Not long ago I talked about how to pay off your mortgage early. For many people that is exactly what they would like to do. Pay off their mortgage and be debt free. The idea of not having a mortgage payment each month may excite you. But is it really better to pay off your mortgage early or invest?
A lot of people I’ve talked to don’t care if investing is better or not. The emotional benefit of being totally debt free is more important than anything. If you’re in that boat, then that’s fine. Being totally debt free is a great goal to have.
But I hope you’ll stick with me and see if it is better to pay off your mortgage early or invest the extra money in something else.
First, let’s get real basic here so we’re all on the same page.
Say you have an extra $500 per month. You could make extra payments on your mortgage and pay it off several years early and save tens of thousands in interest.
Alternatively, you could take that same $500 per month and invest it.
Now, which is better?
Well, it depends on a couple of things. The first and biggest is how disciplined you are.
If you have an extra $500 per month, do you have the discipline to put than in an investment account no matter what? Be honest with yourself. Most people will say that they have the discipline for it, but when you look at their finances it’s obvious that the aren’t the best money manager.
A recent article on Love Money that talked about tips for saving money noted that most people don’t have what it takes to consistently save on their own. Even people who consider themselves to be good with money don’t to all that well in practice.
The second thing to consider is how far along in life you are. Someone who is under 40 has a lot more time before retirement than someone who is 60. For someone farther along in life it may not be a wise decision to invest in something prone to volatility.
Now let’s assume that you are going to be disciplined enough to invest the extra money each and every month and that you can tolerate the risk of investing in something with a sufficient return.
The Power of Leveraged Investing
Advanced financial lesson here: leveraged investing is an incredibly powerful tool. It allows you to invest with someone else’s money.
When talking about a mortgage you are essentially investing with the bank’s money. Rather than paying off your debt with the bank you are using the money to invest using leverage.
What if you took that extra $500 each month and invested it in a Roth IRA of paying down your mortgage?
You can easily achieve an 8% return with conservative investments. If the interest rate on your mortgage is less than 8% then you will come out ahead by using the extra money to invest.
For example, if you had a $200,000 mortgage with a 5% interest rate and paid an extra $500 per month you would pay off your mortgage in 14 years and save $101,000 in interest.
However, if you invested the $500 each month in an investment with an 8% return you would have $155,000 after 14 years.
In this case investing would have increased your net worth by $54,000.
In almost all cases it is more beneficial to invest rather than pay off your mortgage. There are two exceptions however.
- If you have a high interest rate mortgage you won’t be able earn enough on an investment without taking unreasonable risk.
- If you are in a high income tax bracket.
Tax Benefits of a Mortgage
One thing that you do need to consider when deciding whether to invest or pay off your mortgage is the tax implications of the decision.
All of the interest you pay on your mortgage is tax deductible. Since everyone’s tax situation is different it’s difficult to pin down a number. But the tax benefit could be high enough to offset any additional gain you would have from investing.
On the other hand, there can be tax benefits to investing. A Roth IRA is a great example. The contributions you make may be tax deductible.
If you are in a high tax bracket talk to your tax professional before making a decision.
Paying Off Your Mortgage Vs. Investing: The Bottom Line
Since this decision relies on so many variables it’s impossible to give an answer that is right for everyone.
Here are some general guidelines. If all of these criteria apply to you then it is most like better for you to invest than it is to pay off your mortgage.
- You are disciplined enough to invest the extra money each and every month.
- You have a low interest rate on your mortgage. 5% or less is ideal.
- You have enough time until retirement to have moderate risk investments in your portfolio.
- You are in a low enough tax bracket that the interest deduction on your mortgage doesn’t have a large impact on your taxes.