If you have extra money, should you pay off your mortgage or invest?
You need to pay off debt, build retirement savings, and build an investment portfolio.
If you’ve got a little more cash than you expected – perhaps because you’ve spent a lot less crouching during the pandemic – what’s the smartest way to use that extra cash flow?
Naturally, it all depends. There is no one-size-fits-all approach and it largely depends on your risk tolerance and long-term goals.
Timing can also play an important role. Mortgage rates today are near all-time lowswhile stocks continue to make new highs.
A popular question among people with more disposable income is: should I use this to pay off my mortgage or invest in the stock market? Here are some pros and cons to make that decision a little easier.
Option 1: Pay off the mortgage early
Let’s try to make the math easy:
You borrow $200,000 on a 30-year loan.
Your fixed interest rate is 3%.
Your mortgage loan payment is $843 per month.
Now let’s increase the mortgage loan payment by an additional $1,000 per month. Use an online Mortgage Repayment Calculatorand you will see that your mortgage can be paid off in 10 years and seven months – which would save you $69,952 in interest. That’s a big number.
We’ll dig deeper into the dollars and cents, but first, what about the other benefits of paying off your mortgage?
Some cannot be measured financially – for some homeowners, paying off their mortgage is about peace of mind. One less bill could let you sleep better at night.
Paying off your mortgage or paying a lump sum to lower your monthly payments also frees you up to deal with other debts. Mortgage rates are tiny compared to the sky-high rates you can expect on credit cards. Without the burden of large mortgage payments, you can shift those payments to credit card balances, student loans, or any other bill that you want to prioritize.
The biggest benefit, however, is reducing the money you spend on interest. This is especially true if your loan had a high interest rate when you took out your mortgage.
Also, paying off your mortgage isn’t the same as those other pesky monthly bills. With each payment, you build equity in your home—equity that could be tapped into in the future if you’re short on cash. Even if you already have a decent one emergency fundyou never know what life throws at you – 2020 provided the best example of that.
Equity is important, but be careful not to pay off so much mortgage that you’re left with little real Cash register. Are you one of millions of Americans who will lose their jobs in 2020? Tapping into all that home equity without a steady income isn’t easy. It makes sense to keep enough cash (eg Savings account with high return) to protect you from the unexpected.
Second, we’ve seen how paying off your mortgage early can save you a lot in interest, but is it really? the best opportunity to save money? There are alternatives that could give you greater savings over the long term, especially if mortgage rates are reasonable Batting distance to all-time lows.
With your money going into your mortgage, will you miss out on higher returns from other investments?
Option 2: Invest in the stock market
Let’s compare how much you can make on the investment versus the money you would save if you paid off your mortgage early.
So, using these calculations, you would make $182,946.02 by investing while saving only $69,952 in interest by prepaying your mortgage.
It’s a clear win financially, and that’s before the tax implications are factored in. Investing all of that money in a 401(k) or IRA can save you thousands more in tax breaks.
If this was such an obvious choice, it wouldn’t be much of a debate, would it?
What really matters is your risk tolerance. These average returns are just what averages, your return is not guaranteed – you could end up losing money investing in stocks or bonds. And with the stock market making new all-time highs, future stock returns may not be quite as attractive.
With a fixed-rate mortgage, you know exactly how much interest you’ll save by repaying it early.
You might decide to take a less risky approach to investing, perhaps by using a popular app to help you Earn returns with only the “small change” left over from your daily purchases.
Option 3: Use your home’s equity to invest
Home equity is simply the portion of your home that you’ve paid off. As your home value increases and you pay off your mortgage, your equity grows.
If you use this equity as collateral, you can ask a lender to loan you a large sum of money, which is known as a home loan.
You can take out a home equity loan to cover major or unexpected expenses—but what about an investment?
If you look at the returns, it makes perfect sense to invest your equity in the stock market.
Interest on a home equity loan averages around 5%. That means you’d be paying far less interest than the money you’d make investing that money in the S&P 500 at an 8% yield.
But as we found out, the stock market is anything but a guarantee. Are you willing to take the risk that your investment may not perform as well as expected?
This could lead to serious problems. Because the loan is secured by your home, you could lose your home to foreclosure if you are unable to repay it. Or what if you decide to move? If you have not yet paid off your loan in full, your lender expects you to pay it back in full immediately.
And finally, there are some additional costs that you may not consider. Just like getting your first mortgage, there are closing costs – typically 2% to 5% of the total loan amount.
If you’re not too confident about these decisions, talk to a professional. A certified financial planner, like the ones now offer their services onlinecan help you customize a retirement plan.
This article is informational only and should not be construed as advice. It is provided without any guarantee.