If you have extra money at the end of the month and are wondering if it’s better to use those funds to pay off your mortgage early or invest it, ask yourself the following questions to simplify this complex issue:
- What is your current financial situation?
- What is your appetite for risk?
- Do you prefer having lower monthly payments or a potentially larger lump sum of cash for retirement?
Paying off your mortgage faster is considered lower risk because once the loan is paid off, your primary residence is owned free and clear, and you’re free from paying any more interest or fees. You’ll also lower your monthly debt payments and have more cash flow each month. However, in many cases, investing funds can yield a higher return rate, although it carries some risk because your return is not guaranteed.
Read on as we’ll go through the things you should consider to help you decide which one is right for you.
What does the math say?
Before we dive into the details and pros and cons of prioritizing an early mortgage payoff vs. investing, let’s look at one example of how much money you could save in the long run.
Early mortgage payoff
Let’s say you have a $300,000 30-year fixed-rate mortgage at 5%. Using a mortgage calculator, we find that you’ll pay a total of $279,767 in interest over the life of the loan. By applying an additional $500 per month, you’d pay off your mortgage in just 18 years and save $124,383 in interest charges.
So what would happen if you decided to invest that money instead? Many types of investments exist, but we can look at the U.S. stock market. Specifically, we’ll look at the S&P 500, which has returned an average of around 11.88% annually.
Using that rate of return (11.88%), investing $500 per year for 18 years would leave us with around $370,000. Regular payments on your mortgage after 18 years would leave you with a principal balance of $165,000.
Thus, using your investment gains in the stock market to pay the loan would leave you with around $205,000.
Based on the math, is it better to invest or pay off the mortgage?
Based on the numbers, it’s easy to jump to the conclusion that investing your money in something like the stock market is better than paying off your mortgage earlier. In our example, investing your money would leave you with $205,000 in savings after 18 years, as opposed to $124,000 had you decided to pay off your mortgage early.
That being said, there’s much more that you should consider, such as your personal comfort level, your financial goals, your personal risk tolerance, how much you’re currently paying in interest, the types of investments you’re considering, and much more.
Pros and cons of paying off your mortgage early
To help you decide whether paying off your mortgage early or investing is a better choice for you, it’s important to understand the benefits and drawbacks of each. Here are some pros and cons you should consider with paying off your mortgage early.
- You’ll save money on interest charges: A big benefit of paying off your mortgage early is that you’ll save on interest charges, so you could consider it a guaranteed return on your funds. A good way to find out just how much you’ll save is to use an amortization calculator. With an amortization calculator, you’ll be able to figure out how fast you can pay off your mortgage if you apply extra payments. You’ll also be able to figure out how much in interest charges you’ll be saving.
- You can reduce your monthly debt obligations: By paying off your mortgage, you’ll eliminate one of your largest monthly expenses. With fewer expenses, you’ll have more flexibility to work fewer hours, get a better work-life balance, and have a greater ability to take a financial risk such as a career or job change.
- You’ll have peace of mind having a paid-off home: Having a paid-off home is a tremendous accomplishment, and you should consider if the security and emotional feeling of owning your home free and clear is worth more than the possibility of having earned more cash with other investments.
- You’ll lose the mortgage interest tax deduction. One of the downsides of paying off your mortgage, however, is the fact that you’ll no longer have a mortgage interest tax deduction, so you could see an increase in your effective tax rate.
- Your credit score may drop: Your credit score may also see a slight drop. That’s because your credit score considers the types of credit you currently have open, and without an open mortgage tradeline on your credit report, you’ll lose some points for having a less diverse mix of credit.
- You could earn a higher rate of return elsewhere: You should also consider your mortgage interest rate and what you could earn elsewhere. For folks who have a low-interest rate below 4%, you might consider it a better option to choose an investment that has a historically higher rate of return.
- You’ll have less liquid cash to deal with emergencies: By paying off your mortgage, your funds will be tied up in your home’s equity. Turning your home equity into cash is a process that typically takes several weeks with either a cash-out refinance or a home equity loan or line of credit.
Pros and cons of investing
Now let’s take a look at the pros and cons of investing your funds instead.
- You can earn a higher rate of return: When you invest funds, the potential upside can be unlimited. For example, stocks and property values could skyrocket overnight. It all depends on the type of investment you’re considering, although many investments can exceed what you’d get on a mortgage, considering that the average mortgage rate has been below 7% for some time now.
- You can keep more assets liquid: Depending on your investment vehicle of choice, you can keep funds more liquid and easily accessible compared to paying off your mortgage more quickly. Accessing home equity is more difficult and a process that takes more time, whereas investments can simply require you to liquidate stocks or mutual funds.
- Your rate of return is not guaranteed: Investments carry a level of risk, so your return is not guaranteed. Not only could you earn a lower rate of return than what you’re paying in mortgage interest fees, but in extreme cases, you could lose your entire investment balance.
- Your monthly payment remains unchanged: If you decide to use funds to invest instead of paying off your mortgage, you’ll still have to continue making your monthly mortgage payments.
- You’ll continue to have interest payments on your mortgage: Since you’ll still have to make mortgage payments, you’ll be guaranteed to continue having to pay interest expenses with the hope that the money you’ve invested will yield a larger rate of return in the long run.
Types of investments
If you’re thinking about investing the extra money instead of paying off your mortgage early, you’ll have many different options to choose from. You should consider your appetite for risk, the expected rate of return, past performance, whether you have any higher interest debt, the timeline for seeing any gains, and how you might be affected if the investment goes south.
Here are a few different ways you could invest your money along with a few things you can consider for each:
- Investing in the stock market: Data for historical rates of return is fairly simple to get for things like stocks and mutual funds. You could use that information as one piece of data to determine the likelihood that you’ll see similar returns in the future.
- Purchasing or starting a business: The failure rate for startups can be high, so this can be a risky option to consider. However, if you do decide this is right for you, it’s a good idea to have a plan for what you’ll do in case the business does not succeed.
- Purchasing a rental property: Purchasing a rental property can be an attractive option for the monthly cash flow it can provide. Don’t forget to factor in repairs and expenses, especially if you’ll be taking on a mortgage to acquire a rental property. Also consider a vacancy rate in your cash flow projections, just in case you are unable to find a tenant and the property is unoccupied for a short period of time.
Non-monetary benefits to consider
Regardless of what the math says, you should also consider the nonmonetary benefits of paying down your mortgage or investing your extra capital. For instance, some folks may prefer to have the peace of mind of knowing they have a paid-off home, even if it comes at the expense of potentially earning more in investments. Similarly, some folks may not like the risk involved with keeping a mortgage payment and hoping that their return on investments will exceed the interest rate paid in the loan.
Another non-monetary benefit to consider is that with a paid-off mortgage, you can get by with less income each month. In addition to having more financial freedom, you could also see benefits in your personal life. For example, you may no longer need to work as many overtime hours, you’ll have more freedom to quit a high-stress job, and you’d gain the flexibility to try your hand at a new career or a new job with a greater emphasis on its impact on your quality of life rather than its salary.
On the other hand, paying off a mortgage early would mean that most of your net worth could be tied up in your home, so it would take longer to get funds if you needed. This is because accessing your home’s equity is more difficult compared to a checking or savings account. You’d need to apply for a HELOAN or HELOC or do a cash-out refinance, a process that can take several weeks.
Each of these options, paying off your mortgage versus investing, carries its own set of benefits and drawbacks, so you’ll have to consider which one you value more.
What you should consider before making a decision
In making a decision, you should consider your personal financial situation and life circumstances. Here are a few items you can consider:
- Do you have an emergency fund? Having an emergency fund to deal with unexpected expenses is highly recommended, especially if you decide to take on risk from certain investments. You should consider how long your emergency fund would last. Many experts recommend a minimum of a six-month emergency fund based on your regular monthly expenses.
- Do you foresee life changes coming up? Think about how likely you are to have any big life changes occurring soon. This can include the birth of a new baby, a job relocation, or a career change. These scenarios could be good reasons for taking a less risky approach to your finances, and you may want to keep funds as liquid as possible to cover any unexpected expenses.
- Are you current on your mortgage and other debt? Late payments, fees, and the subsequent negative impact on your credit score can easily eliminate any gains you might otherwise see from paying off your mortgage early or investing. For this reason, it’s important to be current on all of your credit card debt, car payments, property taxes, and other debt obligations before you decide to invest or pay off your mortgage more quickly.
What if I am a retiree?
Data from American Financing shows that 44% of Americans between the ages of 60 and 70 carry a mortgage into retirement. If you’re nearing retirement and are thinking about whether you should pay off your mortgage or continue investing, here are a few things to keep in mind:
- How far away are you from retirement? The gains from safe investing comes compounding interest over many years. Long-term investments generally have higher rates of return. If you’re just a few years away from retirement, expecting large rates of return in a short time frame carries higher risk.
- How will your retirement income be impacted if you use it to pay your mortgage versus investing? Paying off your mortgage will reduce your monthly debt payments, but can also reduce the income you’ll receive if you use retirement savings funds to do so. On the other hand, keeping your mortgage means preserving the balance in your investment or retirement accounts, allowing you to draw on them for more income.
- Will your fixed income fluctuate in retirement? This typically applies to investment and retirement accounts that are subject to market fluctuations. You should consider how your income might be impacted if the balance of your retirement savings accounts is negatively impacted. In a way, this carries a certain level of risk, whereas paying off a mortgage guarantees that you’ll have fewer monthly obligations.
- Will your taxable income increase if you withdraw retirement account funds to pay off your mortgage? It’s a good idea to consult a tax professional or accountant, but for some folks, the act of withdrawing funds from an investment or retirement account could result in it being considered additional taxable income for the year.
Pay off mortgage vs investing
The decision to prioritize paying off your mortgage or investing those funds in something like the stock market is a complicated one with no clear answer. However, by understanding your personal financial goals, circumstances, and your appetite for risk, you can make an informed decision as to which is best for you. If you’re unsure, you can also consider doing both at the same time.