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If at the end of the year, I have 10k in hand that I want to save/invest and these are my options:
1.Prepay into mortgage. Rate is 2.1%
2.Invest in stocks and I know I can get at least 7 % return.

Based on this, what other pieces of info should I consider to decide whether I should make a prepayment or if I should invest in stocks?

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"Invest in stocks and I know I can get at least 7 % return" - can you tell me how? Please please please please please???? Don't keep it a secret! (and without the sarcasm - you don't expect anyone to treat this seriously, right?) –  littleadv Mar 5 '13 at 18:37
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@kaushik You're ignoring the risk. Stocks are not a guaranteed return, and debt on your house is a risk. –  C. Ross Mar 5 '13 at 18:46
    
how did you get a 2.1% mortgage? –  warren Mar 5 '13 at 19:26
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It's possible that 2.1% is the current rate on a variable rate mortgage (rate fluctuating monthly). The OP is in Canada and 2.1% is the bank prime rate less 0.9%, a discount that I've seen folks negotiate before. The rate on a 5-year fixed rate mortgage hasn't dipped much below 3% here. –  Chris W. Rea Mar 5 '13 at 19:37
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4 Answers

up vote 8 down vote accepted

I strongly doubt your numbers, but lets switch the question around anyway.

Would you borrow 10k on your house to buy stocks on leverage? That's putting your house at risk to have the chance of a gain in the stock market (and nothing in the market is sure, especially in the short term), and I would really advise against it. The decision you're considering making resolves down to this one.

Note: It is always better to make any additional checks out as "for principal only", unless you will be missing a future payment.

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+1 the analogy is right on. Still, I wonder how risky it would actually be if one stuck with 3%+ yielding stocks. Even in our lost decade, dividends didn't drop much. And in normal times a decade of cap gain would be significant. –  JoeTaxpayer Mar 5 '13 at 19:09
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@JoeTaxpayer 3%+ -taxes. And that's not taking into the inherent risk in having debt on your house. –  C. Ross Mar 5 '13 at 19:11
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@JoeTaxpayer The OP is in Canada. Mortgage interest isn't deductible on a principal residence. –  Chris W. Rea Mar 5 '13 at 21:57
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Similar. Dividends and capital gains (no short vs. long) in Canada are both tax-advantaged compared to regular income. –  Chris W. Rea Mar 5 '13 at 23:32
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So for the Canadian OP, the 3.5% dividend still nets ~ 3%, but the mortgage is the 2.1%. But, if variable, that's another can of worms. –  JoeTaxpayer Mar 6 '13 at 0:25
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what other pieces of info should I consider

  1. Do you have liquid cash available for unexpected home repairs?
  2. Is your mortgage fixed-rate or adjustable? Others have concluded that it is adjustable; when does it next adjust? What is the maximum rate it could adjust to, and what would that do to your monthly payment?
  3. What other stock-like assets do you own?
  4. What is the time horizon of the investment?

If you don't have liquid case available for unexpected repairs, then you probably don't want to use this money for either option.

The 7% return on the stocks is absolutely not guaranteed. There is a good amount of risk involved with any stock investment. Paying down the mortgage, by contrast, has a much lower risk. In the case of the mortgage, you know you'll get a 2.1% annual return until it adjusts, and then you can put some constraints on the return you'll get after it adjusts. In the case of stocks, it's reasonable to guess that it will return more than 2.1% annually if you hold it long enough. But there will be huge swings from month to month and from year to year. The sooner you need it, the more guaranteed you will want the return to be.

If you have few or no stock (or bond)-like assets, then (nearly) all of your wealth is in your house, and that is independent of the remaining balance on your mortgage. If you are going to sell the house soon, then you will want to diversify your assets to protect you against a drop in home value. If you are going to stay in the house forever, then you will eventually need non-house assets to consume.

Ultimately, neither option is inherently better; it really depends on what you need.

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In all likelihood, the best thing you can do, if these really are your only two options (ie no other debt at all), paying-down your mortgage will shorten the term of the mortgage, and mean you spend less on your house in the long run.

Investing is should be a long-term activity - so yes, the likelihood is that, given a modest investment, it will gain at historical averages over the life of the investment vehicle. However, that is not a guarantee, and is an inherent risk. Whereas paying-down a mortgage lowers your financial obligations and risk, investing increases your risk.


I want to know how you got a 2.1% interest rate on a mortgage, though - the lowest I've seen anywhere is 3.25%.

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See my comment on the question; I suspect the rate is variable –  Chris W. Rea Mar 5 '13 at 19:39
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Yes it is a variable 5 yr closed mortgage.( prime - 0.9 ) as Chris points out. –  Victor123 Feb 7 at 15:12
    
and the downvote is for ...? –  warren Feb 8 at 23:20
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The short answer is to invest it since the rate of return is higher than your mortgage. (Assuming that you can withstand interest rate hikes, meet short term liquidity needs and don't need your $10K in the short or near term).

The long answer is if you're comfortable leveraging your house and can put that $10K away for the long term you can reduce your taxes via the Smith Manoeuvre:

  1. Prepay the mortgage
  2. Reborrow via a HELOC
  3. Invest it where you expect the yield to be greater than mortgage rate
  4. Use the loan interest as a tax writeoff (this is the key!)
  5. Repeat step 1 with the resulting tax refund

Alternatively, if you have kids or grandkids and will help them through school, take the government's money by putting it away in an RESP.

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