Do you have a mortgage? A lot of Canadians do. What about an investment portfolio? With any luck, you’ve got one of those too. So, when does it make sense to use some of your investments to pay off your mortgage? This is a frequently asked question. Unfortunately, because many people tend to think of the fixed income in their homes and their portfolios in isolation from one another, the common conclusion is often flawed. Today, I’ll show you how to better team the two in your overall financial planning.

Questioning the Status Quo

In thinking about using investments to pay off debt, many homeowners prefer to keep their portfolio intact, even if it means taking longer to pay off their mortgage. It’s typically assumed that the higher expected returns from the stock market will earn more than relatively low mortgage rates will cost, especially while interest rates remain low.

The rationale might work for some. But before we apply it as a blanket rule for all, there’s an important nuance to know: Instead of just comparing expected market returns to the interest rate on your mortgage, you’ll want to make that comparison in the correct context.

What if you’re not allocating 100% of your assets to stocks? In that case, a more sensible approach might be a two-step tango between your mortgage and your portfolio: (1) Divest some of your fixed income investments to pay off the mortgage, which (2) increases the equity allocation of what remains.

Factoring in Risk Factors

Having a mortgage exposes you to leverage risks. For example, what if you lost your job and couldn’t afford the payments? What if there were a severe recession at the same time? This could cause banks to tighten up their lending practices, and make it essentially impossible to refinance. Lots of “what if’s” could cause your leverage risk to be realized. Another way to think about this is, when you have a mortgage, you are “short” on fixed income. As the borrower, you have effectively sold a bond to the bank, on which you must make interest payments with after-tax dollars. If you fail to do so, you risk losing your home.

In contrast, investing in stocks exposes you to market risks. If you also have a bond allocation in your portfolio, you are also “long” on fixed income. For your portfolio’s fixed income allocation, you become the lender, receiving interest payments that are fully taxable in a taxable account.

Being both short on fixed income with a mortgage, and long on fixed income in your portfolio can be counterproductive. It might be sensible to use the long fixed income position (your bond allocation) to close out the short one (your mortgage). In both cases your fixed income exposure basically remains the same. but paying off the mortgage frees up cash flow and eliminates mortgage interest that has to be paid with after-tax dollars.

An Illustration in Fixed Income Action

Let me illustrate with an example. Using PWL Capital model portfolios’ expected returns as a guide, imagine you currently hold the following:

Scenario 1: Portfolio + Mortgage

  • Investment Portfolio: $900,000, 50% stock/50% bond mix – expected annual return: 4.68%
  • Home value: $500,000
  • Mortgage: $400,000 – annual rate: 3%
  • Total net worth: $900,000 portfolio + $500,000 home – $400,000 mortgage = $1 million

Now, what if you tapped the fixed income allocation in your portfolio to pay off your mortgage? If you did, your total net worth would remain the same:

Scenario 2: Mortgage Paid Off Using Fixed Income

  • Investment Portfolio: $500,000, 95% stock/5% bond mix – expected annual return: 6.09%
  • Home value: $500,000
  • Mortgage: $0
  • Total net worth: $500,000 portfolio + $500,000 home – $0 mortgage = $1 million

As touched on above, I think it’s safe to say most people would initially prefer Scenario 1, i.e., keeping the larger portfolio and chipping away at their mortgage over time. After all, with the 50/50 portfolio expected to earn 4.68% per year and the mortgage costing 3% per year, the preference at first seems “obvious.”

The problem is, this is not a fair calculation, because it fails to factor in that keeping the mortgage also represents a substantial amount of leverage risk – to the tune of four-fifths of the value of the roof over your head. Believe it or not, Scenario 2 actually represents the same amount of risk, shifted into market risk instead.

Rethinking Your Mortgage

I encourage you to watch my more detailed video to consider some additional assumptions and explanations related to this basic illustration. I’ve also included a “worst-case scenario” in the video, exploring how my two scenarios might have actually played out in the 2008 financial crisis.

But here’s the bottom line. 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 and fixed expense.

If you do not have a large enough portfolio to pay off your mortgage, you can still use similar logic. For example, rather than saving $1,000/month into a taxable 60/40 portfolio while also making regular mortgage payments, you might put $600/month into a 100% equity portfolio while adding $400 to an accelerated mortgage payment. Again, your risk/return tradeoff is similar, with the added benefit of getting rid of debt.

Mortgage debt is usually thought about in isolation. I believe it should be considered along with evaluating the risk and return characteristics of your portfolio. When possible (both financially and given your personal risk tolerance levels), paying down mortgage debt while increasing the portfolio’s equity allocation can result in equivalent risk and return characteristics, while eliminating a fixed expense.

Have you considered your mortgage in the asset allocation decision? Tell me about it in the video comments.