If you’re reading this article, you’re probably facing a tough decision, pay off your mortgage or invest. These are two huge financial goals, both of which are high priorities. You probably have a great financial mindset if you have extra income and want to accelerate those goals rather than splurge.
Spending extra money on these goals can limit your risk. For example, having extra money for retirement can give you options. If you retire with an extra cushion and things go wrong in retirement, you could still be fine.
Generally, your mortgage payment is your biggest expense. If you are able to pay off your mortgage, it will be much easier for you to survive a job loss or other loss of income. Plus, paying off your mortgage before retirement will reduce your retirement income needs and your money will last longer.
Focusing your extra income on either goal has its advantages. Plus, everyone has their unique financial situation, which will play into your decision. These items include retirement savings, the length of your mortgage, and how long you have until retirement.
So where do we go from here? Is it better to pay off your mortgage or invest?
A case for investing
The biggest benefit of investing is the compounding of returns. Compound returns are the rate at which returns on your investments accumulate over time. Each year that your investment account grows, more money is available to create returns for the following year.
Over a long period of time, compounding returns can significantly affect your investment accounts. In fact, Albert Einstein called compound interest the eighth wonder of the world.
Let’s take an example. Let’s say you have $100,000 in an account that earns 7% every year. After the first year, you’ll have $107,000 ($100,000 to start with and $7,000 back). So the next year you will start with $107,000. At the end of the second year, you will have $114,490 ($107,000 to start with and $7,490 back).
Since your account started out with more money in year two, the same rate of return earned you $490 more in year two. This amount may not seem like much, but it makes a big difference in the long run. For example, after 30 years, your account will have $761,226. In the 31st year, your account will earn $53,286 ($761,226 x 7%).
The example shows that time is an important factor in compounding returns. In other words, the younger you are, the more you may want to invest rather than paying off your mortgage.
It is important to understand that you are not only investing until the day you retire. You can invest for the rest of your life.
Arguments in favor of paying off your mortgage
Although additional mortgage payments share the characteristics of compound returns, they are not quite the same thing. Because you will eventually pay off your mortgage, the time you have to take advantage of mortgage prepayments is limited to the term of the loan.
Although limited by the 30-year life of the loan, time also plays an important role in the total amount of interest you will pay. For example, let’s say you have a $100,000 30-year fixed rate mortgage with an interest rate of 5%. Over the 30-year life of the mortgage, you will pay $93,255 in interest to the bank.
The interest you pay on future mortgage payments is based on the balance at the time of payment. So if you paid $100 more per month on your mortgage from the start, you would only pay $62,676 in interest. Plus, you’ll pay off your mortgage 104 months earlier.
On the other hand, let’s say you’ve already paid the mortgage for 20 years and you have ten years left. At that time, your mortgage balance will be reduced to approximately $9,510. If you start paying $100 more per month, you’ll only save about $1,500 in interest.
As with compound investment returns, the sooner you make additional payments, the better off you are.
Paying off a Mortgage or Investing: Special Considerations
Some people may be somewhere in the middle. Although investing your extra money is usually the best solution, you may already have enough savings for your retirement. If so, it may be a good idea to put your extra money towards your mortgage.
For example, if you are comfortable with your retirement savings, you may be able to fully pay off your mortgage before retirement. By doing this, you can eliminate one of your biggest monthly expenses. Therefore, your retirement income will go further.
If you’re not sure where you stand with retirement savings, it might be a good idea to contact your financial planner. An advisor can set up a retirement plan for you.
Mortgage rates have been very low in recent years. If you haven’t refinanced and are struggling with a high mortgage interest rate, it may also be a good idea to pay off your mortgage.
BJ Cook is a lifelong stock market nerd. He has held several positions in the world of equity research and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him seeking new ideas of investment. Outside of the investment community, BJ is a die-hard Cubs fan.