Is it better to pay off a mortgage or invest? The answer will depend on your financial situation, but let’s look at pros and cons of each along with a strategy that can allow you to combine the best of both worlds.
Paying Off a Mortgage vs. Investing in the Market
How Does a Mortgage Loan Work?
In general, someone borrows money from a lender to buy a house at a certain interest rate and term length. As payments are regularly made (usually monthly), part of each payment goes toward the principal, lowering the balance. As the balance goes down, more of each payment typically goes toward the principal.
Further reading:
• the different mortgage types
• tips for shopping for a mortgage
• the value of getting mortgage pre-approval
• how to get answers to common mortgage questions
Components of a Mortgage Payment
You may hear the components of a mortgage payment summarized in an acronym: PITI. This stands for principal, interest, taxes, and insurance.
Principal
Initially, your principal is the amount of money you borrow. As you pay down your loan, the principal is the remaining (current) balance. When it comes to the mortgage loan payments themselves, the principal is the portion of the payment that goes toward the balance, reducing the amount. As the balance goes down, more of your payment goes toward the principal and less to interest.
Interest
The interest is based on the interest rate charged on the loan’s principal, and these dollars go to the lender, serving as a key part of the cost of borrowing. As your loan balance goes down, less of your payment typically goes toward interest. Most mortgage loans have a fixed interest rate; others are variable, based on a certain financial index.
Move your cursor on the amortization chart of this mortgage calculator tool to see how principal and interest change over time.
Taxes and Insurance
A mortgage payment typically contains a month’s worth of property tax, which is based on the assessed value of the home and the tax rate where you live. A payment also may include a month’s worth of homeowners insurance and, if applicable, mortgage insurance that protects the lender in case of default.
Investment Gains vs Loan Interest Saved
At a high level, to determine which strategy can have the biggest positive financial impact, you can compare what investment gains you’ve had (or estimate future gains) and compare that to how much interest you would save when paying down your mortgage more quickly.
Pros and Cons of Paying Off Your Mortgage Early
Pros include the following:
• You won’t have a mortgage payment anymore, which frees up money for other purposes: investing, paying for a child’s college expenses or wedding, and so forth.
• You no longer have to worry about having the funds to make your payment. This can be especially helpful if unexpected expenses arise.
• Typically, paying off your mortgage early will lower the amount of money that you pay in total interest — which means that you’ll pay back less on your mortgage overall.
• Paying off your mortgage can give you a real sense of accomplishment, and if you pay it off early, those feelings can be magnified.
• If you need to borrow against the home in the future, none of the proceeds will be needed to pay off a current mortgage.
Here’s more about paying off a mortgage early.
Cons include the following:
• Depending on the current stock market return and the rate you’re paying on your mortgage, it could be more financially advantageous to keep making regular payments and then invest available funds.
• Your credit score could drop a bit because you’ll no longer have a mortgage in your mix of open types of credit.
• Focusing on rapidly paying off a mortgage may cause someone to drain their emergency savings fund, something that’s not typically recommended.
• Although uncommon now, some lenders charge a prepayment penalty for early mortgage payoffs. When this clause exists, it’s for the first three years of a mortgage. Check your mortgage note for specifics, or ask your lender or loan servicer.
• When you no longer have a mortgage, you no longer qualify for the mortgage interest tax deduction.
Pros and Cons of Investing
Pros include the following:
• Many times, when you buy shares of stock, you can get a good return on your investment in the long term. To get a sense of current returns, you can check the 10-year annualized return for the S&P 500.
• Nowadays, it is easier than ever to invest in the stock market. You can use a broker in person or invest online. If a share of a stock of interest is too expensive, you can often buy fractional shares of that stock.
• If you’re in a workplace retirement plan, like a 401(k), your employer may match your contributions up to a certain amount.
• Stocks are liquid assets, which means that you can buy and sell at any time with low transaction costs. So, if you need cash, you can sell stock shares for that purpose. Plus, some stocks will provide you with dividends that you can reinvest or spend.
• Numerous strategies exist, including actively participating in trading or keeping stocks in your portfolio with the hopes of long-term growth.
Cons include the following:
• Regarding the “hopes” of long-term growth, when investing in stocks, you could lose your entire investment in a stock, including the initial investment. If you’re a common stockholder, you get paid last if a company defaults.
• If you’re managing your own portfolio, you’ll need to invest time into investigating stocks, deciding what to buy and sell, and otherwise monitoring the stock market.
• If you sell stocks at a profit, you’ll usually need to pay capital gains tax (although this can be offset through losses).
• While investing, you’ll still need to make your mortgage payment (until the home is paid off).
• Depending on your personality type, watching stock values in your portfolio go down can be an emotional experience, and it may take time to figure out how often you should check that portfolio. Too often, and it can stress you out unnecessarily. Too little, and you may miss key trading information.
Evaluating Your Financial Situation
This involves calculating two key figures: your net worth and your debt-to-income ratio (DTI). To determine your net worth, add up all of your assets (what you own) and subtract your liabilities (what you owe). Assets include your home’s value, vehicles, bank accounts, investments, and cash. Do not include your income. Liabilities are your mortgage, car, personal and student loans, credit card balances, and so forth. This figure can be positive (you own more than you owe) or negative (you owe more than you own), with a financial goal often being to increase your net worth.
For the second metric — your DTI — add up your gross (pre-tax) monthly income as well as your monthly debt obligations, such as your mortgage, car payment, and other loan payments. Divide your total monthly debt by your total gross monthly income, and the resulting ratio (say, 0.30 or 30%) is your DTI. When you have a lower DTI (say, under 30% or even 20%), this indicates more cash flow to either put toward your mortgage or to invest.
Factors You Should Put Into Consideration
The earlier you can begin to pay down your mortgage, the more you’ll likely benefit. That’s when more of your mortgage payment normally goes toward the interest.
That said, the earlier you can begin to invest, the longer you’ll have for your investments to build in value. Plus, because of compound interest, each dollar that you invest today will be worth more than a dollar that you would invest years from now.
Starting in 2018 and set to last through 2025, the federal government nearly doubled the amount of the standard deduction that taxpayers can claim. This means that far fewer people itemize their deductions, which in turn means that the mortgage interest deduction isn’t used by those taxpayers when they file their income taxes.
If real estate values are dropping in your area, paying down your mortgage can help you from going underwater (owing more on the home than what it’s currently worth). Being underwater can make it more difficult to sell or refinance the home. Struggling homeowners can look for mortgage relief programs.
Other Considerations
To this point, the post has largely focused on this question: Is it better to pay off a mortgage or invest? Let’s take a step back and look at issues to consider before doing either. First, do you have an emergency savings fund that could cover your monthly expenses for three to six months? If not, that’s a priority often recommended by experts.
Plus, if you have high-interest debt, such as credit card balances that you don’t pay off each month, it’s usually better to pay that off before paying extra on your mortgage or investing.
Another strategy: You could consider refinancing your mortgage to a lower rate to lower your mortgage payment. Then, when you put extra money toward the balance, even more would go to the principal than when the interest rate was higher.
Deciding What’s Best for You
Pay off house or invest? Perhaps the information provided has already allowed you to make a decision. However, there’s one more strategy to consider: doing both.
Best of Both Worlds: Funding Both at Once
Instead of simply considering two options, pay off mortgage or invest, another possibility meets in the middle: making additional contributions to your retirement investments while also paying extra on your mortgage principal. This is most effective early on, but adds value through the life of the mortgage.
If the stock market becomes especially volatile or is significantly heading downward, you could focus on the mortgage paydown during that time period.
The Takeaway
Pay off the mortgage or invest? It depends on your financial situation and priorities. Each choice has pros and cons, but a best-of-both-worlds strategy is to do both.
If you are seeking a new mortgage loan or want to refinance, more information is available at the SoFi help center for home loans.
SoFi Mortgages are designed to fit your needs: competitive rates, a variety of terms, and down payments as low as 3% for qualifying first-time homebuyers.
FAQ
Is there any disadvantage to paying off your mortgage early?
If a mortgage note includes a prepayment penalty, this can cost you money. Other disadvantages are loss of the mortgage interest tax deduction and a potential drop in credit scores. Plus, it may be more advantageous to invest those dollars instead.
Should I pay off my mortgage or save money?
It depends! Look at the pros and cons of paying off a mortgage and the pros and cons of investing and make the best decision for your financial situation.
Is it better to pay off my mortgage or invest for retirement?
Ideally, you can do both. If that’s not financially possible right now, look at the pros and cons sections to review factors to consider in making your decision.
Should I invest when I have a mortgage and other debts?
Benefits definitely exist when you can invest and make extra payments on your mortgage. If doing both isn’t possible right now, explore pros and cons described in this post to create your strategy. If “other debts” include high-interest debt, such as credit cards that aren’t paid off in full each month, it typically makes sense to prioritize the payoff of that debt.
Photo credit: iStock/burcu saritas
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