By: Sarah Colucci
Senior Mortgage Agent, Lic. M14000929
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There are many reasons people pay off their entire mortgage or a portion of their mortgage balance earlier than expected.
Most mortgage contracts allow a prepayment privilege up to a certain percentage annually, usually not exceeding 25 percent of the original principal balance. Therefore, even if you don't have enough funds to pay off your mortgage in full, you may come into a windfall of cash, have some money saved or even receive a tax refund that you feel can lower your mortgage balance. Lowering your mortgage will also reduce your monthly payment and decrease interest during the term.
Still, you may wonder whether it's best to pay down your mortgage or reinvest the funds elsewhere, possibly generating a higher return that you could use to pay down your mortgage in the future. Like any other financial decision, it all comes down to your financial situation, risk tolerance and overall strategy.
In the 80s, 90s and 2000s, paying down one's mortgage remained a top priority because interest rates were much higher (try 12 to 19%). Additionally, most property owners weren't diversifying their investment portfolios like today in the wake of lucrative investments like cryptocurrency.
It's critical to learn how mortgage financing works so you can make a better decision about your extra money.
Mortgages in Canada are amortized up to thirty years, but the terms are shorter, usually between one and ten years. Your payments will get based on your mortgage amount, interest rate and will be stretched out over the maximum amortization period during the term limit of your mortgage (i.e. five years).
The idea is after each term; you renegotiate your mortgage rate. At the same time, the amortization period gets smaller, meaning you stay on track to pay off your mortgage within twenty-five years, for example, from when you initially took on the mortgage loan (if that's the amortization period you chose).
Your mortgage payments are comprised of both principal and interest. As you pay down your mortgage, the interest you pay will become less and less, while more will go to the principal.
Most mortgage contracts have a clause that allows prepayments of up to twenty-five percent of the original principal balance annually. So, for example, if your mortgage is $300,000, you could pay up to $75,000 each year without a penalty. Whenever you make more than the prescribed principal and interest payment, the funds get allocated to strictly principal, reducing your amortization period, meaning you're on your way to being mortgage-free sooner.
Of course, making any amount of allowable prepayment is beneficial. Still, when interest rates are low, like today, for example, it may make sense to invest the funds into an asset that's earning more. If you're earning 4 percent, isn't that better than saving 1.45 percent on your mortgage?
On the other hand, when you pay down your mortgage with larger chunks of money, like the total allowable prepayment limit, you get to renegotiate your monthly mortgage payment, which could drastically help with cash flow.
Reducing monthly obligations may mean more to you than earning money in investment portfolios, and that's why it's essential to speak to a mortgage professional and financial advisor about sorting through which is the better option.
Investing in other properties.
If you have an increased appetite for risk, you may also consider using your additional funds to expand your real estate portfolio. You can use the money as a down payment on another purchase, financing the rest. Factoring in market appreciation and the rental income that will reduce the mortgage balance, you may find this is more lucrative than simply reducing your amortization period of the mortgage registered against your principal residence.
Investing in other Markets.
Again, depending on your appetite for risk, you may find investing in financial markets of sorts more advantageous. The rate of your return might exceed the amount of interest you saved by prepaying your mortgage.
For example, $100,000 invested that garners a return of 10% may earn you an additional $159,374 compounded over ten years.
It is best to speak to your financial advisor to determine your level of risk tolerance, based on your age, amount of time the money will get invested before you'll require it again, and your overall financial goals.
It's important to note that the market can be a blessing and a curse. You may lose on stocks, and therefore, in the end, not acquire as much profit as you thought. A 10 percent return can quickly plummet to a 1 percent return depending on what is happening in the economy.
On the flip side, paying down your mortgage is permanent and will always reduce your amortization provided you don't refinance or increase it through other means. Still, even if you did, you can structure payments to tailor the amortization period to what you need or want.
Do you have specific mortgage questions? I would be more than happy to help you sort through your options for free, without any obligations to apply for mortgage financing.
Get in touch today. Call or write.