Is it Better to Invest or Pay off My Mortgage? (Everything You Need to Know)

 If you've received a large cash windfall or saved a significant amount of money over the years, it may be tempting to pay off your mortgage loan early. Whether or not paying off the mortgage early is a good idea depends on the borrower's financial situation, the interest rate on the loan, and how close they are to retirement.

Is it Better to Invest or Pay off My Mortgage? (Everything You Need to Know)

Another factor to consider is whether to invest the money or pay down the mortgage. This article compares the interest cost of paying off a mortgage 10 years early against the cost of investing that money in the market based on various investment returns.

If you've gotten a large financial windfall or saved a significant amount of money over the years, it may be tempting to pay off your home debt early.

The borrower's financial status, the loan's interest rate, and how near they are to retirement all influence whether paying off the mortgage early is desirable.

Although paying off a mortgage provides advantages, consider other aspects such as mortgage interest deductibility and cheap lending rates.

Investing that money may yield better returns than the loan's interest rate, but markets also carry the danger of loss.

The Process of Obtaining a Mortgage Loan

A mortgage is a loan made to a borrower to help them acquire a home or property. The borrower signs the loan paperwork and agrees to repay the mortgage lender in monthly instalments until the loan is paid off after all of the legal documents are completed during the mortgage closing.

The loan period is typically 15-30 years. In exchange, the financial institution pays the seller the entire purchase price of the house and charges the borrower interest on the loan amount.

Interest and principal

Mortgage payments consist of two parts: interest on the loan and principle, which is used to pay down the total outstanding sum.

For example, a $1,000 monthly payment can include $300 for interest and $700 for principal reduction. Mortgage loan interest rates might change based on the state of the economy and the borrower's creditworthiness.

Schedule of Amortization

An amortization schedule is the loan payment schedule over a 30-year period. A fixed-rate mortgage loan's payments are largely made up of interest in the early years. In the following years, a higher amount of the loan payment is used for principal reduction.

The following table depicts five loan payments at various intervals for a 30-year mortgage with a starting amount of $200,000 and a fixed interest rate of 3.5 percent.

The table above illustrates that during the first ten years, a higher amount of the fixed monthly payment was used to pay interest. However, as time passed, the ratio of the monthly payment allocated to interest versus principle shifted.

In the 20th year, for example, $611.45 went toward principal and $286.64 went toward interest. All except $2.61 of the previous payment went toward paying off the principle sum.

Because the loan sum is greater in the early years and lowers in the later years, the share of the loan payment allocated to principal and interest changes with time. This makes sense because the interest rate is greater early on because the loan sum is larger.

As the monthly payments lower the outstanding loan, less interest is owed, resulting in a lesser amount of each payment being applied to interest and more to principle.

Mortgage Paying Off Early

Some homeowners opt to pay off their mortgage early, and the rewards vary based on the individual's financial situation.

Retirees, for example, may seek to minimize or erase their debt because they no longer get an income from employment. In other circumstances, consumers may wish to reduce their monthly cash withdrawals by refinancing their mortgage.

Examples of Mortgage Loans

Assume a borrower gets a $120,000 bequest and has 10 years left on the mortgage. The initial mortgage was for $200,000 with a 30-year fixed interest rate.

The chart below illustrates how much it would cost to pay off the loan ten years early and how much interest would be saved at three different loan rates: 3.5 percent, 4.5 percent, and 5.5 percent.

As seen in the table above, the higher the interest rate, the greater the amount remaining on the loan after 10 years.

Interest Saved by Paying Off Your Mortgage

The entire interest cost for the 30-year loan with the 3.5 percent interest rate would be $123,312, and the borrower would save $20,270 by paying it off 10 years early.

Although saving over $20,000 in interest is considerable, the amount saved represents just 17% of the total interest expense for the 30-year loan. In other words, $103,042 in interest has already been paid in the first 20 years of the loan ($123,312 - $20,270), accounting for 83 percent of the total interest paid during the loan's life.

As previously stated, the structure of a mortgage's amortization schedule causes the majority of the interest to be paid in the early years.

Investing in the Stock Market

If a homeowner is thinking about paying off their mortgage early, it's worth thinking about whether part or all of the cash might be better served investing in the financial markets. For the final ten years of the loan, the rate of return on investment may exceed the rate of return on the mortgage.

Is it Better to Invest or Pay off My Mortgage? (Everything You Need to Know)

In other words, the opportunity cost (the interest that might have been generated in the market) should be addressed. However, numerous aspects must be considered while considering an investment, including the projected return and the risk involved.

The table below illustrates how much money you might make on $100,000 if you invested it for ten years at four different average rates of return: 2%, 5%, 7%, and 10%.

• The aforementioned investment profits were compounded, which means that interest was generated on interest and no money was taken over the 10-year period.

Loan Interest Saved vs. Investment Gains

If a homeowner chose to invest $100,000 rather than pay off their mortgage in ten years, they would earn $22,019 based on a 2% average rate of return. In other words, there would be no discernible difference between investing the money and paying off the 3.5 percent mortgage (based on the $20,270 in interest savings from the previous loan table).

However, if the average rate of return over the ten years was 5%, the homeowner would receive $62,889, which is more money than the interest saved in all three previous loan situations, whether the loan rate was 3.5 percent ($20,270), 4.5 percent ($28,411), or 5.5 percent ($37,618).

Even with the 5.5 percent loan rate, the borrower would earn more than double the interest saved by paying off the loan early with a 10-year rate of return of 7% or 10%.

The Compounding Effect

The strength of compounding is one of the reasons for such a disparity between investment earnings and interest savings from paying off the loan early. 

If the $100,000 investment is not withdrawn throughout the ten-year period, the money received each year is reinvested, resulting in interest on interest, which can compound investment benefits.

Tolerance for Risk

Before investing money in the market, investors must first evaluate their risk tolerance or the amount of money they are ready to risk in order to make a profit.

Different Investments' Risks

There are different sorts of investments to pick from, each with its own set of risks. Treasury bonds, for example, are considered low-risk investments since they are guaranteed by the US government if kept until their expiry date or maturity.

However, equities or stock investments include a larger risk of price changes, known as volatility, which can result in investor losses.

Returning to our example, if the homeowner decides to invest their money in the market rather than pay off the mortgage 10 years early, some or all of that money may be lost. As a consequence, even if the investment loses money, the homeowner must still repay 10 years of loan payments.

Identifying Risk Tolerance

A person's risk tolerance is frequently decided by their age, the period of time before the money is required, and their financial ambitions. Retirees, for example, maybe risk-averse since they no longer generate an income from employment.

Younger people in their 20s and 30s, on the other hand, have a longer time horizon, which implies their portfolio has more time to recover from market losses. 

As a result, a younger individual might allocate a larger portion of their portfolio to higher-risk assets like stocks.

The Double-Edged Sword of the Market

Although the stock market may bring substantial gains, it also carries the danger of substantial losses. In other words, while increasing risk might amplify investment returns, it can also lead to increased losses, implying that market risk is a double-edged sword.

In our previous example, a 10% investment gain is not an easy aim to reach, especially if fees, taxes, and inflation are taken into account.

As a result, investors should set reasonable goals for their earnings in the market.

Particular Considerations

Before opting to pay off a loan early, evaluate the interest rate, the remaining balance, and the amount of money saved. Borrowers can use a mortgage loan calculator to calculate their loan's amortization plan.

It should also be explored how that money may be used other than to pay down the mortgage. Some of the money, for example, may be used to start an emergency fund, prepare for retirement, or pay off high-interest credit card debt.

It's also worth noting that for many homeowners, mortgage interest is tax-deductible, which means that the interest paid decreases your taxable income at the end of the year. 

A financial planner and a tax counsel should be contacted before determining whether to pay off your mortgage early or invest the money.

• Much is determined by the nature of the mortgage and your other assets. Pay it off if it is expensive debt (with a high-interest rate) and you already have some liquid assets, such as an emergency fund. Maintaining the mortgage and investing may be a possibility if the debt is affordable (low-interest rate) and you have an excellent track record of sticking to a budget.
• Some people's reaction is to get rid of all debt, but you should always have sufficient finances on hand to weather a financial storm. So the ideal course of action is typically somewhere in the middle: if you need some liquidity or cash, pay down a substantial portion of your debt and save the remainder for emergencies and investments. Just make sure you're honest about how much you're going to spend and how much risk you're willing to accept.