In a recent post, Frugal Canadian discussed the size of the downpayment she should put down and whether she should pre-pay her mortgage. It is a question with no right or wrong answer because a number of variables (interest rates applicable till the mortgage is paid down, annual returns from a diversified portfolio during the same period, future tax rates on income, interest, dividends and capital gains, the annual churn in a portfolio etc.) are unknown at this point. That said, I’ll take a stab at providing a counter-point in this post.

We were not financially very savvy when we purchased our first home, but we did scrounge every dollar we could find for our down payment even when we had accumulated more than then 25% we needed to avoid the mortgage insurance. It seemed to be an easy decision at that time as the markets had just gone through a brutal bear market and saving 5% in interest costs seemed a good deal compared to relentless losses in the equity markets. In hindsight, it was an ideal time to put down a 25% down payment and invest the rest in the market.

We have had a few great years in which diversified portfolios earned double-digit returns and it is hard to find an asset class that lost any money. It is natural to allow recent performance to colour our decision on how to deploy our savings. However, many respected pundits are of the opinion that we are in a period of low returns from all asset classes and diversified portfolios will post returns ranging from the mid- to high-single digits. Note that the estimated returns are on average and actual annual returns will be all over the map.

In such a scenario of low asset class returns, earning a guaranteed post-tax return of 5% sounds pretty darned good and every extra dollar should go towards the down payment. The same argument holds true for pre-paying the mortgage as much as possible. Personally, the sequence for our savings is RRSP contributions, mortgage pre-payments and only then taxable portfolios.

Related: Pre-Pay Your Mortgage

This article has 13 comments

  1. Excellent post, and perhaps it’s off topic, but I’m a little uncertain about the wisdom of waiting to save 25% before you purchase a home. The CMHC insurance is not trivial (2.00% with 10-14.99% down), which would add up to $5,000 on a $250,000 home, but it would seem that most people would lose out by waiting. Unless one is living *very* lean and saving at a *very* high rate, it would seem as though the cost of rent and the natural appreciation of house prices would add up to more than the CMHC insurance for most people…

  2. I just paid off my mortgage and now I own my condo free and clear. Talk about feeling like having shackles removed!
    One strange part is that the bank charged me $250 to close out my mortgage and it was supposedly written into my mortgage contract many years ago when it was signed. It’s some kind of administration charge or dispensing fee because my mortgage was collateralized. Is that normal? No wonder the banks make billions a year!

  3. Phil S – I had a similar experience when paying off my mortgage this year. I think the fee was $100-150 and when I asked about it, I was told it was for the work they do with the Land Titles office removing the lien, etc. I was shocked when I heard this, because THEY put the lien on the house to protect themselves, why should I have to pay to remove it? Another sneaky fee added in by the financial institutions.

  4. Canadian Capitalist

    Al R: Good point and we wish we hadn’t waited to save 25% before buying a home. But I can tell this for sure only in hindsight. When we bought, I was working and my spouse was not and so many people in high-tech were losing their jobs in Ottawa that it seemed prudent to wait and rent. So, the decision to wait or buy right away depends so much on the personal situation.

    Phil & Chris: Its news to me that we have to pay to get rid of the mortgage. I get reminded of the “hands in my pocket” ad whenever I think of our banks. They do have a finger in every pie. Good thing I own a couple of banks!

  5. You can probably add “the homeowner’s own aversion to debt and their psychology as an investor” to the variables side of the ledger.

    At its core this is a logical financial question but as we all know a lot of the answer comes from the homeowner’s mentality. If paying off a mortgage as fast as they can is important to the homeowner, the best thing they can do is to do that — even if you can explain to them, with flashy charts, why a larger equity portfolio would probably be better for their bottom line in 20 years.

    There’s no accounting for personal tastes.

  6. Here’s how I see it. When I’m ready to purchase a home I want to put down as large of a downpayment as possible so that my mortgage payments won’t be as high. I’m sure my cash flow will be tighter then as I plan on having children. That being said, any amount that is left over after the mortgage payments will be invested or put into savings.

    To me it’s the difference between 6 and a half dozen. Whether I put down more for the downpayment or less, the end result should be relatively close in my opinion.

  7. “Hands in my pockets” ad?

    More like Rick Mercer’s spoof ad, “Knee in my package”!

    Meadow

  8. Regarding the 5%.
    At least one financial advisor claims thatthe savings are actually the interest rate plus the interest rate*your marginal tax rate. His reasoning is that the money you save in future interest costs (i.e. the annual interest payments you never make) would have been from after tax dollars. Thus pre-paying your 5% mortgage is equal to earning at 7.7% in the market. You would need to earn enough over the 7.7% to address the tax liability the investment instrument costs.

    This is discussed in the middle of this document:
    http://www.centa.com/CEN-TAPEDE/2003/expert/expert119-01.html

    David

  9. Just a note to PhilS & Chris H. Don’t feel that you got screwed by the discharge fee the lender charged you. You wanted a loan, one of the costs of perfecting the lender’s security is registering the mortgage. Once you paid them off, that mortgage has to be discharged (which is a good thing for you in the long run if you want to sell the property or re-leverage it) and the government does charge a fee for this service that someone has to pay. Its a regular cost of doing business. That said there is no “market premium” for this sort of thing, lenders have a lot of discretion as to what they charge as you can see from the difference the two of you paid (the government fee is a lot less than what you paid). If either of you get a mortgage again (or someone reads this who is looking for a mortgage) just ask the bank to “waive any discharge fees” in your negotiations, if they want your business they will (but make sure its written down as 15-25 years from now you likely won’t be dealing with the same person!). Every standard mortgage document I have seen has the discharge fee quoted right in it, so you should be able to say to your “friendly banker” (ya right) what’s $200 if your getting tens of thousands of dollars of interest. Try it hopefully you’ll save some $!

    HC

  10. Another advantage…if you can get the 25% you can start the smith manoeuvre immediately :-)

  11. I have one question: Is it better to let go of a non-rrsp portfolio to pay down a mortgage?
    SOL

  12. Canadian Capitalist

    SOL: It’s a very tough question and impossible to answer because it depends on future market returns. However, I’ve moved towards the camp that it is better to pay down the mortgage because the overwhelming evidence is that most investors achieve poor investment returns — even in great bull markets.

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