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Jon Reed is an editor for NextAdvisor based in Columbus, Ohio. Before joining NextAdvisor, he covered state…
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Thirty years is a long time. The typical first-time homebuyer is 33 years old, according to the National Association of Realtors (NAR), meaning if they get a 30-year mortgage, the end of that loan seems about a lifetime away.
Thirty years is also a career, the difference between starting out in the workforce and starting to think about retirement.
So when you’ve recovered financially from saving up for the down payment and put aside some cash for when the furnace kicks the bucket, you might start to think about paying some extra principal so you’ll be free from the bank’s clutches before you’re retired.
But is paying down that mortgage to get debt-free the best thing to do with your extra cash? Experts say there might be a better option, especially if you’ve taken advantage of the historically low mortgage and refinance rates the past few years.
“The reality is that all debt isn’t created equal,” says Aleksandr Spencer, chief investment officer of Bogart Wealth, a financial planning firm based in Virginia and Texas. “Some, like mortgages, depending on certain factors, can offer some big-time economic advantages.”
Paying off your mortgage faster shouldn’t be at the top of your financial priority list. Try to pay off higher interest debt and build an emergency fund first.
Investing that money in the stock market might earn you a better return, despite the volatility in today’s financial markets, leaving you with more money in the long run than if you just paid off the mortgage faster, experts say. It’s basic arbitrage – borrowing money at one interest rate and investing at a higher rate in return.
“With a 30-year fixed mortgage, you have 30 years to outperform the bank,” says Bruce Hyde, partner, chief compliance officer, and wealth advisor at Round Table Wealth Management, a financial advisory firm. “It’s a pretty long time and I would suggest that most people can generate a return in excess of the interest rate.”
So should you put more money on that mortgage principal or invest it instead? Here’s what some experts have to say.
A mortgage is a loan in which a bank or financial institution provides the borrower with the money to purchase real estate, with the property itself being used as collateral. They’re typically long-term loans – 30-year and 15-year mortgages are the most common.
As for the interest rate on the loan, it can either be fixed, in which it doesn’t change throughout the term of the loan, or adjustable, changing after a certain period and fluctuating with the market. Rates for mortgage are generally lower than many other types of consumer debt, particularly credit cards.
Your 30-year mortgage doesn’t have to last for 30 years. You can pay more than the minimum of your payment and reduce the principal faster than it shows on your amortization schedule – which tracks how much of your payment will go toward interest and principal every month of the loan.
There are a few ways to do this.
You should also determine if your mortgage has a prepayment penalty attached. Those aren’t as common as they once were, but your loan might still have one. Talk to your loan servicer first to make sure those extra payments are going toward principal and that you won’t run into any headaches.
At the beginning of your loan term, you’ll be paying more in interest than toward principal. “Typically if you want to put money toward the principal balance of your mortgage, it usually makes sense to do it early on because you make a bigger impact by making additional principal payments earlier in the loan’s life,” says Cassandra Kirby, COO and private wealth advisor at Braun-Bostich & Associates, a Pennsylvania financial planning firm.
If you’ve got some extra money every month, there are other things you could do with it. You could invest it with the expectation of getting a return on that money. That return could be pretty good, depending on what you invest in, but it can also be risky.
The returns can be significant. Consider the S&P 500, an index that tracks the performance of about 500 of the largest publicly traded U.S. companies. It has averaged a return of more than 10% since its creation in 1926. Other investment options, such as bonds, carry lower returns but also less risk, Spencer says. With a balanced portfolio of diversified low-cost index funds, you could expect an average return of around 6% or more per year.
Choosing to invest instead of paying more towards your mortgage means taking on risk as markets move up and down. Experts say you should think of it as a long-term deal and focus on the expectation of returns over 30 years. “I balance the risk and return to make sure I have a positive arbitrage but don’t put too much of the portfolio at risk,” Hyde says.
As with most things to do with money, your arbitrage may vary.
Consider these figures, for a $300,000, 30-year fixed rate mortgage with an interest rate of 4%.
Consider instead if you invested $100 or $500 a month for 30 years and got a return of 7% each year:
That difference – a savings of $30,000 versus a possible return of $117,000, or a savings of $92,000 versus a possible return of $588,000 – is big, but it could in practice be even larger, Hyde says. Mortgage interest payments are tax-deductible up to a certain amount, while if you invest in a tax-advantaged retirement account such as a Roth IRA, there could be tax savings on the investments.
Of course, your return might not be 7%, and your mortgage interest rate might be lower or higher than 4%. Experts say the higher your mortgage rate, the harder it is for your investments to beat the interest savings. Whereas if your mortgage rate is lower, even safer assets like bonds can manage a good return. “To pick which way you go really depends on what’s your mortgage rate and what’s the threshold you need to get to, and your risk tolerance,” Spencer says. Of course, if your mortgage rate is much higher than the current going rate, consider that refinancing to a lower rate could save you significantly in the long term and change the math around whether you should invest or pay down faster.
Before deciding, experts say to be clear where this choice lies on your financial priorities. When you have extra cash coming in and you’re deciding what to do with it, a couple of other things should take precedence.
First, those credit card bills. “Higher interest debt, that’s the top priority before you touch your mortgage,” Kirby says. That’s got a higher interest rate, likely one you’re unlikely to beat in the market. Second, make sure you have an emergency fund or some other form of cash reserves you can get to quickly. Third, Kirby says you should prioritize putting money away for retirement by contributing at least the maximum amount toward your 401(k) that your employer will match, if you have one.
The prospect of a higher return means over the long run, investing will most likely leave you with more money, potentially significantly more, than paying off your mortgage more quickly, experts say. “As a rule of thumb, if your mortgage [rate] is under 5%, it makes sense to explore some of these other options because you’re only taking incrementally more risk,” Spencer says.
Beyond the higher return on your investment, Spencer says an advantage of investing is that your money is in a more liquid asset than paying off the mortgage. It’s easier and faster to sell some of your investments, especially if they’re in stocks or funds, than it is to take equity out of your home through a home equity loan or home equity line of credit, which can be a lengthier and more complicated process that comes with a new interest rate.
Paying off your mortgage earlier can provide some benefits, including the psychological one of being debt-free. It’s also much lower risk than investing, particularly if your mortgage rate is fairly high. “If you feel that you can earn more by investing than the rate of interest that you have on your mortgage, you should probably invest,” Kirby says. “That’s hard. That’s kind of market timing. It’s really hard to say what the market will do at any given point in time.”
It also depends on how long you plan to stay in your home, Kirby says. If you’re only going to be there a few years, it makes more sense to invest. Paying off the loan earlier is a better idea if you’re going to be there a long time, she says.
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