Should I pay down my mortgage with a lump sum, or invest?

With files from Jordan Lavin.

There are fewer sweeter moments in life than coming across an unexpected windfall of cash. But what’s the best way to put that infusion of wealth to work? Two great (and responsible) options are making a lump sum payment on your mortgage, or investing the funds to grow them further. But which approach will actually put you ahead financially?

Let’s take a look at how this scenario may play out for a borrower with an extra $100,000 on hand.

Option 1: The benefits of a lump sum payment

First, let’s break down the basics of making a lump sum mortgage payment.

This is a type of mortgage prepayment option for closed terms that allows a borrower to make a larger one-time payment up to a certain percentage of their mortgage amount, either annually or on a monthly basis (usually between 10 - 20%), allowing you to pay between 50 - 100% of your mortgage during your five-year term without incurring a penalty. It should be noted that not all mortgage products offer this option; certain “no frill”mortgages may not allow any kind of prepayment, requiring the borrower to break their mortgage if they want to pay it down early. 

The benefit of making a lump sum payment is that it reduces your overall mortgage principal loan and by extension, the amount of time it takes to pay down your mortgage in full. As a result, you’ll shell out less in interest over that shorter amortization period. Another option is to reduce your monthly payment size, which can be arranged by asking your mortgage provider to recalculate it based on your new balance at the time you make the lump sum payment.

Also read: How much interest would you pay on a 90-year mortgage?

Option 2: Investing in a passive-income investment such as a GIC 

Another option that comes with minimal risk is to invest your windfall in a Guaranteed Investment Certificate (GIC). These are financial instruments that provide a guaranteed return in interest at the end of a set term (typically between one to five years), along with the principal amount. GICs are considered to be extremely low risk as borrowers are investing their money with a federally-regulated financial institution, with their deposits backed by the Canada Deposit Insurance Corporation. 

Currently, the best five-year GIC in Canada has a return of 5.1%.

Long-term wealth or cash flow?

There are other considerations when deciding between a lump sum payment or investing; with the former, you’ll be mortgage free sooner, and will save a significant amount on interest. When your mortgage is paid off, you’ll have greater financial flexibility, with the full amount of what you were paying monthly now on hand to invest or spend as you wish.

However, depending on the type you choose, investing can offer immediate benefits; certain investments can generate cash flow by way of dividends while others – such as an RRSP – can help produce a tax refund. Depending on your investment’s liquidity, it may also be easier to tap into your funds if you need access to them sooner than pulling money out of your mortgage.

Is it better to pay off my mortgage or invest right now?

For most borrowers, deciding whether or not to invest or pay off their mortgage comes down to the bottom line. Let’s break down the numbers to see which comes out ahead with the following scenario, assuming a mortgage borrower:

• Has a mortgage balance of $500,000
• A rate of 5.25%
• Is entering a new five-year term
• They can make up to a 20% lump sum payment
  

Option 1: They opt to reduce their monthly payment and invest the savings each month at a rate of return of 5.1% (in an investment vehicle that allows monthly contributions).

Option 2: They put the entire $100,000 into a five-year GIC with a rate of 5.1%.

Scenario 1: Today’s best 5-year fixed rate vs. a five-year GIC

5-year mortgage rate of 5.25% and 5-year GIC of 5.1% (compounded annually)

Making a lump sum payment and investing the difference in monthly payments results in a return of $46,595 in five years. Combined with the savings of $83,741 from lower mortgage payments, that equals a total of $130,336. Over that time frame, here's what you'd pay on your mortgage:

• Total interest: $95,931
• Principal paid: $65,035
• Total paid: $160,980
• Remaining balance: $334,965
  

Investing $100,000 into a five-year GIC with a interest rate of 5.1% would result in a return of $128,237 over five years – but keep in mind that you’d still need to pay $3,353 per month – $670 more than if you had made a lump sum payment towards your mortgage. 

• Total interest: $118,500
• Principal paid: $81,294
• Total paid: $199,794
• Remaining balance: $418,706

Scenario 2: Increasing the mortgage rate

5-year mortgage rate of 6% and 5-year GIC of 5.1% (compounded annually*)

Making  a lump sum and investing the difference in monthly payments results in a return of $49,515.32 at the end of five years. Combined with the savings of $84,797 from lower mortgage payments, that equals a total of $134,312.32. Over that time frame, you would also pay the following on your mortgage:

• Total interest: $110,109.9
• Principal paid: $60,851.07
• Total paid: $170,961
• Remaining balance: $339,184,93

As in the above scenario, investing $100,000 into a five-year GIC with a interest rate of 5.1% would result in a return of $128,237 over five years – but  you’d still need to pay $3,361 per month on your mortgage – $712 more than if you had made a lump sum payment towards your mortgage:

• Total interest: $137,637.40
• Principal paid: $76,019
• Total paid: $213,656.40
• Remaining balance: $423,981

Upping the risk factor for higher returns

GICs are a great, low-risk way to grow your money over time, but the trade off is lower returns than more volatile vehicles, such as stocks. Let’s say our theoretical borrower has a higher tolerance for risk, and wishes to invest in stocks with a 7% annual return.

Scenario 3: 5-year mortgage rate of 6% and investment return of 7% (compounded annually*)

Receiving a 7% annual return on an original $100,000 investment over five years will result in a total of $140,255.17, which outperforms the mortgage lump sum scenario by $5,942. 

Also read: The best robo advisors in Canada in 2023

Other ways to pay off your mortgage faster

While the fastest way to pay off your mortgage is with a lump-sum payment, you can accelerate this even further by increasing your regular payment. Every dollar you add to your payment goes directly toward paying down your principal. Depending on your lender, you may be able to increase your payment by 15% up to 100% to pay down your mortgage faster.

Finally, make sure you have the lowest mortgage rate possible. The less interest you pay, the faster you can pay off your mortgage. Compare mortgage rates online and contact a mortgage broker a few months before your mortgage comes up for renewal to make sure you’re not paying more than you should.

The bottom line

Even at today’s higher interest rates, mortgages are a cheap way to borrow money. For the best long-term results, take your time to pay off your mortgage and choose to invest your extra cash. 

Also read:

• Guide: Mortgage pre-payments
• How GIC laddering works
• 5 ways to pay off your mortgage early
• Why paying down your mortgage early is not always best