Should You Pay Off Your Mortgage Or Invest?
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Are you a homeowner? It’s estimated there are almost 80 million homeowners in the U.S. I’m a homeowner too, and I see how much money leaves my bank account when I make my monthly mortgage payment.
I have a 30-year mortgage, so it’s not a high payment. And I know I can’t do much about the money being held for taxes (maybe vote for a lower tax rate?). But all that money going to mortgage interest — that’s the money that makes me think.
I think about my retirement plan and retirement savings. I’m putting money toward my retirement account that could be put toward eliminating my mortgage payments. Being debt-free sounds exciting. But would paying off my mortgage early be a wise financial decision? Or is it better to invest in the stock market?
In this article
How your mortgage loan works
A mortgage is a secured loan in which your house functions as collateral. This means you promised the bank (or a lending company) you’d repay a specific amount of money — with interest — within a specific timeframe, usually 10, 15, or 30 years. And you agreed that if you don’t repay the money, the bank has the right to repossess the collateral: your home.
There are a few central pieces to a mortgage. You repay your loan on a monthly basis, and these monthly payments are calculated based on the total loan amount, length of the loan, and the interest rate. Your monthly payment is made up of two parts: principal and interest. Principal is the amount that pays down the loan. Interest is the amount that is paid to the lender for the privilege of borrowing the money.
The monthly amount that goes to principal and interest varies depending on your amortization schedule. This is the schedule you and your lender agreed upon for applying the payments to the loan. In the beginning years of a standard 15- or 30-year loan term, most of the money being paid is going toward interest payments. In the later years, the majority goes toward principal payments. The amount going toward interest shifts over the years because in the beginning the loan balance is higher — resulting in higher interest costs — and in the later years the balance is lower.
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What happens when you pay off your mortgage early?
The temptation to pay off your loan early could be a good one, but you need to do your research. And that doesn’t just mean reading articles like this one. You need to check your loan terms.
Some loans have a prepayment penalty. This means if you pay off your loan sooner than the term or make extra payments, you will be penalized with a fee. These fees can exist in a few different forms.
- Percentage of the remaining balance. This fee is based on how much remains of the principal. This is often charged if the loan is paid off within the first 2-3 years of the loan term.
- Certain number of months’ interest. They may charge you the interest for a set number of months, such as six months.
- Set amount. You will be charged a specific dollar fee.
- Sliding scale. This is the most common, and also the most complicated. This version is a specific percentage that changes — slides downward — based on when the loan is paid off. For example, you may be charged a 3% fee if the loan is paid off in year one, a 2% fee if paid off in year two, a 1% fee in year three, and no fee in year four.
If your loan has a prepayment penalty, you have some options. First, check to see if you are past the point when paying off your loan will trigger the prepayment clause. Many prepayment penalties only apply to the first few years of the loan.
If the prepayment penalty still applies, you do have the option to simply not pay off your loan early. And, depending on your situation, this may be the best option. You would need to run the numbers (do some math) and determine the consequences of paying off early vs. not paying off early. Once you’ve done your math, the numbers should show you which is the better choice.
What about refinancing?
You have the option to refinance your loan. Having something like a prepayment penalty in your loan doesn’t prevent you from refinancing, and depending on your situation and the current rates, refinancing could be a good option. But you should ask some questions.
How will refinancing benefit me?
Refinancing is taking out a new mortgage, and you will have to complete all the same steps you did when you took out your original mortgage. This can be long and tedious, so weigh the benefits before taking the jump.
What are the current mortgage rates?
Compare the rates being offered to the rates you received when you took out your mortgage. If you took out a fixed rate mortgage originally, you may already have a lower rate so refinancing may actually cost you money. For reference, current mortgage rates are about 4.8% to 5.8%.
How will refinancing affect my monthly payment?
Refinancing could change your monthly payment and, depending on your current financial situation, this could cause problems. You may have become accustomed to a certain monthly living cost, and changing this can be difficult.
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Costs and fees
What are the costs of paying off your mortgage early? Putting your money toward your mortgage debt instead of investing can come with some costs.
Prepayment penalty
One of these costs comes could be a prepayment penalty if it’s built into your mortgage contract.
Possible loss of tax deduction
When you no longer have a mortgage, you will no longer be able to claim the Home Mortgage Interest Deduction on your taxes, which allows you to deduct mortgage interest paid on up to $750,000 of the loan principal. Since the Tax Cuts and Jobs Act was signed in 2017, this deduction has changed, and the majority of homeowners no longer benefit from it. But there is a portion who do. Check to see if you are one of them.
Loss of investment returns in the stock market
The stock market’s benefits are compounded by time. If you reallocate money that would be going into the market into your mortgage, you may lose out on compounding interest in the stock market. Most mortgage interest rates are about 3-5%. The S&P 500 has an average annual return since 2000 of about 7%. This means if you have the same amount of money invested as your mortgage principal, you will still be netting 2-4% per year by investing.
What are the costs of investing?
The investing world typically boasts a high rate of return. But it’s by no means a cost-free world. You will pay some fees for investing in the stock market.
Management fees
You’ll pay a percentage of your investment account for someone to manage it. This could include a financial advisor fee, which will typically be about 1% per year.
Taxes
You’ll pay taxes on your “earnings,” or the amount gained from your investments.
Pros and cons of paying off your mortgage early
Pros
- You’ll pay less in interest for the loan.
- Paying off debt early can be beneficial to your credit score, which could help you avoid high-interest debt in the future.
Cons
- You’ll no longer have access to low-interest debt using your home equity. This includes options such as a home equity line of credit or home equity loan.
- It could be harmful to your financial goals. For example, it’s important to have an emergency fund. If you put money toward your mortgage that you may need in the short-term, you won’t be able to access it.
Pros and cons of investing
Pros
- The stock market will usually offer a better return, even when offset by a mortgage (assuming an average to low mortgage interest rate).
- Investing will offer more liquidity if you have brokerage investments. Even if you invest in an IRA, you still have more liquidity than money tied up in a home—although it will come at high tax costs.
Cons
- The stock market tends to be more volatile than the housing market, and to benefit from it you will have to ride those waves. This requires some risk tolerance and the ability to sometimes watch your investment accounts lose significant percentages.
- If you invest instead of paying off a mortgage, you will likely be holding onto a large amount of debt. If you are unable to pay the debt, your biggest risk is home repossession.
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What about doing both?
Compromise is sometimes the best option. And, for many people, that is the case with this topic. Putting money into both your mortgage and your retirement accounts tends to be the safest and most reliable strategy for personal finance. The stock market and the real estate market both offer benefits, and it can be helpful to take advantage of both worlds.
However, if you have a high-interest mortgage, refinance to a mortgage with a lower rate. This will help you save money on interest and continue to benefit from stock market gains.
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The bottom line
If you’re a homeowner, you’ve probably considered paying extra on your mortgage to be free from debt. Whether or not this is the right decision comes down to your financial planning and goals. But make sure to ask the right questions before making the decision.
Remember that paying off your loan early isn’t always going to benefit you if you can invest that money in a market that offsets your losses and even nets you money. And remember there could be consequences for paying off early written into your mortgage contract. Take the time to look. (Future you will thank you.)
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Writer
A veteran wordsmith and research nerd, Brittany Wren spent a decade working in higher education where she helped people overcome challenges to chart a path forward. These days, she writes about personal finance, careers, parenting and education. Her content has been published by a wide variety of brands including T-Mobile, Intuit, LifeLock, Reliant Fund Administration and CURO Financial Technologies Corp.
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