Should I pay off my mortgage or invest?

January 14, 2021 - 9 min read

What’s the best use for your extra cash?

Maybe you have some extra cash thanks to a bonus or raise. Maybe you recently inherited a big sum of money.

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

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

Or, should you 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 your long-term goals.

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You have extra cash flow. Should you pay extra on your mortgage or invest?

Let’s take a look at one example to demonstrate the difference between paying off a mortgage early and using the same money to invest.

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?

Pay 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 (not including taxes and insurance)
  • You’d pay $113,350 in interest over 30 years

“But if you make additional $2,000 payments every month,” explains Bardos, “you’d pay off your mortgage in 6½ 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.

However, this example assumes you stay in the house for your complete loan term and pay the 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.

Invest in the stock market

History shows that other investments can yield a better annual 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:

  • Instead of paying extra on the mortgage, you choose to invest that $2,000 every month for 6½ 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

For many years now, interest rates on mortgages have stayed well below the average returns of the stock market.

That means you’d likely earn a better return by investing than you’d 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.

However, your investment’s better 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 and managing member at 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 or a certified financial planner to see what makes the most sense for you.

You have a lump-sum of cash. Should you pay off your mortgage or invest?

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 retirement savings accounts.

Using the previous example, let’s 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 11½ 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 the home is 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.

“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 into your retirement plan 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 term by several years.

  • With accelerated payments, you send extra money to your lender or loan servicer once or more each year
  • You should indicate these additional dollars must be applied toward your principal (not future interest)
  • This strategy will decrease the interest that accrues on your mortgage in the future, reducing your loan’s term and enabling you to pay off your loan more quickly

“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 than your monthly payment 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 financial decision. Many homeowners are likely to earn a higher rate of return on their money by investing it.

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

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

“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.”

Ask yourself a few questions 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. Note, the vast majority of mortgages taken out since 2014 do not charge prepayment penalties
  • 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

Other smart uses for your extra cash

There’s a chance that neither paying off your mortgage nor investing in the stock market is your best option.

Depending on your financial situation, there could be other smart uses for your dollars. Consider:

Do I have an emergency fund?

There are plenty of scenarios where emergency savings come in handy. What if you lost your job or fell ill and couldn’t work? What if you faced a major car repair or needed to move unexpectedly?

You’d need some extra cash. That’s why so many financial advisors recommend keeping an emergency fund in your savings account. The size of your cash reserve is up to you, but most experts suggest keeping enough money to pay for up to 6 months’ living expenses if necessary.

Putting all your extra cash into your mortgage wouldn’t leave you much flexibility to cover unexpected needs. You’d need a home equity loan to liquidate your real estate asset.

You could liquidate stock investments more easily, but you may face early withdrawal penalties and income tax implications for pulling money out of retirement accounts.

Some people end up using credit cards to address the emergency and then pay high interest rates on those revolving balances.

Is there other higher interest debt I should pay off first?

Either investing or paying off a mortgage could be short-sighted if you’re saddled with a lot of high-interest debt.

When you owe $20,000 in credit card debt at 20% interest, for example, you’re paying $4,000 a year in finance charges. For most homeowners, paying off this higher-interest debt first could unlock more savings than you’d earn investing.

In this case, you may want to consider a cash-out refinance or a home equity loan to use the value in your home to pay off high-interest credit card debt.

These kinds of loans are one of the perks of homeownership — assuming you’ve built up enough equity to borrow against.

Student loans tend to charge lower amounts of interest; the average American pays less than 6% on student loan balances. So using a home equity loan to consolidate student loans makes less sense.

Will paying off my mortgage early affect income taxes?

Becoming debt-free is a goal for a lot of people for good reason. With no mortgage debt, you can better control how you spend your hard-earned cash. Plus, you have extra peace of mind knowing you own a large asset.

But mortgage debt can have its own advantages, too. For example, some homeowners write off their mortgage interest on their income tax returns each year. Some borrowers can even write off the cost of mortgage insurance premiums.

Mortgage interest is tax-deductible only if you itemize your tax deductions. And you typically shouldn’t itemize deductions unless they exceed the IRS’s standard deduction.

Paying off the mortgage debt would eliminate this tax deduction for those who claim it — and losing any deduction could bump you into a higher tax bracket. Paying a higher tax rate would impact your bigger financial picture.

Talk to a professional tax advisor if you’re not sure about the best way to handle your income taxes. We’re not tax experts after all, and this site does not give tax advice.

Alternative option: Refinance your mortgage and invest

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: Refinancing to save money on your home loan and putting 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 monthly 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.

Before refinancing, make sure your credit score qualifies you for a low interest rate and shop around with at least three different lenders to find the best deal.

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

Time to make a move? Let us find the right mortgage for you

Erik J. Martin
Authored By: Erik J. Martin
The Mortgage Reports contributor
Erik J. Martin has written on real estate, business, tech and other topics for Reader's Digest, AARP The Magazine, and The Chicago Tribune.