Should I pay off my mortgage or invest the money instead?

Erik J. Martin
The Mortgage Reports contributor

Save on your mortgage, invest your money, or do both

Maybe you have extra cash flow thanks to a raise, or you recently came into a big sum of money.

What’s the best way to put those dollars to work for you?

Should you pay extra on your mortgage to shorten your loan term and save on interest? Or should you invest in the stock market?

Maybe you should do both — refinance to save on your loan and invest the rest to see bigger returns.

The right answer depends on your tolerance for risk and long-term goals.

Verify your refinance eligibility at today's rates (Sep 18th, 2020)

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If you get a raise, should you pay extra on your mortgage or invest?

Let’s take a look at one example to demonstrate how much paying off your mortgage early versus investing those extra funds can benefit you.

Say you recently got a raise. You now have an extra $2,000 coming in each month.

What happens if you use that extra money to make early mortgage payments?

Paying off your mortgage early

“Assume you bought a house for $250,000,” says Katsiaryna Bardos, associate professor of Finance at Fairfield University.

  • You borrow $200,000 using a 30-year mortgage loan
  • Your fixed interest rate is 3.25%
  • Your mortgage loan payment is $870 per month
  • You’d pay $113,350 in interest over those 30 years

“But if you make additional $2,000 payments every month,” explains Bardos, “you’d pay off your mortgage in 6.5 years and will only pay $21,900 in interest over that time.”

  • Your total interest savings would be $91,400

That’s a huge amount of money back in your pocket.

But, this example assumes you stay in the house all 30 years, and pay your loan off in full — which most homeowners don’t do.

So let’s see how the returns compare if you invest the $2,000 each month instead of paying extra on your mortgage.

Investing in the stock market

History shows that other investments can yield a better rate of return than the interest rate you are likely paying on your mortgage.

“The historical rate of return on the stock market is around 8%,” Bardos says. She gives this example:

  • You choose to invest that $2,000 every month for 6.5 years
  • Assume you earn an 8% annual rate of return
  • If so, you’d earn $203,700 – which is about $112,300 more than the $91,400 you’d save by prepaying your mortgage

Remember that interest rates on mortgages currently remain well below the average returns of the stock market.

That means you make more by investing than you save by paying off mortgage interest early.

“From a purely financial perspective, it can generally make more sense to contribute any extra money you receive toward your investments rather than paying off your mortgage early,” says Anna Barker, personal finance expert and founder of LogicalDollar.

Mortgage rates are currently lower than average stock market returns, so you can often make more by investing than you’d save by paying off mortgage interest early.

However, your investment’s rate of return is not guaranteed; you could lose money investing in stocks or bonds.

“If you have a fixed-rate mortgage, investing in your home is a sure thing – you know exactly how much money you will save in interest,” notes Elizabeth Whitman, attorney/managing member, Whitman Legal Solutions, LLC.

So when you decide how to use your hard-earned cash, you also have to consider your personal risk tolerance.

If you’re not confident making the decision on your own, speak to a financial advisor to see what makes the most sense for you.

If you have a lump-sum of cash, should you pay off your mortgage early or invest it?

Here’s a different scenario: An older relative passes away and you inherit $100,000 after taxes.

You debate whether it’s smarter to direct the whole lump-sum toward your mortgage or put it into stocks or your retirement funds.

Using the previous example, say you pay down your mortgage by $100,000 during your first month of borrowing $200,000 total.

  • In this example, you’d pay a total of $20,300 in interest for a total savings of $93,000

“Your mortgage would be paid off in 11.5 years instead of 30,” explains Bardos.

  • Alternatively, you choose to invest the $100,000 in stocks that yield an 8% return over 11.5 years
  • Using these metrics, you would earn $243,900

Whitman cautions that putting all that money into your home isn’t necessarily a good idea — especially if that’s your only investment.

“You should have several types of investments, such as stocks, bonds and real estate, so that your portfolio is diversified,” says Whitman.

Putting all that money into your home isn’t necessarily a good idea — especially if that’s your only investment. You should aim to have a more diversified portfolio.

“That way, if the stock market goes down, there’s a chance you won’t lose as much money if, say, the real estate and bond markets remain steady.”

Assuming your rate of return will be favorable, investing some or all of that $100,000 in retirement funds may be your best bet.

“With an IRA, 401(k) or similar investment, you can invest the money using pre-tax dollars. Plus, you don’t pay tax on the money until you withdraw it,” Whitman suggests.

How to pay off your mortgage early

If you want to pay off all or part of your mortgage early, there are a number of ways to do so.

Devoting extra dollars toward your mortgage in the form of accelerated payments can be a great way to save money.

This tactic can reduce the amount of interest that accrues by thousands of dollars over the life of your loan. It can also shorten your loan’s term by several years.

  • With accelerated payments, you send extra money to your lender or loan servicer once or more each year
  • You need to indicate that these additional dollars must be applied toward your principal
  • This strategy will decrease the interest that accrues on your mortgage in the future, truncating your loan’s term and enabling you to pay off your loan more quickly

>> Related: Here’s how to pay off your mortgage early (but should you?)

“By either making more than the minimum repayment amount each month or making more frequent payments, you can reduce the loan principal faster,” says Barker.

“This, in turn, will mean that the overall amount you owe will continue to be reduced more quickly than initially expected, as less interest will be applied on the now-reduced principal.”

You can make accelerated payments by either:

  • Paying a little more each month
  • Making biweekly payments (26 smaller payments a year instead of 12), or
  • Making one extra payment annually (13 total payments instead of 12)

But prepaying your mortgage via one of these options may not be your best move. Many homeowners are likely to earn a higher rate of return on their money by investing it.

What to consider carefully before investing or paying extra on your mortgage

The right choice for you will depend on how much risk you are willing to take.

“Paying off your mortgage is essentially a riskless investment. You know how much you will save right up front,” says Bardos.

“Most other investments with higher returns are associated with higher risks. You can and may lose money. So consider your overall portfolio, risk appetite, and time horizon when making investment decisions.”

Also, ponder a few other matters before pursuing either option:

  • Does your mortgage allow for easy repayment? Or is there a penalty for prepaying your loan? “This may sway you either way if there’s a cost involved that may not make early repayment worthwhile,” says Barker
  • What are your financial goals? “Investing the money may make more sense from a financial perspective. But if you are uncomfortable with the amount of debt you are carrying, putting even some of this toward your mortgage could help you sleep better at night,” Barker points out
  • Are you comfortable investing this much at once? “Depending on how the market is performing, your risk appetite, and your overall investment strategy, investing any extra money you have all at once may not work for you. In this case, you may prefer to put some of the money toward your investments and the rest toward your mortgage,” Barker advises

Alternative option: Refinance your mortgage to save

Maybe you don’t have to decide between saving on your mortgage and investing in the stock market.

There’s a third option to consider: Refinance to save money on your home loan and put the rest of your cash into higher-yield investments.

You may be able to accomplish both goals — paying off your mortgage early and earning returns — if you refinance into a shorter loan term.

However, shorter mortgage terms mean larger payments. So you might not have much cash leftover if you do that.

You could also refinance to a new 30-year mortgage with a lower rate.

With today’s near-record low mortgage rates, you could still save a substantial amount on your overall mortgage interest and have money left over to invest.

Know what your financial goals are, explore your options, and make sure you’re choosing the best strategy to get you there.

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