Should I pay my mortgage off early or invest?
If investment return is greater than mortgage rate, invest the extra money.
Mentioned above is the short-cut answer, but there are a lot of factors that go into the decision to pay off your mortgage early.
If you are thinking about paying off your mortgage early, that means you have some extra money per month to put towards your mortgage. Therefore, we are going to look at two people in the exact same situation who both have some extra money leftover at the end of each month.
John (pays off) and Cindy (invests)
John and Cindy both have:
- 30 year mortgages
- $1,500 monthly mortgage payment (in principal and interest). This payment amount is the equivalent of an approximately $356K mortgage with a 3% interest rate.
- $2,000 per month to put towards the mortgage (and/or invest). OR put another way $1,500 for the mortgage and $500 to invest or put toward the mortgage principal.
John and Cindy both have $2,000 a month to put towards the mortgage and/or invest; which means that they have about $500 extra per month that they are considering putting towards their mortgage to pay it down early OR invest the remaining $500 a month.
John is going to pay down his mortgage early
In our example, John will pay the required payment of $1,500 a month toward the mortgage, and also pay $500 extra per month towards the mortgage principal.
Cindy will invest
On the other hand, Cindy will pay the required $1,500 a month toward the mortgage. However, Cindy will invest her extra $500 per month into an S&P 500 ETF averaging 10% returns.
Note:
- John’s mortgage balance = purple dotted line
- John’s investment balance = solid purple line
- Cindy’s mortgage balance = orange dotted line
- Cindy’s investment balance = solid orange line.
In 5 years
We can see that John’s mortgage balance is $298K and Cindy’s balance is $316K and her total investments are equal to $39K.
In 10 years
John’s mortgage balance is $217K, and Cindy’s mortgage balance is $270K, and her investments are now totaling $102K.
Keep in mind that John still has $0 in investments because he is putting his extra $500 towards the mortgage on a monthly basis while Cindy invests her $500 each month.
In 20 years
Through John’s efforts, John has completely paid off his mortgage, congratulations John!
Cindy, however, still has a $154K mortgage balance but her investments equal $380K.
Since John has now paid off his mortgage, he can utilize the full $2,000 he was putting towards his mortgage and begin to invest it, thereby investing $2,000 a month. In this example, John will invest in the same S&P 500 ETF as Cindy, with average returns of 10%, for simplicity.
Let’s fast forward to the end of the original 30 year term of the mortgage.
In 30 years (end of mortgage)
John paid off his mortgage after 20 years, since then, he’s been investing $2,000 a month over 10 years and his investment balance is now a little over $400,000.
Cindy has now paid off her mortgage at the end of the 30 year term. But her $500 a month in investments over 30 years have added up to over $1.1 million with interest gains in 30 years!
Since Cindy and John both have their houses paid off, we will offset their net wealth figure based on their homeownership.
If we look at their differences in wealth comparing their investments:
Cindy has more than $700K in investments compared to Jeff.
If investment return is greater than mortgage rate, invest extra money.
In our example, the investment returns were 10% which is greater than the 3% mortgage rate. However, if we reversed those numbers, and the mortgage rate was 10% and the investment returns were 3% then the answer is much different.
If investment return is less than the mortgage rate, use extra money to pay down mortgage.
It’s that simple.
Note that there are other things to consider like inflation and capital gains tax, but I’ll try to cover those questions in future postings.
