A reader recently asked me:
What would have the biggest payoff, putting $5,000 annually into a savings account or using it towards your mortgage?
It’s a good question, and one I haven’t thought seriously about because I don’t have a mortgage, but I was in a math mood this weekend so I decided to work it out.
- You buy a $500,000 home (the average price in Canada) with 10% down
- You have a $5,000 surplus that you can use to either put in savings or pay towards your mortgage
- Your savings account grows tax free (TFSA)
- You earn an average rate of return of 5% on your savings because you invest in the stock market but aren’t that great at it
- You secure a mortgage interest rate of 2.39% for the first 5 years of your mortgage and 2.99% for the 5 years after that
- Your house appreciates at 3% per year, but this is irrelevant because you’re a homeowner in all three scenarios
- You don’t renovate your home or move
- You never make withdrawals from your TFSA
All that said, there are too many unknown variables over 25 years so these calculations are for entertainment purposes only and not to be taken as professional financial advice. Even I gave up trying to guess mortgage rates at year 10 and lazily left it at 2.99%.
Nevertheless, let’s indulge.
Result: It’s better to save money than to make extra payments against your mortgage
At first I didn’t even really believe this, so I kept doing the calculations over and over, lest I end up publicly shamed on the internet for my terrible math (which will probably happen anyway). But no matter how many ways I did it, saving still came out ahead of paying down your mortgage:
It makes very little difference how you use $5,000 in the first 5 years of home ownership
As you can see from the table, the difference between putting $5,000 in your savings account versus on your mortgage for the first five years of home ownership is a whopping $800. You’re still ahead with saving, but barely so.
After 25 years, the homeowner who opted to put $5,000 extra into a their TFSA instead of towards their mortgage, comes out $80,000 dollars richer than the person who thought it was worthwhile to put the cash towards his mortgage just to become debt-free 5 years faster:
Even though the aggressive mortgage payer opted to redirect their mortgage payments and extra money to a tax free savings account for the last 5 years, they couldn’t catch up to the investor who had already been diligently putting a smaller amount away for two decades.
So if you needed any incentive to save, that would be it. But why are the results so dramatic?
Cash is liquid and generates income
Money in the bank (or the stock market) offers two major perks that early mortgage payments don’t: liquidity and income generation.
Liquidity is the biggest advantage to cash savings over a paid-off house. You can always withdraw $1,000 from a savings account or sell a stock to cover an unexpected expense, you can’t take a few windows out of your house to pay bills. Even if two net worth numbers were identical, I’d take a situation with a savings account and some debt over zero-savings and zero-debt. You want to be able to make choices with your money, and you can only do that if you actually have money at your disposal to spend.
This is where everyone will chime in that you can secure a home equity line of credit if you focus on paying down your mortgage. This will provide you with the ability to spend money just like cash does. But unlike cash, a HELOC is at an interest rate that works against your net worth instead of for it, so while you might reclaim the flexibility of savings, you won’t have the second most beneficial part of cash investments: income.
Cash generates income in the form of interest, dividends, or capital gains. Even at 1%, cash in the bank is better for your net worth than mortgage pre-payments simply because cash will earn a compounding return and mortgage pre-payments won’t. Paying your mortgage early will get you out of debt faster and save you interest, but even if you pay off your home 5 years ahead of schedule, it’s not enough time to catch up to the person who’s been letting their investments grow for 20 years. This holds true even if the mortgage interest is higher than what you can earn in your savings account, and if you want to know why, check out this post: Why You Shouldn’t Rush To Pay Off Your Mortgage.
You’ve been told this before, but it’s true: compound interest really is the most powerful force in the universe.
As a general rule of thumb, I’m always more interested in income than debts, and passive income is my favorite thing of all. Investing cash will give you an attractive passive income stream, paying down your mortgage won’t.
Nevertheless, it depends on what you value
Complete and total debt-freedom is a goal everyone should have, but how fast you get there depends on how much it matters to you. You can and should focus on whatever is most important to YOU when it comes to reaching your financial goals and designing your life, and this includes savings and home ownership.
But really, you should not pay extra on your mortgage and just save the money instead.