Clark Wealth Management Group - ScotiaMcLeod Fredericton

Some believe that while rates are low, the sensible thing to do is increase the line of credit or mortgage and invest the borrowed money in real estate, a mutual fund, or stock portfolio.

Sales tools (i.e. calculators) abound that project fabulous outcomes for this strategy but many make what could be considered overly optimistic assumptions about the performance of the investment. Worse still, these projections tend to fail to adequately consider the potential downside.

Make no mistake. Borrowing to invest is most appropriate for sophisticated, well heeled investors who are capable servicing the debt and of absorbing magnified losses that can happen when using leverage. Many people would be better off taking advantage of low rates by aggressively reducing their debts.

If you find yourself in the situation where you have excess cashflow, once you have looked after a few other priorities, you should consider maximizing the amount you pay against the principal of your debt – including your low rate mortgage.

Before you attack your mortgage principal in earnest however, be sure to: 1) have an emergency fund set aside equal to three months expenses 2) maximize the amount you shelter from tax in your RRSPs 3) maximize the amount you invest tax free in your tax free savings accounts.

Here are three reasons why you should pay down your mortgage before you start building a non-registered investment portfolio or borrowing to invest:

1. It’s never been easier. There is no easier time to reduce the principal of a debt than when interest rates are low. It’s like running down a hill with a strong wind at your back. In a more typical interest rate environment where rates are higher, it takes more dollars just to cover the interest – let alone reduce the principal. For example, interest costs monthly on $225,000 at 4% are $744 whereas at a more typical 7% they’re $1,294 – a $550 per month difference. If you were to increase your monthly payment by that $550 ($6,600 per year) while your interest rate is low your mortgage would be paid off in 14 years instead of 25 years, saving you some $61,000!

2. It’s less risky. If you accelerate the pay down of your mortgage now, you should owe significantly less money than you normally would when your rate renewal term comes. This reduces the risk of being unable to service debt in a higher rate environment.

3. You gain about as much as if you had invested well. For most of us, interest paid on our mortgage is not a tax deductible expense. Let’s assume that your marginal tax rate is 40% and instead of paying down your mortgage by $6,600 mentioned earlier you invested that money and earned 6.5% on it (which is impossible to do without some investment risk). At 6.5% you would earn $429 pre-tax which is about $257 after tax. If you instead simply paid down that 4% mortgage of yours by $6,600 you would save $264 in interest. Clearly a penny saved is a penny earned.

So, paying down your mortgage in a low rate environment reduces the risk of your real estate becoming too expensive for you in a higher rate environment. It is “the” time when getting dollars to your principal is easiest since interest carrying costs are at a minimum. On an after-tax basis it is economically comparable to investing in a non-registered taxable portfolio and arguably carries no investment risk.

It turns out that our parents and grandparents were right about the perils of having too much debt. It’s pretty clear that it will get more expensive to borrow money in the next few years so use this period of low interest rates to your benefit while it is around.

Keir Clark, is a senior wealth advisor, with Clark Wealth Management Group and branch manager at ScotiaMcLeod in Fredericton, NB. He can be reached online at www.keirclark.ca or by telephone at 506-450-6465.

Information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, expressed or implied, is made as to the accuracy or completeness.