- 6 minutes
Deciding Whether to Invest or Prepay Your Mortgage
Far from comparisons with the Joneses and their agenda, deciding how to allocate your personal assets is fundamentally subjective. Your current financial status and anticipated monetary needs, along with practical considerations and your emotional wellbeing must all be factored in. Weighty though it is, deciding in favor of a quicker mortgage payoff vs. investing—or vice versa—needn’t leave you floundering: not when solid financial advice is at the ready. Let’s get equipped to make a concrete, well-informed decision, and find a viable path toward financial progress.
THE DREAM IS SUBJECTIVE
The housing market’s recent history is proof positive that while owning a home is the quintessential “American dream,” burdensome mortgage payments can quickly overwhelm. Even if your payment is doable, the thought of carrying heavy debt over a seemingly vast expanse of time may turn your head. So paying down your mortgage and owning your home outright may be high-priority. However, competing goals, such as investing for retirement or saving for education may cloud the picture. Obviously, applying surplus funds toward various financial endeavors spells sacrifice. Pros and cons must be weighed, and goals analyzed.
WHAT COST FOR OPPORTUNITY?
From small to great, financial decisions inherently carry both risk and potential. And deciding between prepaying your mortgage and investing your extra cash is no exception. The key to making a solid choice lies in understanding and evaluating the opportunity cost. This bit of industry lingo refers to the process of weighing financial gain against what must be sacrificed to reach a financial goal.
Here’s a scenario:
You invested in your dream home, and financed a $360,000 mortgage, at an interest rate of 6.25%. Now, 10 years later, you're faithfully keeping up with monthly payments, and you see that you have cash to spare. Putting in $2155 a month, you are looking at 20 years' worth of monthly payments and a loan balance of $300,000.
If you do find that you have additional cash available monthly, you have options. Let's say you find $400 in your budget that you would like to make the most of.
- Opt for a higher payment per month, which would:
- Result in total interest savings of $62,000
- Reduce your mortgage's duration from 20 to 14 years
- Choose to maintain mortgage payments, and invest your available funds
By making extra payments and saving $62K interest, you will clearly be gaining a lot of financial ground. But before you opt to prepay your mortgage, it is vital to evaluate opportunity cost—You may be passing up an even greater profit to be gained by investing your capital. As always, before an idea becomes a plan, careful thought is warranted. It is vital to determine the degree to which a shift in fund allocation will affect your financial situation.
MORE THAN FACE VALUE
On its face, it may seem like a good idea to pay off your mortgage, but consider: Following the numbers in the above example, you would end up paying $7,400 in interest during the 21st year of the mortgage. However, based on a 25% tax bracket, this results in a mortgage interest tax credit of $1,850 on federal taxes—additional funds that could be invested, saved, etc.
Another approach to consider is based on whether you have the capital available to completely pay off your mortgage. Being without $300K in debt sounds ideal, if you have the resources to eradicate it; especially true because once interest compounds, the total debt would ultimately be over $500K ($517,200 to be exact). However, you would do well to know your options. While paying off your mortgage would seem to save, choosing to invest could potentially earn even more.
Suppose you have $300,000 available, and you opt to invest your funds. Working with a hypothetical investment return of 7%, figure in fees and capital gains tax, and likely your investment would net 5.95%. At this rate, your initial $300,000 would grow to $1,009,814 after 20 years--far making up for the $517K total mortgage. And even if the rate is lower, say 5%, which would net 4.25% after capital gains tax, your $300,000 investment would grow to $718,982, still adding to your capital in the long run.
It must be noted that investments that would pay this type of return are not guaranteed and will fluctuate in value. They are also not FDIC insured. Returns cannot be guaranteed to be consistent and losses may occur during the holding period. Therefore, it is important to recognize this and be prepared to hold an investment during good times and bad in order to generate these types of returns.
Do keep in mind that the rate of return you will see is directly related to the specific investments chosen and that those investment options with a potential for higher returns may expose you to increased risk.
Finally, as state taxes are not accounted for in the above examples, possible credits for mortgage or taxes on interest may shift where your best options lie. You should discuss your options with a tax professional before making any decisions on what direction to take.
Of course, your own unique financial circumstance is the barometer. An open, honest one-on-one with a trusted advisor is a good start to fully understanding the various aspects of your specific situation, and finding the answer that best suits your needs.
12 BULLETS FOR YOUR HOLSTER
While evaluating the opportunity cost is central to making an informed decision, a myriad of factors come into play—from practical considerations to the possible emotional effects of your choice. Now is the time to comprehensively evaluate your situation and see whether mortgage payoff or investing is your best bet. Here's a little help along the way.
- What is your mortgage interest rate? The lower your rate, the greater the likelihood to receive a better rate of return through investing.
- Does your mortgage have a prepayment penalty? While most mortgages don't, it is a good idea to check before making extra payments.
- Are you self-disciplined? While it looks good on paper and in theory, you may find it difficult to faithfully invest extra cash. In this case, extra mortgage payments may make more sense.
- Are you saddled with high balances on credit cards or personal loans? If so, it may be better to focus on paying these debts, as the interest rate is likely high, and the interest itself is not tax deductible.
- Are you currently paying mortgage insurance? If you are, putting extra toward your mortgage until you have gained at least 20% equity in your home may be your best option.
- Consider how mortgage prepayment may affect your overall tax situation: Prepaying your mortgage reduces mortgage interest, and could thus affect your ability to itemize deductions.
The underlying concept of investing is to find the best rate of return. And what is done today has a profound effect on future gains. Therefore, taking into account what may come to pass in your future can and should effect your current financial decisions.
- How long do you plan to stay in your home? Prepaying your mortgage saves interest over the long term; if you plan to move soon, there is less value in funneling extra money toward your mortgage.
- Do you have an emergency fund? It doesn't make sense to pay extra toward your mortgage if you will be forced to borrow money at a higher interest rate in the future. Instead, investing and reaping a greater return may be a more forward-looking option. Besides, if an emergency does strike—perhaps you lose your job or sustain a debilitating injury—your situation may make it more difficult for you to borrow against your home’s equity.
- 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.
- Speaking of retirement, have you saved enough? If not, consider contributing the maximum allowable each year to tax-advantaged retirement accounts before prepaying your mortgage. Prepayment may not be the savviest financial move if it means forgoing a generous employer match: A match of 50% of what you contribute could potentially add thousands of extra dollars to your retirement account each year. Don’t shortchange your retirement fund.
Sometimes, the best rate of return is peace of mind. Whatever that means for you, your emotional wellbeing should be high on your list of variables that could potentially effect whether you choose to invest, or prepay.
- How comfortable are you with debt? If you worry endlessly about how much you owe, the emotional benefits of paying off your mortgage deserve serious thought.
- Regardless of your options, if paying off your mortgage before reaching a financial goal will make you feel substantially more secure, factor that into your decision.
BALANCE IN THE BEST OF BOTH WORLDS
If you need to invest for an important goal, but you also yearn for the satisfaction gained from paying down your mortgage, there is no need to settle. It's as simple as allocating part of your available cash toward one goal, the rest toward the other. In cases such as these, even minor adjustments can make a notable difference. Perhaps you could opt for biweekly payments versus the traditional monthly schedule, potentially shaving years off your mortgage. Or maybe you would rather pack a punch and dedicate bonuses or tax refunds to paying down your principal. Fine-tuning the disbursement of your assets can definitely reap rich dividends.
Remember though, that change is inevitable: Interest rates will rise and fall, innumerable factors will affect the markets, your personal circumstances may shift. As life changes, so should your financial plan. Making the best possible decisions now can help you to be informed and prepared for future changes in the market, fluctuating interest rates, and any unforeseen variation in your personal finances.
Never assume that every financial decision rests entirely on your shoulders. Your trusted advisor is always ready to share insights, give pointers, and direct you toward a sure financial future.