You’ve come into some extra money. Maybe a relative left you an inheritance, or your employer gave you a holiday bonus. Or maybe you’ve set up your budget to get you some extra savings each month. You want to use this extra cash to improve your financial situation. But what’s the best way to do so? Is it smarter to finish paying down your mortgage so that you can truly own your home? Or should you invest the money for the future? Let’s explore the pros and cons of each approach.
Benefits of investing
Investing your money is a great way to increase the value of your capital over time. Historically, the stock market has generated strong returns — just as long as you diversify your portfolio. For instance, the S&P 500 — a stock market index that includes the 500 largest companies in the U.S. stock market — averaged an annual return of 12% over the last 30 years. So if you invest and hold the assets you could make much more interest than what you’re paying on your mortgage.
Investments can also produce income, either in the form of dividends paid by stocks or interest payments you receive for holding a bond. Placing your money in an income-producing investment can be a good way to build an alternative income stream.
Investments are also relatively liquid. You can sell your investment and spend the money whenever you need to. Money locked up in your home equity can be more difficult to access.
What are the risks?
But investing isn’t a sure thing. The biggest downside of most investments is their volatility. The value of an investment can move up and down unpredictably, so they’re not good to rely on in the short-term. And if you invest too much money in any one place, you risk losing it all.
Benefits of paying down your mortgage
Paying down your mortgage brings its own benefits.
One advantage of paying down your mortgage is that you effectively lock in a return on your investment equal to the interest rate you pay on the loan. For every extra dollar that you put towards the mortgage, you pay less interest over the life of the loan. If your mortgage has a high interest rate, that can save you a lot of money.
Paying down your mortgage also accelerates your progress toward paying the loan off entirely. Owning a home and not having to pay a mortgage bill or rent can help improve your overall cash flow. And saving (and investing!) in the future will be much easier when you no longer have to worry about making a large mortgage payment every month.
What are the risks?
The biggest downside of paying down your mortgage is liquidity. Once you put your money towards your mortgage, you can’t withdraw it without selling or opening a home equity loan or line of credit. So if you don’t yet have an emergency fund that can comfortably cover any unanticipated expenses, spending your savings on your mortgage may be unwise.
Which is right for you?
You need to consider many factors when deciding between investing and paying down your mortgage, including:
- Mortgage interest rate.
- Expected return on investment.
- Home value vs. outstanding loan balance.
- Your risk tolerance.
- How long you plan to live in the home.
Benefits of investing instead of paying off your mortgage
If you’re willing to accept the risk and volatility that comes with investment, investing tends to offer higher returns than paying down your mortgage early. In the long run, the stock market offers returns of nearly 10% each year. Mortgage rates are usually far below that rate, so you’ll come out ahead by investing.
Investing is also good if you plan to live in your house for a long time, or forever. If you don’t plan to sell your home anytime soon, paying your house off early doesn’t give you much benefit, other than getting rid of a monthly bill.
Reasons you should pay your mortgage off firsts
If you’re burdened with an unusually high interest rate on your mortgage, or struggling to make your monthly payments, pay down your mortgage first. To illustrate, a typical mortgage in 1981 had rates ranging from 15% to 19%. If your mortgage rates are anywhere close to that, you should pay it off as soon as possible.
This is also a good option if you don’t like taking on risky investments, and would rather secure a guaranteed return by reducing loan interest costs.
Paying down your mortgage early is also the right choice you’re planning to sell your home in the near future. The last thing that you want is for falling home values to leave you underwater on your loan right before you plan to sell. Making extra payments can reduce that risk.
If you’re currently paying private mortgage insurance, making additional payments can get you closer to getting rid of those PMI costs, saving you money each month.
Older people nearing retirement might also consider paying down their mortgage. Your income in retirement will likely be lower than it was when you were employed. As such, reducing or eliminating your monthly mortgage bill can be a huge help in making ends meet.
Consider the following factors when deciding where to allocate your surplus savings.
- Better long-term returns
- Liquidity is important if you need to pay for home repairs
- Keeping your mortgage can bring tax deductions
Paying down your mortgage
- Safe, guaranteed returns
- Paying off your mortgage improves cash flow
- If you’re planning to sell, it reduces the risk of getting underwater on the loan
Ready to get started? If you’ve decided to invest your surplus savings, click here to compare investment advisors who can help maximize your return on investment.
Struggling under the weight of monthly mortgage payments, and looking to spend your savings on advance loan payments? Consider refinancing your mortgage.