Many homeowners with extra income have a decision to make. Do you pay off the mortgage early or invest your extra cash? With mortgage rates at near historic lows, this question is being asked by more homeowners than you realize. My wife and I were in the same boat in early 2018. Either decision has its own advantages.
The better option for you depends on several factors including:
- Your Current Income
- Access to Liquid Cash
- Mortgage Interest Rate
- Potential Investment Returns
Personally, I paid off my mortgage early. I’ll explain my reasons why later, but your situation might be different than mine. For you, it can be better to invest your extra income and continue to make your minimum monthly mortgage payment. Several of my friends and families invest their extra income. Either choice helps you gain financial security in different ways.
A Quick Invest to Debt Payoff Comparison
Before we look at the advantages of each option, let’s look at some numbers.
Let’s assume you have a $200,000 mortgage with a fixed interest rate of 4.5% and a 30-year term. Your monthly payment is already $1,013 plus your monthly escrow for taxes and insurance. You’ve already made five years of minimum monthly payments and your financial situation has improved. Now, you have $100 extra to invest or put toward your home loan.
What Happens If You Invest $100 a Month for 25 Years?
If you invest $100 every month for the remaining 25 years, you will invest $30,000. Your investments are most valuable in a tax-deferred retirement account and provide the best income potential. If you earn a 7% annual rate of return, your $30,000 investment will be worth $79,000 in 25 years. You earn $49,000 in passive income.
What Happens If You Make an Extra $100 Monthly Payment?
When you make an extra $100 monthly loan payment instead, you pay $20,806 less in interest. And, your mortgage is paid off four years sooner.
To “catch-up” on investing, let’s say you invest $1,100 (your $1,000 monthly payment plus the $100 extra payment) each month for the next four years. Over these remaining four years, you will invest $52,800. With a 7% rate of return, you will earn $9,448 in passive income.
If you only decide to invest the extra $100 each month for the remaining four years, you will invest $4,800. And, you will earn $800 in interest.
Which Option is Better?
Strictly looking at the numbers, you have an extra $28,000 if you invest with this example. That can be one year one less year you have to work to save for retirement.
But if you pay off your mortgage early and substitute the $1,100 mortgage payment for investing, you close the gap. You still make more money investing the extra $100 every month for 25 years, but it’s only $18,000 more.
Some people choose to invest their extra income because they earn more than they save by paying off the mortgage early. Others prefer to make extra mortgage payments when the interest rate is close to the potential investment yield.
But, you need to look beyond the interest rates and investment returns when you make your decision.
Rule #1: Pay Off High-Interest Debt First
If you still have credit card debt or personal loans with an interest rate above 10%, pay these loans off first. No sound investment can consistently produce these returns.
And, you should have an emergency fund of at least three to six months of living expenses.
After you accomplish these two goals, you can decide to pay off your mortgage or invest.
When to Invest Your Extra Income
Investing your extra income is probably the more popular option right now. A general suggestion is that if your investments can earn 7% or more, your gains exceed the mortgage interest.
As much as you hate being in debt, you can be wealthier long-term. Investing your extra cash means you “get paid to stay in debt.” This is only possible because mortgage rates are lower than most potential investment returns.
These are a few reasons why you should invest your extra income instead of paying off debt.
Potential Market Returns Exceed Mortgage Interest Savings
The historical average return of the S&P 500 is 7%. This number includes dividend returns and stock price appreciation. With 30-year mortgage interest rates at 4.65% or lower as of September 2018, you can earn more money investing. If your mortgage is several years old, it’s possible that your rate is around 3.25%. When that’s the case, the incentive to invest is even higher.
If you’re just going to keep your money in bank CDs or money market accounts that yield 2% or less, you’re better off paying off your mortgage.
Tip: Use this investment calculator to see how much you can earn by investing your extra income. Enter the extra income for the remaining months on your mortgage loan.
Earn Compound Interest
Besides the higher potential yield, reinvesting your dividends lets you earn compound interest. In other words, you “earn interest on interest.” Let’s take a $1,000 investment that earns 2% per year. After your first year, you earn $20 in dividend income. For the second year, you earn $20.40 on the original balance. Since you’re buying more shares each month, your dividend income increases too.
You Want Instant Access to Your Cash
Another advantage of investing is that you have instant access to your cash. If necessary, you can buy today and sell tomorrow. With a house, you must sell the house to access your money.
If you invest your extra income in a Roth IRA or Roth 401k, your earnings grow tax-free! With Traditional IRA and 401k, your contributions lower your taxable income this year. And, you don’t pay any taxes until you make a withdrawal.
I once saw the quote, “You can’t eat your house.” Sure, you don’t plan on selling your investments until a few years down the road. But, it’s easier to sell an investment than having to borrow money because you don’t have time to sell your house and find a new place to live.
When You Should Pay Off the Mortgage
If you’re still paying private mortgage insurance (PMI), make extra payments to waive this extra monthly loan charge. Once you no longer pay PMI, you can decide to either invest or continue making extra payments to pay off your house early.
Your mortgage should be the last loan you make extra payments on if you also have auto loans or student loans with a higher interest rate and shorter loan term. Once you pay off your home loan, you no longer have any monthly payments. If you’re like the average American with a $1,100 monthly payment, that’s an extra $13,200 of disposable income every year.
I like to think of it as an instant $13,200 pay raise. And, you don’t have to work a second job to earn it!
Peace of Mind
Being debt-free gives you the benefit of having financial peace of mind. Not having to make a monthly loan payment can be a huge blessing if you earn a small income or have other large expenses coming up that you need to save for.
If you lose your job or have an unexpected, large expense that’s bigger than your emergency fund, you don’t have to struggle to pay the mortgage and your other bills.
But, to have true peace of mind, you should have a minimum 6-month emergency fund and you’re not forced to sell your house or borrow money to pay the bills.
You Want to Avoid Stock Market Volatility
Some people like dealing with absolute numbers. Even though history shows that your investments should earn more than you save in interest payments, it’s not guaranteed. If the broad market produces flat or negative returns for a decade, you might have been better off paying off your mortgage early.
The S&P 500 has 7% annual average returns since 1928, but there have been several recessions during this span. Nobody can time the market, but you can accurately predict how much interest you save by paying off your mortgage early.
In a matter of seconds, you can plug your mortgage stats into a mortgage payoff calculator. You know exactly how much money you save if you repay your loan several years early.
Why I Paid Off My House Early
Now that we’ve covered the advantages of both options, I’ll briefly share my story.
Initially, I was in the invest your extra income camp. That is, until I switched careers and became self-employed. We also took a 50% pay cut in the process.
Today we both earn a variable income, but we have enough access to liquid cash that we don’t have to sell our house if a financial emergency happens. We’re also frugal by nature and aren’t going to borrow money and go back into debt for a frivolous purchase. While we’re sacrificing a potentially higher long-term net worth, we don’t struggle to pay the monthly bills.
Owning our house loan-free is very important to us, because we can now save our money for future investments and expenses without borrowing money. Having a mortgage for another decade wasn’t worth the risk with our entrepreneurial ambitions.
Personal finance is personal. You need to choose the option that’s better for you. But, you should know why you’re deciding to invest more or get out of debt sooner.
What’s the best option for you? Paying off your mortgage or investing your extra income?