By Tom Bradley

I’ve had the privilege of living though a number of stock market and housing cycles (Read: I’m old). As I talk to people who haven’t (young), I’m alarmed by how complacent they are about debt.

One of the most common questions I get from young homeowners is, “Tom, I have a 2.7% mortgage. Should I pay it down, or give you the money to manage? You can do better than 2.7% can’t you?”

Well, yes, I hope we can do better than 2.7%, but ...

More recently, a young friend tried an investment strategy out on me over a beer. “Rather than pay down our mortgage, we’re thinking of saving the money and using it to buy another house. We’ll live in one of them and rent the other out. The rent covers the mortgage payments, so the second house won’t cost us anything. Is that the right way to look at it?”

I want to share my answers to these two questions, but first a little background.

Current assumptions

There are some assumptions embedded in these questions:

  • Interest rates are going to stay low (near zero bond yields).
  • Houses will continue to rise in value, or at least always be worth more than the mortgage outstanding (limited downside).
  • There will always be a market for the house (liquidity).
  • The banks will always be competing vigorously for mortgages (easy credit).

A dose of reality

My assumptions are more conservative than my young friends’:

  • Real estate is cyclical. There will be a number of downturns during a young homeowner’s life. It’s impossible to know ‘when’ and ‘how bad’, but a 15-20% decline should never be discounted.
  • Mortgage rates will be 2-5% higher at some point.
  • The banks will be less accommodating, if not downright ornery, at some point.
  • When a downturn comes, it will be difficult to sell a home. There will be lots of similar houses/condos on the market, open houses will be sparsely attended and there won’t be any bidding wars.
  • After the downturn, the recovery period could take a while. In Toronto in the early 90’s, the decline from peak to trough took 4-5 years. In total, it was more than a decade before prices reached previous peaks. Cycles that run for a long time, as is the case today, may also take a long time to correct.

Mortgage vs. TFSA

My answer to the first question goes something like this.

I like to see clients find a balance between paying down the mortgage and investing. Even if the mortgage is a priority, some contributions to RRSPs and TFSAs, however small, are important for developing a savings discipline and a better understanding of what investing is all about.

To make investing a priority over paying down the mortgage – i.e. making minimum mortgage payments and using any extra cash to contribute to your portfolio – I believe two conditions need to be met. One relates to your personal balance sheet (financial position) and the second to your household income statement (budget).

1. You need to have a lot of equity in your home. What does a lot mean? There’s no exact number, but I would think it’s in the neighbourhood of 50%. In other words, if your house is worth $400,000 and you have a mortgage of $200,000 or less, then you might shift your priority from debt reduction to investing.

2. You need to have a healthy cushion in your household budget. By healthy I mean you can comfortably pay your bills, enjoy some perks like travel and new sports equipment and still have extra cash around at the end of the year. In other words, if there is a temporary loss of income or mortgage rate increase, you can deal with it without putting stress on the household.

If you don’t meet these two conditions, then paying down the mortgage should continue to be the priority.

Income properties

The answer to the second question has mostly been answered already, but further elaboration is needed.

The income property strategy makes sense if:

1. You can generate some income after all costs. At least a little. Without a yield, the second property isn’t an ‘income property’, but rather a leveraged speculation on real estate prices.

2. You’ve looked at some downside scenarios and are comfortable you can get through them and won’t have to bail out of the strategy at the bottom. Distress sales are expensive - in addition to transaction costs (commissions, legal fees, taxes, repair and staging costs), the sale price can be another 5-10% below an already depressed market. You want to buy in a weak market, you definitely don’t want to sell.

3. You have some other non-real estate investments to diversify your portfolio.

With regard to the last point, having all your eggs (your retirement portfolio) in one basket (real estate) is a risky strategy, especially when the basket is prone to ups and downs, involves leverage and is not easily sold. I’m not saying don’t buy real estate (although I’ve suggested a number times that it’s not timely), but only do it if you meet the three conditions outlined above and have your eyes wide open.

Homeowners and investors should never be complacent about debt.