Pay off Mortgage or Invest: Which Is Best?
8 MIN READ
Paying off your mortgage early can be a wise financial decision that saves you some money in interest long-term. However, doubling up on mortgage payments isn’t for everyone. Some may be much better off investing the money instead. Of course, investing the money into the market carries more risk, but returns may very well exceed the cost of the remaining mortgage interest.
Current market rates are historically low for mortgages. Deciding whether to pay off the mortgage early or invest the money instead will depend on a homeowner’s financial situation, risk tolerance, and overall financial goals.
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Paying Off Your Mortgage First
Pros
Goodbye Monthly Payments
According to the United States Census Bureau, the average mortgage monthly payment on a 30-year-fixed mortgage for many homeowner is $1,275 and $1,751 on a 15-year fixed mortgage. Paying off your mortgage early frees up extra cash that could be put toward other things like investments.
You Own Your Home
Owning your home outright means that there’s no longer a chance of you ever losing your house due to financial hardship. Having no payments also brings out the possibility of downsizing and turning your home into an income-generating rental property. If nothing else, the house becomes part of your estate and can be listed as an item for your loved ones to inherit.
You’ll Save Money On Interest
Every single mortgage payment you make has a portion allocated towards interest. Therefore, paying off your mortgage sooner than your 15 or 30-year term means less interest paid over the duration of the loan. This may reduce your total loan cost by tens of thousands of dollars.
Call your lender before doubling up to send in extra payments to ensure the extra money paid goes towards your principal. Unfortunately, this isn’t always the case.
Financial Peace of Mind
Similar to the benefit of having no more monthly payments, there is no bank to call you 12 times a day if you lose your job. Paying off your mortgage early means you will never again have to choose between paying the mortgage or feeding your family. Once you own your home and no longer have a mortgage, you have found financial freedom that very few may ever experience in their lifetime.
Cons
Mortgage Prepayment Penalties
Some mortgage lenders charge a fee for prepayment in the event of a sale, refinance, or early pay-off within a pre-specified amount of time from your closing date. This probably no longer applies if you’re more than five years out from your closing date. If you do pay a mortgage prepayment penalty, you can deduct that penalty as mortgage interest under the current IRS code.
You’ll Lose the Mortgage Interest Tax Deduction
The mortgage interest tax deduction allows homeowners to reduce their taxable income by the amount of mortgage interest paid during that tax year. Interest can be deducted on the first $1 million of mortgage debt for a primary or secondary home. However, those who purchased a home after December 15, 2017, can only deduct the interest on the first $750,000 of their mortgage.
Earn More Than You’ll Save
Mortgage rates are the lowest they’ve been in a very long time. The average stock market return is around 9% over a decade, while the average mortgage rate is around 3.5%. This means that if you paid your mortgage off ten years early instead of investing in the stock market for the same length of time, you would have been better off investing in the stock market.
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Investing First
Pros
Liquid Assets Build Wealth
If you are paying extra money each month towards reducing your mortgage balance, the only way you’ll ever see that money again is if you refinance your loan or pull out cash from a HELOC. If you ever find yourself in a financial bind where you need fast access to money, it’s much easier to liquidate stocks, bonds, or other market investments than selling your house.
Earn Compound Interest
Compound interest is earned on both the principal and interest in an account. For example, if you deposited $500 per month into a retirement savings account earning at a rate of 5%, you’d have $6,300 after the first year. Each year after that, the account would earn 5%. After 30 years, $500 per month contributions would total $180,000 with a total account value of $398,634.
Cons
Degree of Risk
Over long periods of time, the stock market provides steady returns. That being said, there are periods where the market can swing either way temporarily. If you don’t play on being a long-term investor, this risk of loss could be entirely too stressful to swallow.
Paying More Interest
While it is true that carrying a mortgage for a more extended period will result in more interest paid, high-interest debt should always be paid down first. Interest charges for personal loans, student loans, credit card debt, and auto loans will counteract any gains made from investment portfolios.
Doing Both
Pros
An intelligent investment strategy can also allocate more money towards a mortgage loan. Splitting the difference and working towards two long-term financial goals at the same time will simultaneously build wealth and reduce debt.
Cons
Having two substantial financial goals as the main priority can distract from high-interest debt like student loans and credit cards. High-interest debt should be paid off first before moving on to investments and early mortgage pay-off.
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Other Things to Consider
Amortization Schedule
The amortization schedule is the loan payment schedule over the 15 or 30-year mortgage period. In the beginning years of the loan, mortgage payments are predominately made up of interest, with a smaller portion going towards principal. Over time, this proportion flips to allocate a more significant amount towards the principal.
In the first ten years of the loan, the loan balance is at its highest. As such, the portion of interest is also at its highest. As the mortgage is paid down, there is less interest owed. Consequently, a greater portion of each payment is applied to principal and less to interest.
Investment Gains vs. Loan Interest Saved
For some, investment gains in the market will far exceed loan interest saved by paying off a mortgage loan early.
For a 30-year fixed mortgage rate loan, 83% of the total interest over the length of the loan will have been paid in the first 20 years. Therefore, paying the mortgage off ten years earlier than planned would have only saved a homeowner 17% of the total interest cost for the entire 30-year mortgage.
If a homeowner has an unusually high mortgage rate, this may be worth it. In most cases, however, the extra money sent to the mortgage lender will have a better return investing in the market.
Risk Tolerance
Various types of investments are associated with different levels of risk - which means how much money a person is willing to lose to make gains.
For example, treasury bonds secured by the government are low risk as their amounts are guaranteed. On the other hand, stock investments have much higher volatility since prices can go up and down multiple times in the same day.
Emergency Fund
It is vital to have a solid emergency fund in the event something happens to your family or your home. If you’re suddenly faced with financial hardship, the best-case scenario is to have enough money set aside to cover any unexpected expense that could pop up. Before investing or paying extra money towards your mortgage, it’s wise to have three to six months of total living expenses saved in an accessible account for a rainy day.
Tax Benefits
Contributions to retirement accounts and other investments are usually tax-deductible and not subject to federal or state income tax levels until the money is withdrawn. By depositing money into retirement accounts, you are responsibly preparing for your future while enjoying immediate financial benefits - lower taxes.
After the money is put into a retirement account, all interest, dividends, and appreciation are also added to your account free of taxation. In addition, all taxes may be deferred until withdrawal. This means more money will be working harder for you.
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Higher Interest Debt
Instead of paying off a mortgage early, an investment strategy may leave a homeowner with accumulated high-interest debt. Maintaining high balances would surely defeat any progress or gains made from an investment portfolio.
Employer Match
Employers often will match a percentage of retirement account contributions. If you can max out your match amount with your employer, it would be wise to take advantage of this. If you don’t, you’re literally leaving free money behind.
Key Takeaways
Before you pay off your mortgage early, it’s a good idea to figure out what you would do with the extra money saved in lieu of mortgage payments. The financial rule of thumb is first to pay off debts with the highest interest rate. Compared to student loans, car loans, and credit cards, the mortgage is rarely the priority.
Deciding whether to pay off your mortgage or invest is a personal decision that depends on personal finances and goals. Simply putting an extra $500 toward your monthly mortgage payment instead of doubling up can take years off of your loan, bringing you closer to the pursuit of mortgage-free living.