“The longer it will take you to pay off your mortgage, the more the math favor investing over paying off the mortgage.”
One of the longest-running debates in personal finance is the question of whether to use extra money to pay off your mortgage or invest.
3 Things to do Before Considering Either Option
Before you get aggressive on investing or paying off your mortgage you need to ensure your financial house is in order. Before choosing either option, you should have the following.
3. Already be allocating at least 15% of your income to retirement savings
Once you have the financial essentials on lockdown, it’s time to decide which is better investing or paying off the mortgage.
Running the Numbers
Let’s say you have a $500,000 mortgage with an interest rate of 4% that is set to be paid off in 30 years.
Your mortgage payment would be $2,378 per month.
Over that 30 years, you would pay $856,000, of which $500,000 would be principal payments and $356,000 would be interest payments.
If you wanted to aggressively pay the mortgage off in 10 years, you would pay $607,000, of which $500,00 would be principal payments and $107,000 would be interest payments. This would save you $249,000 in interest payments.
To pay off the mortgage in 10 years rather than 30 years would require you to increase your monthly payment to $5,055 an increase of $2,677 per month.
How much money would you expect to have after 30 years by investing $2,677 per month? Assuming a 6% annual return, you would have approximately $2.69 million. Clearly a better-expected return than paying off the mortgage quicker.
I am sure the Dave Ramsey fans are thinking wait! What if you pay the mortgage off in 10 years and then “go nuts” on investing the once the mortgage payment is completely gone?
It’s a completely valid point. The reason you pay the mortgage off is to be rid of the mortgage payment. Once you’ve paid off the mortgage you will have an extra $5,055 each month. What happens if you dedicate that new cash flow to investing?
Let’s run those numbers
If after you pay off the mortgage in 10 years, you invest the entire $5,055 (your previous mortgage payment) for the next 20 years you would have $2.34 million. Add in the $249,000 saved from paying off the mortgage earlier and you have $2,589,000.
While this makes the math much closer, you still have more expected wealth after 30 years by investing.
Important Factors to Consider
Paying off your mortgage in 10 years rather than 30 years is extremely aggressive and the math still favors investing. The math would be even more favorable towards investing in a scenario where the mortgage was paid off in 15 or 20 years rather than 10 years.
The reason? Compound interest.
- If you go the investing route, you get 30 years worth of compound interest on your first monthly investment installment.
- If you pay the mortgage off in 10 years and then invest, you only get 20 years of compounding.
- If you pay the mortgage off in 15 years and then invest, you only get 15 years of compounding
- If you pay the mortgage off in 20 years and then invest, you only get 10 years of compounding.
The longer it will take you to pay off your mortgage, the more the math will favor investing over paying off the mortgage.
Your Mortgage Rate Makes a Huge Difference
I used a mortgage rate of 4% in this example. At this rate, the math is close when it comes to paying your mortgage off in 10 years compared to investing.
- If your mortgage rate is locked in at less than 4%, the math would strongly favor investing.
- If your mortgage rate is higher than 4%, the math would begin to favor paying off the mortgage.
You Need to Account for Risk
Paying off your mortgage provides you with a guaranteed return, which is lower than the expected return on investing. Note the word “expected” because it is doing a lot of heavy lifting in that sentence.
Investing involves risk and there is no guarantee on your returns. Over the next 30 years, a balanced investment portfolio might provide an average rate of return greater than 6% or less than 6%.
If your risk tolerance and level of comfort with investing are low, you may be better off paying the mortgage off before investing. While it may not be the optimal choice according to the math if going paying off the mortgage will help you sleep better at night then numbers be damned!
If your risk tolerance and level of comfort with investing are high, then you will probably enjoy going the investment route and watching your net worth grow over time.
So, which is better, paying off the mortgage or investing? It should be clear by now that the answer is, “it depends”. It depends on all the factors just discussed.
It’s less important which option you choose and more important that you find a way to increase your savings rate. How much money you save will be the determining factor of how much wealth you build.
Making of a Millionaire is pleased to offer a FREE personal finance course “Aligning Your Money With Your Values”
Aligning Your Money with Your Values
The Shockingly Simple Guide to Transforming Your Relationship with Money in One Day
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.