Should you pay off your mortgage?

I want to address a common question: what should you do with a windfall of cash?

Clients often ask me whether it’s better to use these funds to pay down, to pay off their mortgage, or to keep them as liquid assets.

Let’s say you receive $300,000. Should you pay down your mortgage or invest the money for future growth and passive income? There’s no single right answer, just optimal answers, and these depend on your personal situation and goals. 

Based on my years of experience, I believe in building financial resilience. If you’ve followed me for a while, you know I advocate for bulletproofing your life to better absorb shocks to your personal situation. The primary way to do this is by building liquidity to establish emergency cash and increase your passive income.

My recommendation if you receive a large amount of money: do both.

Most people, even high earners, find it challenging to pay for daily expenses, raise a family, and save/build liquidity. 

A practical approach is to split your windfall in half. Reinvest half and use the other half to pay down your mortgage principal. This way, you grow your investments while reducing your mortgage balance, interest expense, and amortization. 

Some lenders will allow you to keep your amortization per the contract by reducing your obligated mortgage payment, increasing your monthly cash flow.

Why this approach? In my 39 years in the industry, I’ve rarely seen people who pay off their mortgage with a windfall successfully rebuild their investment portfolio with the savings. To be clear, many have started investment savings but never catch up to the initial investment that they received. Most end up using the extra cash flow to support a higher lifestyle.

Let’s look at the math.

If your mortgage payment is $2,200/month, how long does it take to save the $300,000.00?

Simple math: $300,000/$2,200 = 136.36 month = 11 years. 

Not including the growth of the investment over the same time period.

If you invested that $300,000 at a 6% return, it could grow to over $569,000 in the same period.

The focus should be on growing your Net Worth. The higher your Net Worth, the better off you are.

It’s not just about paying down debt at the expense of investments, but finding the sweet spot for your situation. 

Liquid vs. Illquid Assets

• Liquid assets are resources that can be quickly and easily converted into cash without significant loss of value. Examples include: cash, money market funds, stocks, short-term bonds. Liquid assets are a shield to your lifestyle should you become sick, lose your job, separate, etc. 

• Illiquid assets are investments or properties that cannot be quickly or easily converted into cash without a significant loss in value. Examples include: private equity, real estate, art, collectibles or thinly traded bonds. 

Sources of Passive Income and Tax Strategies

There are three primary sources of passive income being Interest Income, Dividend Income, and Capital Gain Income. Again, there is no one right choice, but there are optimal choices for you. 

*These examples are all pre-tax for simplification. However, tax implications should be considered when investing money to generate income.

• Interest income is generated from savings accounts, GICs (Guaranteed Investment Certificates) and bonds. They are fully taxed as ordinary income at your marginal tax rate and are considered to be the least tax-efficient income. It is taxed in the tax year received or accrued. If you earn $5,000 interest income, all $5,000 is added to your income and taxed. 

Example: You earn $60,000/year in salary and $5,000 interest income. Your taxable income is $65,000.00. Taxes paid on the $5,000 at 38% would be $1,900.     

• Dividend income is earned from taxable Canadian corporations. Dividend income is taxed preferentially in Canada via a Gross Up and Dividend Tax Credit system to prevent double taxation. Eligible dividends are grossed up by 38% and taxed with a higher tax credit, approximately 15% federally. The Dividend Tax Credit is a non-refundable tax credit applied to reduce the tax owed, acknowledging taxes already paid by the corporation. 

  
  

Example: You earn $60,000/year in salary and $5,000 in dividend income. Your taxable income is $60,000 + ($5,000 X 1.38% = $6,900). Therefore, your taxable income is $66,900.00.  

The increased taxes at a 38% tax rate would be $6,900 x .38 =$2,622. 

The Dividend Tax Credit of 15% of the Grossed Up amount is $6,900 X .15%= $1,035. 

Total increase to taxes would be $2,622 - $1,035 = $1,587.

In this scenario, the dividend has a better after-tax effect of $313. 

• Capital Gains income is taxed by including 50% of the profit (capital gain) in your income, which is then taxed at your marginal rate. This year, the upcoming change to Capital Gains tax is being implemented, where the first $250,000 is 50% taxable, and gains exceeding $250,000 will be taxed at 66.67%. Capital Gains are only taxed when they are realized (the asset is sold), and losses may be offset against gains. 

Capital Gains will be omitted in the example, as you would need to sell the assets to generate the income. 

If you have recently come into some cash and would like to determine your next steps, please reach out. I’m here to help you find your optimal choice for your situation.