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Updated on Wednesday, November 4, 2020
While paying off your mortgage early by making extra payments isn’t always recommended by financial experts, it may be worth doing if eliminating debt gives you peace of mind. But if you have a higher risk tolerance, investing your extra money may pay off in larger returns over time.
That being said, deciding whether to pay off your mortgage or invest your money is a personal decision; there is no one right answer for everyone. What makes sense for you is dependent on your current mortgage interest rate, risk tolerance and target retirement age.
- What to consider when deciding whether to pay off your mortgage or invest
- When to pay off your mortgage early
- When to invest
- You don’t have to choose: When to pay extra on your mortgage and invest
What to consider when deciding whether to pay off your mortgage or invest
When considering whether it’s better to pay off your mortgage early or invest, it’s important to know that there’s no one-size-fits-all solution. Whether it makes sense for you or not is dependent on the following factors:
Mortgage interest rate
While mortgage rates are low right now, that’s not always the case. If you have a higher interest rate on your mortgage because of your credit or when you took out the loan, you could be needlessly paying more in interest charges.
According to Lawrence D. Sprung, a certified financial planner (CFP) and wealth advisor with Hauppauge, N.Y.-based Mitlin Financial, paying off high-interest mortgages could allow you to save a substantial amount of money.
“Paying off your loan early could save you tens of thousands of dollars, depending on how early you pay off the loan,” he said. “Once you pay off the mortgage, you will have the amount you paid monthly to utilize in other areas.”
Your assumed rate of investment return
If you invest your money in the stock market, for example, rather than making extra payments toward your mortgage, you could have a higher rate of return on your money. Alex Caswell, a CFP and wealth planner with RHS Financial, cautioned that returns in a portfolio are dependent on a person’s risk tolerance, as the stock market can fluctuate a great deal.
Your potential returns — and your potential risk of stock market losses — should be factored into your decision to invest instead of paying down your mortgage.
How many years you have left to pay off your mortgage
Consider how many years you have left on your mortgage repayment term, and how long you have until you reach your retirement age. If you are decades away from retirement, it may not make sense to accelerate your mortgage repayment.
“A rule of thumb I like to use is if your mortgage term has more than 10 years left and the interest is in the low single digits, you are better off investing that money,” said Caswell.
How much you owe on your mortgage can also affect your decision. When you have a mortgage, you can claim the mortgage interest deduction on your taxes. With this deduction, you can deduct the interest you paid on the first $750,000 of indebtedness, or $375,000 if you’re married and filing separately, as long as you are itemizing on your taxes.
If you owe more than that, or if you do not itemize on your taxes and instead take the standard deduction, then this deduction isn’t as valuable.
When to pay off your mortgage early
If you’re trying to figure out whether to pay off your mortgage or invest, here are three scenarios in which it’s a good idea to pay off your home loan early.
You have a high-interest mortgage
Does paying a mortgage early reduce interest charges? Luckily, the answer is yes.
If you have a mortgage with a relatively high interest rate, making extra payments can allow you to save a lot of money over the life of your loan. For example, the average fixed interest rate on a 30-year home loan was 4.54% in 2018 (in July 2020, the average fixed rate for a 30-year mortgage went below 3%, so that 2018 rate is comparatively high but not nearly as high as mortgage rates have been in the past, such as in 2000, when the average for a 30-year was around 8%). According to the Federal Reserve Bank of St. Louis, the average sales price of homes in the United States was $384,000 at the end of 2018.
If you had a 30-year, $384,000 mortgage at 4.54% interest, your monthly payment would be $2,398.14. If you only made the minimum payments, you’d pay a total of $824,931.17 over the life of your loan. Interest charges would cost you $319,731.17.
But let’s say you increased your monthly payment by $250. You’d pay off your mortgage six years sooner, and you’d save over $75,000 in interest charges.
When thinking about how to handle your money, calculate your interest savings with extra payments. Seeing how much you can save may influence your decision.
You want to free up available credit
If you have a large mortgage and monthly payment, paying it off early can lower your debt-to-income ratio and make it easier to qualify for other forms of credit.
“Once the home is paid off, you can use that credit in other areas if appropriate,” said Sprung. “Also, you could then use the equity in your home, if it made sense for other purposes, too.”
By paying off your mortgage, you’ll be a more attractive borrower to creditors.
Having debt is stressful for you
How debt affects your mindset is a major consideration. “Some people do not feel comfortable carrying a large amount of debt,” said Sprung. “For many, their mortgage represents the largest debt they have, and this may keep them up at night. It may make sense in these instances to pay off the mortgage early to have that peace of mind.”
If having debt causes you anxiety, one of the key benefits of paying off your mortgage early is relieving yourself of that stress and getting an increased sense of security.
When to invest
While paying off a mortgage early makes sense for some people, it’s not for everyone. Here are three occasions when it may be wiser to invest instead.
You have a low-interest mortgage
If you qualified for a low interest rate on your home loan (30-year fixed rates are currently below 4%), your money may work harder for you if you invest it in the stock market.
“A driving factor would be whether or not you felt you could achieve an after-tax return greater than the cost of the loan,” Sprung said.
How much your money can grow is dependent on your risk tolerance and the market’s performance. There is no guarantee your money will grow, of course, but historically over time, the stock market has yielded higher returns than some other investments. A 60% stock, 40% bond portfolio has had average returns of around 8.6% a year since 1926.
If you invested $250 per month into a portfolio of 60% stocks and 40% bonds rather than making extra mortgage payments, and earned an average annual return of 8.6% per year, you’d have $379,609.62 after 30 years. That amount is substantially higher than what you’d save in interest charges by making extra payments toward your mortgage, so it could be smarter to invest in this case.
However, past performance is not necessarily indicative of future returns, and there can be periods in which the stock market is down and does not yield nearly that return, so you should understand your own returns may not keep up with those of previous decades. Also, such returns are less likely over shorter time periods, and the closer you are to retirement, the more conservative you may want to be in your investments (for instance, adding more bonds to your portfolio as you lower your exposure to stocks).
You’re behind on retirement planning
If you’re like many Americans, you may be behind on your retirement savings. According to a 2019 study by MagnifyMoney, 35% of Americans are not currently saving for retirement, and 37% waited to start saving until they were 30 or older.
If your nest egg is relatively small for your age, you can use your extra money to invest in your retirement and make additional contributions to a 401(k) or IRA. Over time, your money can grow, helping you have a more comfortable retirement.
You have other financial goals
Unlike other forms of debt, such as credit cards or personal loans, mortgages are sometimes viewed as “good debt.” “It is a constructive debt,” said Caswell. “It helps you purchase an asset. In addition, it is tax-deductible.”
Because your home is building equity and your interest payments can be tax-deductible if you itemize, you may not want to rush to pay off your loan. Instead, you can use the money to pursue your other financial goals, such as buying investment properties, paying for a child’s college education or traveling.
You don’t have to choose: When to pay extra on your mortgage and invest
If you’re still torn between paying off your mortgage and investing, there’s another solution: Do both.
“I believe that, typically, a compromise approach works best, assuming paying off the mortgage early makes sense,” said Sprung. “There are no guarantees with investment returns, but with rates as low as they currently are, there is a good opportunity to achieve a return above your mortgage rate over a long period. Taking the compromise approach will provide you with the ability to both pay down the loan more quickly and potentially take advantage of the long-term returns on your investments.”
How to split your contributions between your mortgage and investments
If you have extra money, you can split it and contribute half toward your mortgage payments and half toward your investments. By doing so, you can still pay off your loan early while building your nest egg.
For example, if you had the same 30-year, $384,000 mortgage at 4.54% interest as mentioned above but paid an extra $125 per month toward your loan rather than an extra $250, you’d still pay off your loan earlier and save money. Your mortgage would be paid off five years earlier, and you’d save over $43,000 in interest charges.
At the same time, you could contribute $125 per month in an investment account. Assuming your money earns an average return of 8.6% per year, you would have $189,804.81 after 30 years.
Before investing your money, you might consider meeting with a financial advisor and/or an accountant to discuss your finances and goals, if you feel you need professional input. When working with a professional, said Sprung, people can aim to consider “their specific asset allocation, the rate they are paying on their mortgage, factor in any tax deductions they receive for mortgage interest and see if this leads them to the conclusions that investing [after taxes] would produce a rate of return higher than paying off the mortgage.”