If you've got extra cash, should you pay off your mortgage or invest?
You have debts to pay, retirement savings to pad, and an investment portfolio to build.
If you find yourself with a bit more money than expected — maybe because you spent a lot less while you hunkered down during the pandemic — what’s the smartest way to use that extra cash flow?
Of course, it all depends. There isn’t a one-size-fits-all approach, and it mostly hinges on your appetite for risk and your long-term goals.
Timing can also play an important role. Today, mortgage rates are near all-time lows, while stocks continue to hit new highs.
One popular question among people who find themselves with more disposable income is: Should I use it to pay off my mortgage or invest in the stock market? Here are some pros and cons to help make that decision a little easier.
Option 1: Pay off your 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 up that mortgage loan payment by an additional $1,000 per month. Use an online mortgage payoff calculator, and you'll see that can pay off your mortgage in 10 years and seven months — which would save you $69,952 in interest. That’s a big number.
Pros
We’ll get deeper into the dollars and cents, but first, what about the other benefits of paying off your mortgage?
Some can’t be measured financially — for some homeowners, paying off their mortgage is about peace of mind. One less bill might make you sleep easier at night.
Paying off your mortgage, or paying a lump sum to lower your monthly payments, will also free you up to tackle other debts. Mortgage rates are tiny compared to the sky-high interest rates you can expect on credit cards. Without the burden of high mortgage payments, you can shift those payments towards credit card balances, student loans or any other bills you want to prioritize.
But the biggest benefit is cutting down 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 down your mortgage isn’t the same as those other annoying monthly bills. You’re building equity in your home with each payment — equity that could be tapped in the future if you find yourself short on cash. Even if you already have a decent emergency fund, you never know what life will throw at you — 2020 offered the greatest example of that.
Cons
Having equity is important, but be careful not to pay down so much mortgage that you’re left with little real cash. Are you one of millions of Americans to lose their job in 2020? It’s not easy to tap into all that home equity without a steady income. There’s value in keeping enough cash (for example, in a high-yield savings account) to protect you from the unexpected.
Secondly: we’ve seen how paying off your mortgage early can save you a bundle on interest, but is it actually the best way to save money? There are alternatives that could net you higher savings in the long-run, especially when mortgage rates are within striking distance of all-time lows.
With your money going toward 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 earn investing against the money you'd save by paying off your mortgage early.
Instead of adding $1,000 every month to your mortgage repayments, you invest that money for 10 years and seven months.
The average annual return for the S&P 500 Index since 1957 is 8%.
In total, you’d earn $182,946.04, according to a compound interest calculator.
Pros
So, according to those calculations, you’d earn $182,946.02 by investing, while saving only $69,952 in interest by paying off your mortgage early.
It’s a clear win financially, and that’s before taking into account the tax implications. If you invest all that money in a 401(k) or IRA, you can save thousands more in tax breaks.
Cons
If this was such an obvious choice, it wouldn’t be much of a debate, would it?
What it really comes down to is your tolerance for risk. Those average returns are just that, averages, your return isn’t guaranteed — you could end up losing money investing in stocks or bonds. And with the stock market notching new all-time highs, the returns on stocks going forward may not be quite as attractive.
When you have a fixed-rate mortgage, you know exactly how much you’ll save in interest by paying it off early.
You might decide you'd prefer to take a more low-stakes approach to investing, maybe by using a popular app that helps you earn returns on just the "spare change" left over from your everyday 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’s value increases and you pay down your mortgage, your equity grows.
Using that equity as collateral, you can ask a lender to let you borrow a large sum of money, through what’s called a home equity loan.
You can take out a home equity loan to cover major or unexpected expenses — but what about to invest?
Pros
If you look at the rate of returns, using your equity to invest in the stock market makes perfect sense.
Rates for a home equity loan are averaging around 5%. That means you’d pay far less in interest compared to the money you’d earn if you invest that money in the S&P 500 at 8% returns.
Cons
But as we’ve explored, the stock market is far from a guarantee. Are you willing to take the risk that your investment might not perform as well as expected?
That could lead to some serious problems. Because the loan is secured by your house, you could wind up losing your home to foreclosure if you can’t pay it back. Or, what if you decide to move? If you haven’t finished paying back your loan, your lender will expect you to pay it back immediately in full.
And finally, there are some extra costs you might not consider. Just like when you took out your first mortgage, there will be closing costs — usually 2% to 5% of the total loan amount.
If you’re not feeling too confident about these decisions, speak to a professional. A certified financial planner, like those who now offer their services online, can help you customize a retirement plan.
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
