Should you pay off your mortgage early?

by Ann deBruyn

Photo by Terje Sollie from Pexels.

Let’s face it, we all dream of a debt-free life, and paying off your mortgage can be a big part of that. Even if it’s a distant goal, it’s fun to imagine the financial freedom that comes with settling one of life’s biggest loans—your mortgage.

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That’s just one of the reasons paying off mortgage debt should be on every homeowner’s priority list. It can also save you tons of money in interest fees. That doesn’t mean you don’t have other potentially lucrative options, though. To determine if you should prioritize your mortgage debt, you’ll need to consider both the pros and the cons of paying off your mortgage. Is it better to pay on your mortgage now to save on fees later, or to invest your money instead?

To help, take a read of these scenarios. 

Reasons to pay off your mortgage, first

The single-biggest reason to prioritize paying down your mortgage is that it saves you money. 

Every time you make a mortgage payment, that payment is split into two distinct parts: the principal and the interest. The principal is the amount of money you borrowed and still owe. So, if you borrow $100,000 and repay $25,000, then the principal owed is $75,000. The interest is the fee you pay to the lender in order to borrow that money. It’s the cost you pay to use someone else’s money to buy an asset.

In general, the interest on a mortgage loan is expressed as a percentage. And the calculation of how much you owe is amortized—meaning the period of time you’re paying it back. This enables the lender to calculate the expected earnings of their risk (loaning you the money), as well as establish a timeline for when the loan will be repaid in full. Plus, it helps you and your lender determine how much interest will be paid during the total lifetime of the loan. The most common amortization schedule for new mortgage loans in Canada is 25 years, although you can drop it down to five years or, in some cases, increase it to more than 25 years. 

The simplest strategy for paying off a mortgage is to do it quickly. By reducing the amount of time it takes to repay the principal debt, you’ll save money in the long run. For example: If you borrowed $450,000, and the amortization schedule was for 25 years with an interest rate of 3%, you would actually pay just a little under $639,000 back to the lender. That’s assuming there are no interest rate increases during the 25 years. To summarize, you paid the lender close to $190,000 in interest on a $450,000 loan. Reduce the amortization of that loan to just 15 years, and you shave $80,000 off the interest payments you’ll be paying.

Now, anyone with access to a simple mortgage calculator will point out that reducing the number of amortization years will prompt an increase in your monthly mortgage payments. So for that reason, this isn’t a viable option for many homeowners. 

But there are other ways to lower the amount of interest you pay. One option is to make accelerated or lump sum payments. This allows you to pay more against the outstanding principal, reduces your interest payments, and it shortens the length of time required to pay off the loan. Just remember: The goal is to take less time to pay off the mortgage, as this will lower the principal amount of the loan and decrease the amount of interest you’ll pay.

Another reason to pay off your mortgage is that owning a principal residence without debt gives you the financial freedom to funnel money that formerly went to your mortgage into your savings or to pursue lifelong dreams, like travelling.

Mortgage interest adds tens of thousands of dollars to the real cost of a home, so a shorter mortgage slashes the amount you pay in total. The money that’s freed up can then be allocated to another priority, such as retirement savings, saving for a child’s education or pursuing some passion projects.

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When not to pay off your mortgage early

Paying off your mortgage as quickly as possible should be an important goal for any homeowner—whether you’re halfway through the process, just starting out or even contemplating buying a house. But there are circumstances when making the mortgage debt a priority just doesn’t make sense.

For example, if a person is self-employed or runs a home-based business, it may not be as beneficial to pay off the mortgage early. That’s because a portion of your mortgage interest becomes tax-deductible when you’re self-employed—this deduction helps to bring down your taxable income.

Also, if your property is both your home and an investment property, it may not make sense to focus on paying off the mortgage quickly. Instead, investors should focus on paying off the mortgage on their primary residence first, before tackling the mortgage on an investment property.

Reasons to prioritize investing, first

Some homeowners would rather put every spare penny into an investment rather than paying down their mortgage debt. Their rationale is that the return on the invested dollar is greater than the guaranteed return you’d get for paying off your mortgage.

Take for instance a homeowner with $50,000, deciding whether to invest or pay their mortgage. They could make a lump sum payment towards their current mortgage. The additional $50,000 would reduce the principal borrowed and this reduces the overall interest paid. If the mortgage was $450,000, the homeowner locked in their mortgage rate at 2.85%, and if they made no other accelerated or lump sum payments, this additional $50,000 would reduce the overall amount of interest they’d pay on their mortgage by $44,880. (Assuming a 25-year amortization, the lump sum was made in month six of the loan and there were no interest rate increases). This is like getting a guaranteed return of 2.8% on your invested money. Compare this to high-interest savings accounts (HISAs) that pay between 1.5% and 2% or GICs that pay 1.95% or 2.25%, and this return looks good.

But if you’ve been a disciplined saver or if you have a pension you can count on in retirement, it may be possible to take the $50,000 and invest it in riskier investments for a possible better return.

Another option is the Smith Manoeuver. This is the process of cashing out your investment portfolio to pay off your outstanding mortgage debt. Then taking out a loan against your paid-off home and using that money to invest. The advantage of this is that outstanding loan is now fully tax deductible (as interest paid on loans used to invest are tax deductions, according to the Canada Revenue Agency (CRA)). But be warned: This is a much more advanced used of leverage and it is risky. For instance, if the market were to drop significantly (ahem, COVID), you would lose money and still owe the loan used to invest.

So, is it worth paying your mortgage off early?

Let’s recap. While there are many reasons you should consider paying off your mortgage as soon as possible, there are a few instances in which it may make more sense to use that money elsewhere. 

The pros of paying off your mortgage early:

  • Save money on interest. The fewer payments you set up to pay off your mortgage loan, the less you pay in interest. Paying off your mortgage early could save you tens of thousands of dollars. Just make sure to clarify with your lender that the extra payments will be going toward your principal, not the interest.
  • No more monthly payments. Pay off your mortgage and you eliminate monthly mortgage payments and free up cashflow to put toward other goals, such as retirement savings or a child’s education fund. 
  • You own the home outright. When there is no debt to repay, then you completely own your home—as well as the equity included in that asset’s value. Not only does this give you more freedom, particularly if you hit a financial setback, but it also means you can use the equity to help achieve other financial goals.
  • Peace of mind. For conservative or risk-averse savers, not dealing with a mortgage debt brings peace of mind. Even for more risk-averse investors, owning a home provides peace of mind as it allows you more flexibility on what to do with current earnings and accumulated equity. 

The cons of paying off your mortgage early:

  • Earn more by investing. The average interest rate for mortgages right now is around 3%. The average stock market return over 10 years is about 9%. So, investing in the stock market for 10 years, instead of putting that money towards your mortgage for the same amount of time, could be more profitable. 
  • Mortgage prepayment penalties. If you don’t pay attention to the rules around prepayment privileges you could end up paying lenders significant fees and penalties for paying off your mortgage early. To avoid these costs—and they can add up to thousands or tens of thousands of dollars—be sure to read your mortgage contract carefully. Find out what you are allowed to pay before penalties and then plan accordingly. 
  • Potential to hurt your credit score. Several factors make up your credit score, including the amount of credit you have access to, the amount you’ve borrowed and the types of loans you hold. For example, you could have a credit card, car loan and a mortgage. By taking away one type of credit, your credit score could decrease. However, this hit to your credit score should be fairly small.

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How to reduce the overall cost of your mortgage

If the above two options aren’t accessible to you, know that there are other things you can do. If your primary goal is to save money, you can look for ways to lower the cost of your mortgage, without paying it off in full. That would leave you with extra money for investing. Here are eight ways to do that:

1. Start smart and maximize your down payment

While it’s possible to get away with only putting 5% to 10% down on a home purchase, the single biggest cost-cutting measure you can do is to maximize your down payment. Not only will you owe less, reducing the overall interest you pay, but you’ll also avoid having to pay mortgage loan insurance premiums—a fee buyers pay for the privilege of putting less than 20% down on a home. This insurance doesn’t protect you, the buyer, but the bank should you default on your mortgage loan. (How large should your down payment be?)

One good way to maximize your down payment is to use the federal Home Buyers’ Plan, which lets you withdraw up to $35,000 in a calendar year ($70,000 for a couple) from your registered retirement savings plan (RRSP) to put toward a home you will live in or build.

2. Buy what you can afford

Yes, it sounds obvious. Buy a home that fits your budget. But the reality is, when it comes to buying a home, most of us struggle. On one side, we want our dream home. On the other is the desire to be fiscally smart. Quite often, it’s a trade-off. If you focus on buying within your budget (not the maximum mortgage amount your bank has agreed to lend you, but the mortgage that works with your financial plan), then you’re less likely to dip below the 20% down payment and more likely to stick to your plan of paying off the debt sooner.

3. Shop for the best rate

Quite often, then, buyers will stick with banks or financial institutions they already know and have accounts with. But when shopping for the best mortgage rate, it’s actually better to cast your net wide and far. Consider outside-of-the box lenders, including credit unions and mono-lenders (lenders who use mortgage brokers and only deal with mortgage loans), as quite often these institutions can offer much better rates and terms than big banks.

4. Pay attention to when you’re charged interest

Most standard mortgages in Canada charge interest semi-annually. That means twice a year the lender calculates the interest you owe, based on the outstanding principal debt and the accumulated interest on outstanding debt. This is known as semi-annual compounding interest (compounding, because it’s interest on interest). The rate at which compound interest grows depends on the frequency of compounding. The higher the frequency (or number of compounding periods), then the greater the compound interest. For that reason, a loan with an interest rate of 10% compounded annually will actually accrue less interest than a loan with 5% interest that is compounded semi-annually, over the same time period.

5. Accelerated payments

When finalizing your mortgage, consider going from one monthly payment to accelerated payments. There are many different payment options in Canada, including bi-weekly and accelerated bi-weekly. With bi-weekly payments, you’ll make 26 payments per year (your monthly mortgage payment is multiplied by 12 and divided by the 26 pay periods in a year). With accelerated bi-weekly, you still make 26 payments per year but for a slightly higher amount than regular bi-weekly payments (your monthly payment is divided by two). Those extra payments reduce your principal debt just a tad bit faster.

6. Lump sum or extra payments

But the real key to paying off your mortgage debt faster is to get a mortgage that allows you to make extra payments. Most mortgages allow borrowers to make annual prepayments of 10% to 20% of principal, without extra fees. These extra payments go directly towards paying down the principal. If possible, try to avoid a mortgage that only allows you to make extra or lump sum payments on the mortgage anniversary—as this can reduce the likelihood of making the extra payment.

7. Increase your regular payments

To give yourself the best of both worlds, consider going with a longer amortization and increasing your regular payments using your mortgage loan prepayment privileges. For instance, if your monthly mortgage payment is $1,200, you could increase this to $2,400 per month, if your loan terms allowed for double-up payments. In effect, you would be paying off a 20-year mortgage in just 10 years. Better still, you’d have the flexibility to switch back to the lesser regular monthly payment if you were to experience any changes like a sudden job loss or the birth of a child.

What will you do?

We’ve outlined a lot of tips and strategies here. But in the end, the answer as to whether or not you should pay off your mortgage early really boils down to what’s important to you in both your short-term and your long-term financial plan.