To pay off mortgage faster or to buy more investments? That’s a question for many people.
For homeowners, capital allocation skills are critical. Capital allocation means deciding where to put our extra savings into each month.
Some people, like my parents, stuff their money under the mattress because they don’t want any risks. The problem with that is they lose money due to inflation. With 3% annual inflation, the money will devalue by 26% in just 10 years earning 0%!
A more productive use of cash saving is either: 1. use it to down debt such as mortgage or 2. Invest in stocks/index ETFs
There are many reasons to choose one over another. It depends on personal situations such as finances, goals, and risk tolerance.
This is a dilemma many people face and I hope I can help solve it. We will break down some pros and cons below and what I will do personally if I get a second chance to pay off the mortgage.
Option 1: paying off a mortgage early
The mortgage was designed to be paid off naturally over number of years: 25 years or 30 years. Part of the monthly payment is interest and part of it goes to the principal. It’s called amortization.
If we increase the monthly payment or make additional lump sum payments using extra cash, it can be paid off much faster than the pre-determined schedule.
Whenever you prepay extra cash towards the mortgage on top of the regular mortgage payment, it will apply directly to the principal thus reducing the interest you’ll pay over the mortgage term.
Let’s use an example:
Mortgage: $300,000
Interest rate: 4%
Term: 30 years
Putting an extra $500 per month towards the mortgage will save you hundreds of thousands in interest and cut YEARS off your loan term: total interest paid: $215,610 v.s. $123,193 and 30 years v.s. 18.3 years! See screenshots below:
Owning your home outright eliminates lots of risk and a significant monthly expense, providing a sense of financial security. Mortgage payment is a significant portion of monthly expenses. Without a mortgage payment, you’re less vulnerable to job loss or economic downturns.
Paying off your mortgage offers a guaranteed after-tax return equivalent to your interest rate. If your mortgage rate is 4%, paying it off is like earning a risk-free 4% return on your money, and you don’t have to pay tax on this 4% return.
Without mortgage payment, your monthly expenses are significantly lower, giving you higher cash flow and greater flexibility to save, invest during bear markets, or spend on other priorities. Remember, cash flow is king! Best of all, you have one less bill to worry about every month!
Finally, if you decide to pay off mortgage faster by prepayment, remember leave some cash for emergencies of at least 6 months to 12 months. You don’t want to run into situation where you almost pay off the mortgage and then run out of cash to pay bills.
Option 2: use the extra cash to invest instead
Another choice is keep paying the same mortgage payment and invest the extra cash in equity (stocks, ETF, mutual funds etc.) hoping to generate a substantially higher return than the mortgage rate. There are risks and rewards from buying investments and the return is not guaranteed. We may suffer losses.
Why Invest Instead
Historically, the expected long term annual return from investing in US stock market is around 8% for SP500 or 14% for Nasdaq. Nasdaq offers higher return than SP500 but it’s also more volatile. For example, excluding dividend, in 2000, SP500 dropped -50% while Nasdaq 100 dropped -83%. In 2022, SP500 dropped -27% while Nasdaq 100 dropped -37%.
If your mortgage interest rate is fixed for long term and is low (e.g., 3%), and you have long investment time horizon of 10 years or more, investing your extra funds in index funds make more sense because it could yield a much higher return over time thus increasing your net worth.
Also, money invested in stocks is generally more liquid than funds tied up in your home equity. Home equity needs refinancing to take out. This liquidity can be super useful in emergencies or for seizing opportunities e.g. bear market fire sale.
Certain investments, like 401(k)s or IRAs, offer tax benefits that can amplify your returns. Additionally, mortgage interest is often tax-deductible, reducing the effective cost of your loan.
According to IRS: “Home mortgage interest. You can deduct home mortgage interest on the first $750,000 ($375,000 if married filing separately) of indebtedness. However, higher limitations ($1 million ($500,000 if married filing separately)) apply if you are deducting mortgage interest from indebtedness incurred before December 16, 2017.”
Investing allows you to build a diversified portfolio, spreading risk across different asset classes. But if you put all your money into your home increases your exposure to real estate market fluctuations, e.g. 2008 housing crisis.
Let’s look at other factors:
Interest Rates
- If your mortgage rate is significantly lower than the average investment return and locked in long term, investing is often the better choice.(e.g. 3% fixed mortgage rate vs 8% index return.)
- If your mortgage rate is above 6%, paying off your mortgage is better.
Risk Tolerance
Investing comes with risks including market volatility and potential losses. If you’re risk-averse, the guaranteed return of paying off your mortgage looks more appealing. Remember, bear markets can last years as in 2000, 2007. I personally refinanced at the end of 2019 and lost money from buying the wrong individual stocks during COVID! Remember, investing is not guaranteed!
Time Horizon
Paying off your mortgage can provide immediate financial benefits by increasing cash flow and reducing debt. Investing is better suited for long-term growth, particularly if you have decades to let your investments compound. So for young people starting out, it makes more sense to invest than paying off mortgage early. For people close to retirement, it makes more sense to pay off the mortgage.
Option 3: combined approach: the best of both worlds
If you’re torn between the two options, there’s a third one: consider splitting your extra funds between paying down your mortgage early and investing. It doesn’t have to be all or nothing. This strategy allows you to reduce your mortgage debt while also building an investment portfolio for long term net worth growth.
Tools to Help Decide
- Mortgage Payoff Calculators
Use online calculators to see how extra payments affect your loan term and interest savings.
I like this one: http://bretwhissel.net/cgi-bin/amortize
- Investment Calculators
Estimate potential returns based on your investment contributions and time horizon.
I like this one: http://www.moneychimp.com/calculator/compound_interest_calculator.htm
What will I do personally?
Back in 2019, my stock portfolio was twice the size of my mortgage, I had the chance to pay off the mortgage and still had around $100k in stocks. If I had the second chance again, I would pay off the mortgage and cut expenses in half. If our expenses is 50% lower, we only need 50% less income to pay bills. Less is more.