Advising Clients on Mortgage Repayment vs. Investing
When a client comes in with an inheritance or bonus, one of the hottest questions is: “Should I pay down my mortgage?”
Conventional wisdom often pushes for knocking down debt as quickly as possible. However, as a financial planner, you know that the answer isn’t always clear-cut.
Let’s explore the nuances of this decision, including when mortgage repayment might not be the best move, and how strategies like the Smith Maneuver can come into play.
Conventional Wisdom: The Allure of Mortgage Repayment
For many, the longstanding belief has been that aggressively paying off a mortgage is a surefire way to secure financial stability. This advice is built on a few key ideas:
Debt Elimination: Paying off a mortgage early reduces overall debt and provides peace of mind.
Reduced Costs in Retirement: If your mortgage is paid off in retirement, you have more disposable income available to enjoy yourself.
Interest Savings: A lower principal means less interest accrued over time.
Risk Aversion: For clients wary of stock market volatility, reducing debt seems like the safest option.
These points can be compelling—especially for clients who have experienced or witnessed periods of high interest rates. Historically, when mortgage rates soared, rapid repayment was seen as a shield against unpredictable borrowing costs.
When Mortgage Repayment Isn’t Always the Best Strategy
Despite its appeal, the strategy of early mortgage repayment may not always serve your client’s best interests. Key factors to consider include:
1. The Opportunity Cost of Locked Funds
Every dollar used to pay down a mortgage is a dollar that isn’t working for your client elsewhere.
When you pay down the mortgage, the “effective rate of return” on the repayment is the mortgage rate. Today, that’s roughly a 4% annualized return from repaying your mortgage.
According to most data, the average annual return on the S&P 500 is around 10% when considering both price appreciation and dividends reinvested over a long period of time; however, this can vary depending on the specific timeframe analyzed.
When mortgage rates are low and investment returns are strong, the bonus from investing in stocks might generate more wealth if invested rather than used for additional mortgage payments.
Low Rates vs. Investment Growth: If your client’s mortgage interest rate is low, and you identify opportunities in the market where the potential returns significantly exceed that rate, directing funds toward investments could be a smarter move.
More Retirement Income: If you have more retirement savings, you’ll have more income with which to enjoy yourself. While repaying your mortgage might reduce your retirement costs, investing the money in the market and having it grow at higher rates means you’ll retire with more savings. If you want to, you could repay your mortgage in full on the day you retire with the extra wealth you’ve created.
Inflated Investments: However, market conditions can vary. When asset prices are high (as they have been recently), the upside for future returns may be limited, tilting the balance back towards debt reduction.
Guaranteed Benefits: When you pay down your mortgage, interest savings are guaranteed.
2. Client’s Risk Tolerance and Financial Goals
As a planner, you know that every client’s situation is unique. Some might prioritize a debt-free lifestyle and psychological comfort, while others are comfortable taking on risk for higher returns. It’s critical to match the strategy with the client’s long-term goals, risk profile, and overall financial plan.
The Current Economic Landscape: Mid-Range Mortgage Rates and Investment Valuations
At present, mortgage rates in many regions hover in a mid-range—not so low as to ignore the cost of debt, yet not high enough to demand immediate repayment as the only option. At the same time, many investments, particularly equities, have seen inflated valuations.
Mid-Range Mortgage Rates: These rates imply that the cost of borrowing isn’t negligible, so every extra dollar paid toward the mortgage guarantees a “return” equal to the interest saved.
Market Conditions: With many asset classes priced at premium levels, the expected future returns may not be as high as they were in more favorable market conditions. This creates a situation where reducing debt can be an attractive, risk-free return compared to uncertain market gains.
Tax Credits: For Canadians, if you invest instead of paying down the mortgage, you can make some of your mortgage interest tax deductible. It’s done using a strategy called the Smith Maneuver.
Leveraging the Smith Maneuver: A Canadian Twist
One particularly Canadian strategy to consider is the Smith Maneuver. This financial technique allows clients to transform the non-deductible interest on their mortgage into a tax-deductible expense by borrowing to invest.
How the Smith Maneuver Works
Recycling Borrowed Funds: Technically, clients pay down their mortgage and then borrow the cash again for the purpose of investing. By borrowing funds against home equity and investing them, the client can potentially offset the cost of the mortgage interest through tax credits.
Tax Efficiency: The tax credits received help lower the net cost of borrowing, which, in turn, can make the investment returns more attractive.
For clients who are comfortable with some paperwork and a little complexity, the Smith Maneuver might be an excellent option to consider. It allows for the dual benefit of mortgage reduction and tax-advantaged investing.
Tailoring the Strategy: Key Considerations for Financial Planners and Wealth Professionals
When advising your client on whether to channel extra cash toward mortgage repayment or investing, it’s crucial to weigh several factors:
Evaluate the Mortgage and Market Conditions
Mortgage Interest Rate: Compare the client’s current rate with the potential after-tax returns from investments.
Investment Environment: Assess whether the market is offering attractive opportunities or if asset prices are currently overvalued.
Understand the Client’s Broader Financial Picture
Risk Tolerance: Consider how comfortable the client is with investment volatility versus the security of paying down debt.
Long-Term Goals: Align the strategy with their overall financial objectives—whether that’s growing wealth, achieving a debt-free lifestyle, or a balanced approach that incorporates both.
Properti Edge has developed a “Financing Strategy Advisor” tool to help assess clients’ risk tolerance and support this conversation.
Consider the Role of Tax Strategies
Tax Efficiency: If applicable, discuss the potential benefits of the Smith Maneuver and how it might allow the client to benefit from tax-deductible interest.
Complexity and Monitoring: Ensure that the client understands the additional complexity and the need for ongoing management that comes with such strategies.
Conclusion: A Balanced, Customized Approach
For Financial Planners and Wealth Professionals, the decision on whether a client should use extra cash to pay down their mortgage is far from one-size-fits-all, and the answer changes over time.
While “conventional wisdom” may encourage many to reduce debt as quickly as possible, a closer look at what creates more total wealth over time reveals a more nuanced picture. A picture that considers mortgage rates, the interest rate and stock market cycles, and tax strategies, including the Smith Maneuver.
By carefully assessing your client’s unique situation—comparing the guaranteed returns of mortgage repayment against the potential, albeit more volatile, gains from investing—you can craft a tailored strategy that meets both their financial and emotional needs.
Whether advising a lean towards debt reduction or an allocation toward investments, the key is to align the recommendation with your client’s long-term financial goals and risk tolerance.
In today’s complex economic landscape, your expertise is crucial in guiding clients through these decisions, ensuring that every dollar works optimally toward securing a stable and prosperous future.
