Wondering whether to pay off a mortgage or put the funds toward investments is a happy dilemma for some homeowners. The answer will depend on your financial situation, but let’s look at pros and cons of each along with a strategy that can allow you to combine the best of both worlds.
Paying Off a Mortgage vs Investing in the Market
Maybe you’ve socked away a nice savings. Or perhaps you inherited some money. If you’re trying to decide whether to put the money toward paying down your home mortgage loan or into the market, it helps to understand the mortgage payment process.
How Does a Mortgage Loan Work?
There are different mortgage types you likely considered when shopping for a mortgage, but in general, someone borrows money from a lender to buy a house at a certain interest rate and term length. As payments are regularly made (usually monthly), part of each payment goes toward the principal, lowering the balance. Early on in the life of your loan, the bulk of the payment will cover your interest charges. As the balance goes down, more of each payment typically goes toward the principal.
Recommended: Answers to Common Mortgage Questions
Components of a Mortgage Payment
You may hear the components of a mortgage payment summarized in an acronym: PITI. This stands for principal, interest, taxes, and insurance.
Principal
Initially, your principal is the amount of money you borrow. As you pay down your loan, the principal is the remaining (current) balance. When it comes to the mortgage loan payments themselves, the principal is the portion of the payment that goes toward the balance, reducing the amount. As noted above, as the balance goes down, more of your payment goes toward the principal and less to interest.
Interest
The interest is based on the interest rate charged on the loan’s principal, and these dollars go to the lender, serving as a key part of the cost of borrowing. As your loan balance goes down, less of your payment typically goes toward interest. Most mortgage loans have a fixed interest rate; others are variable, based on a certain financial index.
Move your cursor on the amortization chart of this mortgage calculator tool to see how principal and interest change over time.
Taxes and Insurance
A mortgage payment typically contains a month’s worth of property tax, which is based on the assessed value of the home and the tax rate where you live. A payment also may include a month’s worth of homeowners insurance and, if applicable, mortgage insurance that protects the lender in case of default.
Investment Gains vs Loan Interest Saved
At a high level, to determine which strategy can have the biggest positive financial impact, you can compare what investment gains you’ve had (or estimate future gains) and compare that to how much interest you would save when paying down your mortgage more quickly.
Pros and Cons of Paying Off Your Mortgage Early
Pros include the following:
• You won’t have a mortgage payment anymore, which frees up money for other purposes: investing, paying for a child’s college expenses or wedding, and so forth.
• You no longer have to worry about having the funds to make your payment. This can be especially helpful if unexpected expenses arise.
• Typically, paying off your mortgage early will lower the amount of money that you pay in total interest — which means that you’ll pay less for your home overall.
• Paying off a mortgage early gives you a guaranteed financial return, while there is always risk involved in putting money into the market.
• If you need to borrow against the home in the future, none of the proceeds will be needed to pay off a current mortgage.
Cons include the following:
• If the current stock market return rate is pretty good and your mortgage rate is low, paying off your mortgage early could have a lower rate of return than being in the market.
• Your credit score could drop a bit because you’ll no longer have a mortgage in your mix of open types of credit.
• Focusing on rapidly paying off a mortgage may cause someone to drain their emergency savings fund, something that’s not typically recommended.
• Although uncommon now, some lenders charge a prepayment penalty for early mortgage payoffs. When this clause exists, it’s for the first three years of a mortgage. Check your mortgage note for specifics, or ask your lender or loan servicer.
• When you no longer have a mortgage, you no longer qualify for the mortgage interest tax deduction.
Pros and Cons of Investing
Pros include the following:
• Many times, when you buy shares of stock, you can get a good return on your investment in the long term. To get a sense of current returns, you can check the 10-year annualized return for the S&P 500.
• If you’re in a workplace retirement plan, like a 401(k), your employer may match your contributions up to a certain amount.
• Stocks are liquid assets, which means that you can buy and sell a portion of your portfolio at any time. You can’t really do that with a house. Plus, some stocks will provide you with dividends that you can reinvest or spend.
Cons include the following:
• You could lose your entire investment in the stock market, including the initial investment. If you’re a common stockholder, you get paid last if a company defaults.
• If you’re managing your own portfolio, you’ll need to invest time into investigating stocks, deciding what to buy and sell, and otherwise monitoring the stock market.
• If you sell stocks at a profit, you’ll usually need to pay capital gains tax (although this can be offset if you also have some losses).
• While investing, you’ll still need to make your mortgage payment (until the home is paid off).
• Depending on your personality type, watching a stock that you own decline in value can be an emotional experience, and for some people, keeping tabs on their portfolio can be stressful. check that portfolio.
Evaluating Your Financial Situation
You may feel the urge to pay down your mortgage or make investments, but whether you should actually do so requires calculating two key figures: your net worth and your debt-to-income ratio (DTI). To determine your net worth, add up all of your assets (what you own) and subtract your liabilities (what you owe). Assets include your home’s value, vehicles, bank accounts, investments, and cash. Do not include your income. Liabilities are your mortgage, car, personal and student loans, credit card balances, and so forth. If you owe more than you own, the time may not be right to make a big investment — in either your home equity or the stock market — even if you are paying all your bills on time.
For the second metric — your DTI — add up your gross (pre-tax) monthly income as well as your monthly debt obligations, such as your mortgage, car payment, and other loan payments. Divide your total monthly debt by your total gross monthly income, and the resulting ratio (say, 0.30 or 30%) is your DTI. A lower DTI (say, under 30% or even 20%) indicates more cash flow to either put toward your mortgage or to invest.
Factors You Should Consider
Timing The earlier you can begin to apply extra payments to pay down your mortgage principal, the more you’ll benefit, because a lower principal will reduce interest over the life of the loan. That said, the earlier you can begin to invest, the longer you’ll have for your investments to build in value. Plus, because of compound interest, each dollar that you invest today will be worth more than a dollar that you would invest years from now.
Taxes Starting in 2018 and set to last through 2025, the federal government nearly doubled the amount of the standard deduction that taxpayers can claim. This means that far fewer people itemize their deductions, which in turn means that the mortgage interest deduction isn’t used by those taxpayers when they file their income taxes.
Home values If real estate values are dropping in your area, paying down your mortgage can help you from going underwater (owing more on the home than what it’s currently worth). Being underwater can make it more difficult to sell or refinance the home. Struggling homeowners can look for mortgage relief programs.
Recommended: Home Loan Help Center
Other Considerations
To this point, the post has largely focused on this question: Is it better to pay off a mortgage or invest? Let’s take a step back and look at issues to consider before doing either. First, do you have an emergency savings fund that could cover your monthly expenses for three to six months? If not, that’s a priority often recommended by experts.
Plus, if you have high-interest debt, such as credit card balances that you don’t pay off each month, it’s usually better to pay that off before either paying extra on your mortgage or investing.
Another strategy: You could consider refinancing your mortgage to a lower rate to lower your mortgage payment. Then, when you put extra money toward the balance, even more would go to the principal than when the interest rate was higher.
Deciding What’s Best for You
Pay off your house or invest? Perhaps the information provided has already allowed you to make a decision. However, there’s one more strategy to consider: doing both.
Best of Both Worlds: Funding Both at Once
Instead of simply considering two options, pay off mortgage or invest, another possibility meets in the middle: making additional contributions to your investments while also paying extra on your mortgage principal. This is most effective early on, but adds value through the life of the mortgage.
If the stock market becomes especially volatile or is significantly heading downward, you could focus on the mortgage paydown during that time period.
The Takeaway
Whether you choose to pay off a mortgage or invest depends on your financial situation and priorities. Each choice has pros and cons, but a best-of-both-worlds strategy is to do both.
Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.
FAQ
Is there any disadvantage to paying off your mortgage early?
If a mortgage note includes a prepayment penalty, this can cost you money. Other disadvantages are loss of the mortgage interest tax deduction and a potential drop in credit scores. Plus, it may be more advantageous to invest those dollars instead.
Should I pay off my mortgage or save money?
It depends, but you definitely want to make sure you save up three to six months of expenses in an emergency fund before you pay down your mortgage.
Is it better to pay off my mortgage or invest for retirement?
Ideally, you can do both. If that’s not financially possible right now, weigh the interest rate on your loan and whether or not you benefit from the mortgage interest deduction on your tax return vs. what you think you might be able to earn on investments in the market. This will help you make your decision.
Should I invest when I have a mortgage and other debts?
If “other debts” include high-interest debt, such as credit cards that aren’t paid off in full each month, it typically makes sense to prioritize the payoff of that debt over investing. If your employer offers a retirement plan with a company match, you might want to prioritize that investment in order to capture the match. And if you are paying your current debts comfortably, investing more widely could be the right move.
Photo credit: iStock/burcu saritas
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