If you manage your finances well, you might have extra cash after you’ve paid your monthly bills. What should you do with this extra money?
You could spend it, of course, or invest it for the future. But there’s another option to consider: Making additional mortgage payments toward your principal to pay off your mortgage loan early.
Many financial experts are divided about whether investing extra money or paying off a mortgage early is the best strategy.
Freedom and Flexibility
For some people, the financial freedom and flexibility that often come with being mortgage debt–free is a big factor to consider. Paying off your mortgage early could make household budgeting easier in retirement, or even enable you to retire earlier than you’ve planned.
For other mortgage holders, the decision is more about risk vs. return. There is little, if any, risk in prepaying a mortgage, because you already know what your rate of return will be: the interest rate on your mortgage.
For instance, if your mortgage interest rate is 4½%, this would be the return earned by every dollar that goes toward prepayment (not factoring in the mortgage interest deduction if you qualify).
However, if you invest the money, you’ll assume some market risk. The level of risk depends on the assets you invest in, but there’s no such thing as a risk-free investment.
What’s Your Interest Rate?
Your mortgage interest rate is another factor to consider. If your rate is relatively low, so is the return from prepaying your mortgage. The final decision for many people comes down to whether they believe they can earn a higher return investing the money than they would prepaying their mortgage.
If you have a 30-year fixed-rate mortgage with a 4½% interest rate, your investments would need to earn at least this much (without regard to a possible mortgage interest deduction) to justify not prepaying your mortgage. Since 1927, the inflation-adjusted average annualized return of the S&P 500, a leading U.S. stock market index, has been around 7%.
Clearly there’s the potential to outperform your mortgage interest rate by investing your money for the long term. Remember, though, that the stock market can be volatile in the short term and offers no guarantees.
No Simple Answer
There’s no single answer to the “invest or pay down the mortgage?” question. Talk to your CPA for more guidance on making the right decision for you.