Mortgage debt is a normal thing to have in Canada. Based on 2016 census data, 61.7% of Canadian families owned a principal residence, and 57.3% of those families had a mortgage.
If you have both a mortgage and an investment portfolio you might have wondered if it makes sense to use your investments to pay off your mortgage or keep investing while following a normal mortgage repayment schedule.
I think that the most common advice out there, and probably the most common thinking, is that it makes sense to keep the portfolio in tact to benefit from the higher expected returns of financial market investments compared to the relatively low cost of mortgage debt.
This might seem logical from the perspective of maximizing expected returns, and for some people it might be logical. However, if the investment portfolio is not allocated 100% to stocks, paying off the mortgage and increasing the portfolio’s equity allocation may be a more sensible approach to increasing expected returns.
To illustrate this point I will use the PWL Capital financial planning assumptions for expected portfolio returns and a mortgage rate of 3.00%.
I will imagine someone with a $500,000 home, a $900,000 investment portfolio currently invested in 50% stocks and 50% bonds, and a $400,000 mortgage. They are deciding between continuing to pay off the mortgage using their income over time or selling their investments to pay the mortgage off immediately.
Here are the two options up for consideration. Keeping the mortgage and a 50/50 portfolio or paying off the mortgage and keeping the remaining capital a 50/50 portfolio.
| Keep the mortgage + 50/50 | Pay off the mortgage + 50/50 | |
|---|---|---|
| Home | 500,000 | 500,000 |
| Portfolio | 900,000 | 500,000 |
| Mortgage | (400,000) | - |
| Net Worth T+0 | 1,000,000 | 1,000,000 |
Initially there is no impact on net worth. There could be some consideration for taxes payable on selling $400,000 of the portfolio, or penalties to pay off the mortgage in a lump sum, but I will ignore them to keep things simple.
I will also ignore the impact of mortgage payments on the mortgage balance. In reality the payments would decrease the mortgage balance, but they could also be assumed to be added to the portfolio in the no-mortgage scenario. It is easiest to ignore them on both sides.
If we assume that the 50/50 portfolio earns 4.68% per year and the mortgage costs 3.00% per year, here is how it looks after one year:
| Keep the mortgage + 50/50 | Pay off the mortgage + 50/50 | |
|---|---|---|
| Home | 500,000 | 500,000 |
| Portfolio | 942,120 | 523,400 |
| Mortgage + 3.00% interest | (412,000) | - |
| Net Worth T+1 | 1,030,120 | 1,023,400 |
Clearly keeping the mortgage and growing the larger portfolio was better, but we are not comparing apples to apples. Keeping the mortgage results in a substantial amount of leverage. Leverage increases risk.
Comparing apples to apples
Based on this, it might be more reasonable to compare keeping the mortgage and a 50/50 portfolio to paying the mortgage off and increasing the portfolio risk level to 95/5, that is 95% stocks and 5% bonds, with a higher expected return of 6.09%.
| Keep the mortgage + 50/50 | Pay off the mortgage + 95/5 | |
|---|---|---|
| Home | 500,000 | 500,000 |
| Portfolio | 942,120 | 530,450 |
| Mortgage + 3.00% interest | (412,000) | - |
| Net Worth T+1 | 1,030,120 | 1,030,450 |
With the more aggressive portfolio you get a nearly identical expected outcome whether you keep the mortgage or not. Despite the appearance of taking more equity risk, arguably your overall risk has decreased.
If you do not think you could handle a 95% equity portfolio, it might help to think about this another way. In either case you have a $500,000 home. Keeping the mortgage and investing $900,000 effectively means investing $500,000 of your own money and borrowing the remaining $400,000 as a mortgage. This is a leveraged investment.
In the worst 12 months of the financial crisis, a 50/50 portfolio lost 20.58%, so a $900,000 portfolio lost $185,220. In our example only $500,000 of that was your own money. A $185,220 loss on $500,000 equates to a 37% loss, but you also paid 3% in mortgage interest on your $400,000 mortgage that year for a total loss of 39.44%.
Alternatively, owning a 95/5 portfolio through the financial crisis resulted in a portfolio loss of 38.92% for the year, with no interest costs. You should be almost indifferent with a slight preference for the riskier portfolio with no mortgage debt.
If a 95/5 portfolio still seems way too risky, then you may have purchased a house that is outside of your risk-appropriate price range! Whether you actually have the 95/5 portfolio, or you have a 50/50 portfolio with the mortgage, you effectively have the 95/5 portfolio.
In the case of a starting equity mix that is more aggressive than 50/50, say 70/30, it would not have been possible pay off the full mortgage balance without affecting expected returns. However it would still be possible to pay off a substantial portion of the mortgage while increasing equity exposure to maintain expected returns.
| Keep the mortgage + 70/30 | Pay some of the mortgage + 100/0 | |
|---|---|---|
| Home | 500,000 | 500,000 |
| Portfolio | 900,000 | 644,444 |
| Mortgage | (400,000) | (144,444) |
| Net Worth T+0 | 1,000,000 | 1,000,000 |
And one year later:
| Keep the mortgage + 70/30 | Pay some of the mortgage + 100/0 | |
|---|---|---|
| Home | 500,000 | 500,000 |
| Portfolio | 947,880 | 684,658 |
| Mortgage + 3.00% interest | (412,000) | (148,778) |
| Net Worth T+1 | 1,035,880 | 1,035,880 |
In either case, having a mortgage and a conservative portfolio, or having no mortgage and an aggressive portfolio, the risk and return characteristics are very similar. Paying off the mortgage has the added benefit of eliminating the guaranteed mortgage interest cost. Where this does not work is if the portfolio is already at 100% equity. In that case there is no way to increase expected returns other than adding leverage.
Mortgage debt should be considered when evaluating the risk and return characteristics of a portfolio. Where possible, paying down mortgage debt while increasing the portfolio’s equity allocation can result in equivalent risk and return characteristics without the added risk and cost of leverage.