Is it smarter to pay off your mortgage or invest your extra cash?
Should You Pay Off Your Mortgage or Invest?
Owning a home outright is a dream that many Americans share. Having
a mortgage can be a huge burden, and paying it off may be the first item
on your financial to-do list. But competing with the desire to own your
home free and clear is your need to invest for retirement, your child's
college education, or some other goal. Putting extra cash toward one
of these goals may mean sacrificing another. So how do you choose?
Evaluating the opportunity cost
Deciding between prepaying your mortgage and investing your extra cash isn't
easy, because each option has advantages and disadvantages. But you can start
by weighing what you'll gain financially by choosing one option against what
you'll give up. In economic terms, this is known as evaluating the opportunity
Here's an example. Let's assume that you have a $300,000 balance and 20 years
remaining on your 30-year mortgage, and you're paying 6.25% interest. If you
were to put an extra $400 toward your mortgage each month, you would save approximately
$62,000 in interest, and pay off your loan almost 6 years early.
By making extra payments and saving all of that interest, you'll clearly be gaining
a lot of financial ground. But before you opt to prepay your mortgage, you still
have to consider what you might be giving up by doing so--the opportunity to
potentially profit even more from investing.
To determine if you would come out ahead if you invested your extra cash, start
by looking at the after-tax rate of return you can expect from prepaying your
mortgage. If you plan on itemizing deductions on your tax returns, this is generally
less than the interest rate you're paying on your
mortgage, once you take into account any tax deduction you receive for mortgage
interest. Once you've calculated that figure, compare it to the after-tax return
you could receive by investing your extra cash. Could you receive a higher after-tax rate of return if you invested your money instead of prepaying your mortgage?
Keep in mind that the rate of return you'll receive is directly related to the
investments you choose. All investing involves risk, including the possible loss of principal, and there can be no assurance that any investment strategy will be successful. Investments with the potential for higher returns may
expose you to more risk, so take this into account when making your decision.
Other points to consider
While evaluating the opportunity cost is important, you'll also need to weigh
many other factors. The following list of questions may help you decide which
option is best for you.
- What's your mortgage interest rate? The lower the rate on your mortgage,
the greater the potential to receive a better return through investing.
- Does your mortgage have a prepayment penalty? Most mortgages don't,
but check before making extra payments.
- How long do you plan to stay in your home? The main benefit of prepaying
your mortgage is the amount of interest you save over the long term;
if you plan to move soon, there's less value in putting more money
toward your mortgage.
- Will you have the discipline to invest your extra cash rather than
spend it? If not, you might be better off making extra mortgage payments.
- Do you have an emergency account to cover unexpected expenses? It
doesn't make sense to make extra mortgage payments now if you'll be
forced to borrow money at a higher interest rate later. And keep in
mind that if your financial circumstances change--if you lose your
job or suffer a disability, for example--you may have more trouble
borrowing against your home equity.
- How comfortable are you with debt? If you worry endlessly about it,
give the emotional benefits of paying off your mortgage extra consideration.
- Are you saddled with high balances on credit cards or personal loans?
If so, it's often better to pay off those debts first. The interest
rate on consumer debt isn't tax deductible, and is often far higher
than either your mortgage interest rate or the rate of return you're
likely to receive on your investments.
- Are you currently paying mortgage insurance? If you are, putting
extra toward your mortgage until you've gained at least 20% equity
in your home may make sense.
- How will prepaying your mortgage affect your overall tax situation?
For example, prepaying your mortgage (thus reducing your mortgage interest)
could affect your ability to itemize deductions (this is especially
true in the early years of your mortgage, when you're likely to be
paying more in interest). It's important to note that due to recent tax law changes, specifically the increase in the standard deduction, many individuals aren't itemizing their taxes and are no longer taking advantage of the mortgage interest deduction.
- Have you saved enough for retirement? If you haven't, consider contributing
the maximum allowable each year to tax-advantaged retirement accounts
before prepaying your mortgage. This is especially important if you
are receiving a generous employer match. For example, if you save 6%
of your income, an employer match of 50% of what you contribute (i.e.,
3% of your income) could potentially add thousands of extra dollars
to your retirement account each year. Prepaying your mortgage may not
be the savviest financial move if it means forgoing that match or shortchanging
your retirement fund.
- How much time do you have before you reach retirement or until your
children go off to college? The longer your timeframe, the more time
you have to potentially grow your money by investing. Alternatively,
if paying off your mortgage before reaching a financial goal will make
you feel much more secure, factor that into your decision.
The middle ground
If you need to invest for an important goal, but you also want the satisfaction
of paying down your mortgage, there's no reason you can't do both. It's
as simple as allocating part of your available cash toward one goal,
and putting the rest toward the other. Even small adjustments can make
a difference. For example, you could potentially shave years off your
mortgage by consistently making biweekly, instead of monthly, mortgage
payments, or by putting any year-end bonuses or tax refunds toward your
And remember, no matter what you decide now, you can always reprioritize
your goals later to keep up with changes to your circumstances, market
conditions, and interest rates.