Posted by: Don Bayer, CFP
I’ve often found myself expecting more from my investment statement; a feeling shared by many over the past few years. I wondered, “How can my clients benefit from the lessons learned over the past few years?” The answer? Share with them the #1 lesson everyone should learn about contributing to their bottom line and not their bank’s.
Just do the Math
At MonsterMortgage.ca we love to find different opportunities and loopholes in your mortgage contract to lower the cost of borrowing, avoid penalties and accelerate the pre-payment of your mortgage.
Understanding the financial benefit to this strategy can change the way you think about money in general. The key to contributing to your bottom line is to understand that it is not about how much you make but how much you are allowed to keep after paying your income taxes.
The following discussion shows how a client can earn a guaranteed rate of return of 5.0% simply by paying off their mortgage. Are there bigger returns out there in the market? Perhaps, but they come with risk. This strategy is risk-free.
Paul and Mary have a mortgage of $250,000 with a 3% interest rate amortized over 25 years.
In order to pay off this mortgage, assuming their interest rate remains 3%, they will pay an additional $104,933.22 in interest over 25 years, or a total of $354,933.22 including principle and interest.
Canadian law requires that Paul and Mary pay their mortgage with after tax dollars, meaning, they first earn their income, then pay income tax and then make their mortgage payment with money left over. Most Canadians have what is referred to as a “Marginal Tax Rate” or MTR. Your MTR is defined as the amount of income tax you pay, on average, based on your taxable income. If you have a 40% MTR, you pay income on the last dollar you earn at 40%. In Canada, we have a graduated tax system, the more you earn, the more income tax you pay. It is important to understand what your personal MTR is – there are a number of calculators online that can help you to determine this.
What we showed Paul and Mary is that the 3% interest rate they pay on their mortgage is considerably higher, why? The interest rate on their mortgage is considerably higher because they must pay the 3% on their mortgage with “after tax income”.
1. you earn your salary
2. you pay your income tax based on your MTR
3. You use the money left over to pay your mortgage.
Let’s use an example where Mary earns $70,000.00 per year and her MTR is approximately 33%.
Marginal Tax Rate (MTR) = 33%. Your MTR is the amount of income tax you pay based on your taxable income. This rate would range between 15% – 46%. REMEMEMBER, THE HIGHER YOUR INCOME THE HIGHER YOUR MTR.
Interest (I) = 3.5%. This is the interest rate you currently pay on your mortgage.
Interest (I) divided by (1-MTR). The formula used to calculate your Guaranteed Rate of Return
3.5/ (1-.33) = 5.22%.
Mary would make a Guaranteed Rate of Return of 5.22% if all she did was use her extra money to pay down her mortgage (invest in herself) vs. investing it elsewhere.
Now, if you decide to make lump-sum or bi-weekly accelerated payments, you are putting more gas on the fire and you will win by paying down your mortgage faster.
In the previous example with Mary, we have used today’s low interest rates, however; these historically low rates may not stick around for the full 25 years! If your interest rate is 4%, the return on your money is approximately 6%, at a 5% interest rate, your guaranteed return is a staggering 7.46%!
This argument is compelling simply because it is 100% mathematically accurate. Isaac Newton cannot dispute this – there is no other way to get this type of guaranteed return, without incurring significant market risk. So, if you worry about putting more money into the market or in a tax sheltered RRSP, think again because the best investment you can make in 2013 is paying down your mortgage.
Lastly, putting your foot down on your mortgage as quickly as you can will significantly reduce the amount of interest you pay and will allow you to own your home years earlier than your neighbour will. Sometimes, simple is truly better. Following this advice will reassure you an excellent, yet guaranteed return on your money– and to top it off, you will be able to sleep soundly at night.
Mortgage Interest Rate (%) Rate of Return (%) 3.0% 5.00% 3.5% 5.83% 4.0% 6.67% 4.5% 7.50% 5.0% 8.33% 5.5% 9.17%