cent while bonds have an expected return of 3 per cent. We will also assume a mortgage interest rate of 3 per cent.
If you keep everything as-is for a year you will expect to earn $6,000 on your stocks, $3,000 on your bonds, and pay $3,000 in mortgage interest. The bonds and the mortgage are effectively cancelling each other out, which is approximately what we would expect when you simultaneously buy and sell an asset class. Instead, as opposed to keeping everything as-is, you might choose to pay off your mortgage using the bonds in your portfolio. You end up in effectively the same overall position.
The psychological downside of doing this is that you are left looking at a 100-per-cent equity portfolio in your investment account. While that may look intimidating, I’ll show you why you should be indifferent regarding the two scenarios.
Imagine that we have a major downturn and stocks drop 50 per cent in value over 12 months while bonds return a modest 2 per cent. If you had kept your $200,000 50-per-cent stock and 50-per-cent bond portfolio, you would have lost 24 per cent, or $48,000, in that year. However, in terms of your overall net worth, one could argue that only $100,000 of the portfolio is your own money because you still owe the bank $100,000. The $48,000 loss on $100,000 of capital amounts to a 48-per-cent loss, but you also paid 3 per cent in mortgage interest on $100,000 that year for an overall loss of 51 per cent.
Alternatively, if you had paid off your mortgage using your bonds, your remaining $100,000 stock portfolio would have dropped in value to $50,000 in the downturn. This is a 50-per-cent loss on the portfolio, with no additional interest costs as you have used your bonds to pay off the mortgage. In the end you get a very similar result in both scenarios. Due to eliminating your mortgage interest you do have a slight preference for using your bonds to pay off your mortgage and maintaining the smaller but more aggressive portfolio.
We have now seen that owning bonds (owning debt) and having mortgage debt (owing debt) effectively cancel each other out, and you may be better off using the bonds in your portfolio to pay off mortgage debt to arrive at a similar overall asset allocation.
With that in mind, we can apply this idea to your situation. Let’s say you have a target asset allocation of 75 per cent stocks and 25 per cent bonds.
Instead of taking $10,000 and putting it into your TFSA at a 75-per-cent stock, 25-per-cent bond allocation, you might put $7,500 into your TFSA at a 100-per-cent equity allocation, and pay off an extra $2,500 on your mortgage. In either case the effect on your net worth and overall asset allocation is the same, but paying off the mortgage has the added benefit of reducing your fixed-interest costs. Not to mention, I have never talked to someone who did not like the idea of paying off their mortgage.
If I were you, I would take a look at my desired asset allocation and let that guide my decision. Rather than adding cash destined for bonds to your TFSA, you might make an extra mortgage payment. This does mean that your TFSA will have a more aggressive asset mix. If a 100-per-cent equity mix on these new TFSA contributions seems too aggressive, you should keep in mind that your asset allocation is the same whether you are buying bonds in your TFSA or paying down a bit of your mortgage. In fact, I think that there is a strong argument that carrying mortgage debt genuinely makes your overall financial situation riskier than having an aggressively invested TFSA.
In terms of an optimal interest rate to make the mortgage versus TFSA decision, I think that it is important to remember that if we were having this conversation with higher interest rates, not only would you be paying more on the mortgage, but the yield to maturity on ZAG would also be higher. I do not think that my suggestion would change. If interest rates rise above expected stock returns, say 6 per cent, that would be a different story and might warrant forgoing TFSA contributions altogether to pay down the debt.