One of the most common questions that homeowners struggle with is whether to pay off their mortgage early or focus their efforts on investing their extra money. Each option comes with its own advantages and disadvantages, and there are many factors you should consider.
The right answer won't be the same for everyone, making it an even more difficult decision. In this article, we break down what you should consider when deciding which route to go and what the math really says.
In this Article:
What to Consider Before Deciding
Are you debating whether to pay off your mortgage or invest with your extra money? Here are some of the most important factors you should consider:
1. Your Mortgage Interest Rate
Your mortgage interest rate is essentially the price to pay for your mortgage. The higher your rate, the more expensive your loan. As a result, it's one of the most important factors to consider when deciding whether you should pay off your mortgage early or invest.
2. Home Appreciation in Your Area
When you're weighing your options of whether to pay off your mortgage or invest, it's often about weighing your mortgage rate against your potential investment returns. But it's also important to consider how quickly homes appreciate in your area. After all, that could impact which option has the best payoff.
3. Your Income Tax Rate
Both investing and paying off your mortgage have tax benefits. The interest you pay on your mortgage is tax-deductible. But so are contributions to many retirement accounts. Depending on your income tax rate, it could be beneficial to combine the two tax benefits for as many years as possible.
4. Expectations for Inflation
The Federal Reserve has a target inflation rate of 2% per year. And for your wealth to grow, your returns need to exceed the inflation rate each year.
Inflation tends to work in your favor when it comes to paying off debt. That's because the principal you pay back decades down the road is worth less than the same amount you borrowed. But inflation works against you when it comes to growing wealth. And that's because inflation erodes the value of your savings and investments.
5. Your Risk Tolerance
Regardless of what the math says, the right answer won't be the same for everyone because people have different risk tolerances. When it comes to paying off your mortgage, there's no interest rate risk as long as you have a fixed-rate mortgage.
Your true risk of prioritizing your mortgage comes in the opportunity cost of not using that money for something else. You know what you'll save by paying it off early. Investing on the other hand always carries some risk of losing your money.
6. Your Financial Situation
Any time you make a big financial decision, it's important to look at your entire financial situation. Look at all the factors.
- How much do you have in savings?
- How much wiggle room do you have in your monthly budget?
- Your financial goals.
- Do you have other higher-interest debt?
When Should You Pay Off Your Mortgage Early?
First, let's walk through some of the pros and cons of using your extra money to pay off your mortgage early.
Benefits of Paying Off Your Mortgage Early
- Save money on interest — Regardless of your mortgage interest rate, paying off your loan early allows you to save money on interest. Just make sure your lender doesn't charge prepayment penalties.
- Give yourself peace of mind — Paying off your mortgage gives you the peace of mind that comes with being debt-free. Debt is often an emotional burden for families and individuals. That freedom could be even more important than the financial benefits.
- Reduce your monthly expenses — For most families, housing makes up their largest monthly payment. When you pay off your mortgage, you free up a lot of money in your budget. You're better prepared in case of job loss or other financial hardship. Plus, you aren't stuck with a large monthly payment when you reach retirement.
- Build equity — As you pay down your mortgage loan, you increase the equity in your home. This helps to build a safety net that allows you to refinance or take out a home equity loan later. It also increases your profit if you eventually sell your home.
Drawbacks of Paying Off Your Mortgage Early
- Lack of liquidity — A home is a highly illiquid asset. If you run into a financial emergency, you can't quickly withdraw money from your home to cover it. Sure, you might consider a cash-out finance or home equity loan. But qualifying for those is dependent on your creditworthiness at the time.
- Opportunity cost — While paying off your mortgage, you lose the opportunity cost of the return you could get by investing that money. And historically, the rate of return from the stock market exceeds mortgage rates.
- Losing out on a tax break — Making regular mortgage payments while also contributing to tax-advantaged retirement accounts allows you to maximize your tax deductions. By paying off your mortgage early, you're reducing your retirement contribution deduction for those years. And you reduce the number of years you can take advantage of both deductions together.
When Should You Invest Your Extra Cash?
Now that we've looked at the advantages and disadvantages of paying off your mortgage early, let's weigh the pros and cons of investing your extra cash instead.
Benefits of Investing Your Extra Cash
- Historically higher returns — Historically, the stock market has seen an average annual return of 10%. Mortgage rates are almost always significantly lower than that. If you focus just on the math, your return is greater by investing.
- More liquidity — Investment accounts are significantly more liquid than a home. You can quickly sell investments and withdraw money anytime. There may be some consequences for withdrawing from retirement accounts, but that's not always the case. And in case of an emergency, the penalties may be worth it.
- Tax-advantaged contributions — Contributions you make to a 401(k) and traditional IRA are tax-deductible. And while Roth IRA contributions aren't deductible, your withdrawals in retirement aren't taxed. Either way, contributing to these accounts comes with major tax benefits.
- Time to compound — To save enough for retirement, your money needs years to grow and compound in the market. By investing early with your extra cash, you could be exponentially increasing the amount of money you'll have in later years.
Drawbacks of Investing Your Extra Cash
- Higher total interest paid — If you decide not to pay off your mortgage early and to invest instead, you're extending the number of years you'll make a mortgage payment.
- Stock market volatility — Investing in the stock market always comes with risk. While the market generally trends upward over the long term, there have been years when it went the other way. People with a low-risk tolerance may not feel comfortable carrying a mortgage while risking their savings in the market.
- Debt — Debt creates an emotional burden for many families, especially as non-mortgage debt continues to grow. When you choose to invest with your extra funds, you're putting off debt freedom for more — potentially many more — years.
What Does the Math Say?
When it comes to deciding whether to pay off your mortgage or invest, it's important to look at the math. The decision could be more of an emotional one for some people, especially those with a low-risk tolerance or who are debt-averse. But in this section, we're going to look at only the financial factors.
Suppose you have an extra $500 per month and are deciding whether to put it toward your mortgage or invest it.
- If you have a 30-year fixed-rate mortgage with an interest rate of 3.5%, an extra $500 per month could reduce your total interest by nearly $78,000. You would also pay off your mortgage in just 18 years — 12 years ahead of schedule.
- But what if you had invested that same $500 per month in the stock market for the same 18-year period that it took you to pay off your mortgage? If you had earned an 8% return, your contributions would have grown to more than $226,000. This is nearly three times the amount you could save by paying off your mortgage early.
As you see, if we rely purely on the math, investing instead of paying off your mortgage early has a greater return.
What About Refinancing Your Mortgage and Investing the Rest?
One option that homeowners can consider, especially in today's low-interest-rate environment, is refinancing their mortgage and investing the extra money. Refinancing a high-interest rate mortgage while rates are low allows you to significantly reduce the amount of interest you pay in the long run. And you can save even more on interest by refinancing to a 15-year loan.
Once you've refinanced and locked in those savings, then you can use your extra money each month to invest. This scenario gives you the best of both worlds: interest savings on your mortgage and the higher stock market returns.
The Bottom Line: What Should You Do?
Should you pay off your mortgage early or invest your extra money? It's a question homeowners have been asking themselves for years. If you rely solely on math, investing your money has a greater return on investment.
But you don't have to choose just one or the other. Refinancing your mortgage to a lower interest rate while also investing your extra money each month is an excellent way to save money on interest and grow your money in the stock market.
And we all know that finances aren't just about the numbers. Finances can also be highly emotional. As a result, it's important to consider your comfort level with debt and your risk tolerance before making your decision.