When it comes to optimizing your money, one hotly debated topic is whether you should use your available income to pay off your mortgage faster or invest the money for the greatest return. The future is unknown, but there are emotional and logical arguments to be made for investing or paying off the mortgage first.
Planning for financial independence means you consider even more factors to find the right answers for yourself. To invest or pay off the mortgage, is the question. Let's take a look at the arguments so you can make an educated decision about which is better for you. After all, personal finance is personal and this is a decision you’ll have to make for yourself.
The Arguments for Paying Off the Mortgage
There’s something special about being completely debt free including the mortgage. When you’re debt free, not a penny of your income should go toward making interest payments. You no longer worry about setting aside a portion of your monthly income to pay for your housing. While you do still pay for things like repairs, maintenance, insurance and taxes, these costs won’t be nearly as big as the principal and interest on a mortgage payment, in most cases.
When you’re no longer making principal and interest payments for a mortgage each month, chances are your monthly expenses will decrease by quite a bit. This also reduces the amount of money you’d use in calculations to see how much money you need to set aside for FI like the 4% rule. If you have carefully planned to pay off your mortgage before you reach FI, the reduction in expenses due to no longer having a mortgage payment could play a big role in your plans.
While others would rather invest money to potentially earn a higher return, those that decide to pay their mortgage off have one major fact on their side. Paying down a mortgage gives you a certain return on your money. If you make extra principal payments on your mortgage, you don’t pay interest on that money you no longer owe. The certain return on the money you put into your mortgage will be the interest rate of your mortgage. Of course, this assumes your home value stays constant or is increasing. If the value of your home is decreasing, this may not hold true.
Emotionally, paying down your mortgage may make more sense, too. While investing to reach FI definitely speeds up the process rather than just putting money in a savings account, sometimes it’s harder to get excited about building up an investment account than it is to get excited about paying down a mortgage.
When my wife and I were paying down over $80,000 of student loan debt, we did everything we could to put a few extra dollars toward paying off that debt. I imagine there is a similar feeling when someone is trying to pay off their mortgage quickly. That same intensity may be more difficult to achieve when it comes to investing, resulting in putting more money toward paying down the mortgage than you would invest.
The Arguments for Investing
While paying off the mortgage may be the emotional option, investing is often seen as the logical option to optimize your money. Mortgage rates have recently been at all-time lows. Mortgage rates of under 5% make it easy to see how investing rather than paying down the mortgage could result in a higher return for your money. If your average rate of return on your investments is at least 8%, you have quite a bit of wiggle room above the 5% or lower rate you’re probably paying on your mortgage.
Another reason why investing is the logical answer to the debate is the fact that the principal and interest portion of a fixed rate mortgage will remain the same each year as time goes on. So, you can use future dollars that are worth less than today’s dollars, due to inflation, to pay off your mortgage. You don’t have to lower your returns by the rate of inflation because your mortgage payment won’t be increasing with inflation like all of your other expenses will.
Here’s a quick chart that shows the difference in time it would take to pay off a mortgage between applying money toward a 5% interest rate mortgage versus investing that money at an 8% annual return. This also assumes a brand new 30 year fixed rate mortgage with a $200,000 starting balance.
|Extra Principal Payments||Years To Pay Off Mortgage With Prepayments||Years For Investments To Reach Mortgage Balance Remaining With No Prepayments|
|Extra $500||15 years 2 months||13 years 11 months|
|Extra $1,000||10 years 4 months||9 years 6 months|
|Extra $1,500||7 years 11 months||7 years 5 months|
Keep in mind, you may have to pay taxes on your investment earnings and dividends you may receive. On the other hand, you won’t be able to deduct your mortgage interest unless you’re one of the few people that will still itemize your deductions after the recent tax law change.
Ultimately, You Decide
What matters is you decide what is best for you and your situation. Keep open to adjusting as future needs and wants to become evident. Compare the numbers; the interest rates, the time intended in the home, and your risk tolerance. And remember, you can do a little of both if you’d like or change your mind and switch methods later on. The decision is in your hands.
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