By their nature, mortgage payments take up a big chunk of the budget every month. Because it’s such a big monthly expense, one of the things people often want to do when they have some extra cash is put it toward their mortgage payment to pay off their home faster, which is a good goal to have.
However, while paying debt comes with its advantages, current low mortgage rates might factor in and make investment returns very attractive in comparison to paying off such low-interest debt.
The decision of whether to pay off your mortgage or invest your extra funds depends on your personal finances and long-term life goals. The purpose of this article is to give you some factors to consider to make the right decision for you and your family. Let’s start with some math before diving into the pros and cons.
The most logical place to start when it comes to any financial decision is the math, so let’s run through an example loan and do some comparisons of how much interest you save with a planned extra monthly payment of $500 for 20 years. You can do some calculations of your own with our amortization calculator.
Loan Term: 30 years
Interest Rate: 3.25%
Principal: $300,000
Mortgage With Minimum Monthly Payment
Mortgage With Extra $500 Monthly Payment
Monthly Payment: $1,305.62
Monthly Payment: $1,805.62
Interest Paid Over Life Of Loan: $170,022.82
Interest Paid Over Life Of Loan: $99,092.37
Time To Pay Off: 30 years
Time To Pay Off: 18 years, 6 months
Difference In Interest Paid: $70,930.45
As you can see, you wouldn’t have to put $500 extra toward your mortgage payment for 20 years because the loan would be paid off in 18 and a half. Now let’s take a look at what would happen if you were to invest that extra $500 on a monthly basis.
A popular strategy for stock market investors who aren’t looking to pick winners and losers is to invest in an index fund. The Dow Jones Industrial Average has returned around 7.6% per year, according to data from Macro Trends dating back to 1916.
What would happen if, starting from nothing, you invested $500 per month in an index fund tied to the Dow for 20 years? Because the stock market has its ups and downs, we’ve tried to account for this using a 7.5% return with a 4% variance in either direction. You can try out your own scenarios with this investment calculator.
Rate of Return
3.5%
7.5%
11.5%
Returns after 20 years
$169,678.09
$259,828.09
$408,030.48
Although there are years in which investing in the stock market will net you significant losses, the tendency when investing longer-term is that you’ll see gains based on the historical data. If we assume a rate of return even at the low end, you would be more than doubling the amount of money you would have after 20 years if you invested the money rather than putting it toward your mortgage.
We know what the math says, but what about other factors? Let’s take a closer look.
We can start by looking at the advantages and disadvantages of putting extra money toward your mortgage first to pay it off early.
Based purely on the numbers, there’s an obvious benefit to investing over paying off your mortgage when considering current mortgage rates. However, there are plenty of reasons why working toward paying off your mortgage is a valid choice made by many.
You’re Building Equity In The Home
You build equity with each payment you make, and this equity builds faster if you’re putting additional money directly toward the balance each month. Equity is important because it gives you the flexibility to do things like take cash out of your home.
Except for VA loans, most major mortgage investors require you to leave 20% equity in the home after a cash-out refinance, so having significant equity can help assure you have enough money after refinancing to accomplish your goals.
You’re Lowering Your Debt
By paying off your mortgage, you would be taking a significant debt off the books. This payment can lower your debt-to-income ratio (DTI). Because DTI is a key metric in loan qualification, the lower your monthly debt payments compared to your gross monthly income, the more you’ll be able to be approved for if you need to get another loan. Plus, the closer you are to debt-free, the better your credit score will be.
You May Be Able To Take Advantage Of Lower Interest Rates
Because you built up equity and lowered your DTI, you might be able to take advantage of lower interest rates based on having more equity while showing less of a debt burden. That means if you want to refinance an adjustable-rate mortgage or are looking for better terms, your lender will be more likely to approve you for a competitive interest rate.
Although there are benefits to paying off your mortgage faster, there are also downsides. Let’s run through them.
You’ll Have Slower Growth Of Your Investments
After getting a mortgage, you’ll probably notice that you won’t have extra money for investing. This lack of funds could have consequences for your retirement savings and other long-term financial goals.
You’ll Have Fewer Tax Deductions
Homeowners love to take advantage of the home mortgage interest deduction. Those who itemize can deduct mortgage interest on loan amounts up to $750,000 ($375,000 if married filing separately). Loan limits would be $1 million ($500,000 if married filing separately) if you purchased or refinanced the home prior to December 16, 2017.
There’s no loan limit on mortgages originating prior to October 13, 1987. If you make big strides to pay down your mortgage or fully pay it off, it eliminates or substantially reduces the benefits of this deduction.
You Might Have A Prepayment Penalty
Prepayment penalties are fees charged by some lenders as a consequence of paying off your mortgage. Lenders will include them in terms of the loan to discourage people from paying it off during the first several years and depriving the lender of the interest they would otherwise charge the borrower.
Check your contract. Rocket Mortgage® doesn’t charge prepayment penalties.
If you’re thinking of prioritizing investments over paying off your mortgage, there are also benefits and drawbacks to this strategy.
The following are benefits of putting an investing strategy first.
Investments Earn Compound Interest
The figures we gave you on the stock market above were annual returns. That means you would earn 7.5% interest on whatever money was invested each year, meaning your returns could grow exponentially over time. Of course, this is a bit simplified because it assumes a constant interest rate.
You Might Benefit From An Employer Match
Many employers offer a match up to a certain level for team member retirement funds. If putting the money toward investments gets you to the maximum matching amount, it could be a good idea to max out the match. Otherwise, you leave free money on the table. Roth IRAs or 401(k)s are also good investment options as they can steadily grow over time without close supervision.
You Can Build Wealth In Liquid Assets
If you are working toward paying off your house, the only way to get that money back out should you need it is to refinance your mortgage or take out a home equity loan. If you invest in stocks, bonds or some other financial vehicle, it’s much easier to sell and cash out these items. Some people may enjoy that accessibility.
While there are benefits to prioritizing investment, there are also numerous reasons this may not be the right option depending on your situation.
Any Investment Carries Risk
Although the stock market tends to generate returns at a steady clip over time based on historical evidence, it’s important to note that there are stretches where there can be some wild swings.
From 1916 through 2021, the Dow lost 10% or more on an annual basis 18 times. If you invest in bonds, there’s always the chance that inflation eats up any guaranteed return. This risk could be particularly horrifying if you know you don’t tend to be a long-haul investor.
You End Up Paying More For Debt
We talked about mortgages, and you could be spending tens of thousands of dollars extra in interest by not paying off early. Still,it’s also important to think about your debt holistically. Interest rates for personal loans, student loans and credit cards may be much higher. You may want to pay high-interest debts down or off before investment, even if you’re not paying extra toward your mortgage.
It Takes Longer To Build Equity In Your Home
Whether you want to build equity to have better qualifications to take advantage of low rates, do a cash-out refinance or just have enough left for a down payment on an upgrade after you sell, it will take longer to build equity if you don’t put extra toward the principal balance on your mortgage. This flips over time, but if you just make the scheduled payment, for the first several years in a 30-year mortgage, you pay more toward interest than principal.
If you have a healthy emergency fund and plenty of cash reserves, you may be tempted to make extra payments to your mortgage or to start long-term investing in the Dow. The math would tell you investment is probably the way to go.
However, very few decisions in life come down to just the numbers. You also must consider your long-term goals, financial situation, risk tolerance and debt load. Beyond the numbers, the things in favor of investment might include building up liquid assets and your retirement account.
Although we hope that this article gives you some things to think about, we realize that every situation is different. If you’re unsure of your next move, it’s never a bad idea to speak with a financial advisor. In the meantime, here’s more info on what to expect when paying off your mortgage.
Kevin Graham is a Senior Blog Writer for Rocket Companies. He specializes in economics, mortgage qualification and personal finance topics. As someone with cerebral palsy spastic quadriplegia that requires the use of a wheelchair, he also takes on articles around modifying your home for physical challenges and smart home tech. Kevin has a BA in Journalism from Oakland University. Prior to joining Rocket Mortgage, he freelanced for various newspapers in the Metro Detroit area.
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