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When you end up with extra cash, whether it’s through a windfall or an adjustment to your monthly budget, figuring out how to put that money to best use can feel like a daunting task.
One decision you might be contemplating is whether to pay off your mortgage with the new money or invest it. While neither option is a poor financial choice, there are benefits and drawbacks to both.
Here’s what you should consider when deciding between paying off your mortgage or investing:
- Consider your tolerance for risk
- Pros of paying off your mortgage
- Cons of paying off your mortgage
- Pros of investing
- Cons of investing
- How to decide between paying off your mortgage or investing
- Other uses for your extra funds
- Another option: Refinance to a shorter loan term and invest
Consider your tolerance for risk
You need to know your own comfort level when it comes to the risks involved with homeownership and investing. Here’s how the two options generally differ in terms of risk:
- Homeownership: In general, homeownership is considered less risky than stocks and other investments, since real estate often appreciates steadily over time. However, you also run the risk of having to sell in a down market, and you could still lose money if property values in your area drop.
- Investments: Stocks and other investments tend to be riskier investments because prices can be more volatile, with more frequent market crashes. If you have a higher risk tolerance, though, stocks typically rise in value faster than real estate.
On the other hand, the S&P 500 saw an annualized return of 13.84%, including dividends, over the past decade, from July 2010 to July 2020, according to The Wall Street Journal.
Pros of paying off your mortgage
Paying off your mortgage early versus investing any extra money makes sense for several reasons:
- Save on interest costs: The faster you pay off your mortgage, the less you end up paying in interest overall. Say, for example, you take out a $240,000, 30-year fixed-rate mortgage at 5%. By the time you repay the loan in full, you’ll have paid a total of $223,813 in interest. Paying the same loan off in 15 years lowers the total interest paid to $101,623 — a savings of $122,189.
- Peace of mind: Your home is likely your largest monthly payment, and it’s also the most important. Not having this debt hanging over your head can help you feel better about life and your situation. It also gives you more financial freedom to explore other ventures that enrich your life, such as traveling, increasing your savings, or investing.
- Tangible asset: Your home is a tangible asset that you can live in. The faster you pay down your mortgage, the more equity you build in the home, which can net you more cash in the end should you decide to sell. Even if you don’t sell, your equity is a source of wealth you can tap into to cover a major expense, or even to supplement your income in retirement.
Counterpoint: Since real estate tends to appreciate more slowly than stocks, you could miss out on significant market gains from other investments should you decide to throw all of your extra cash toward your mortgage.
Refinancing can also help you pay off your mortgage faster. If you have more money in your budget, consider refinancing to a shorter term with a lower interest rate. You can pay off your mortgage more quickly while saving money on total interest charges — just keep in mind that your monthly payment will be higher as well.
Credible can help you with your next mortgage refinance. With Credible you can compare prequalified rates from all of our partner lenders in just a few minutes.
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Learn More: When to Refinance a Mortgage: Is Now a Good Time?
Cons of paying off your mortgage
Paying off your mortgage isn’t always the best use of extra cash. Some drawbacks of eliminating your mortgage payment early include:
- Non-liquid asset: A liquid asset is one that’s quick, easy, and inexpensive to convert to cash. Home equity isn’t a liquid asset because you have to apply and be approved for a loan, wait weeks for the loan to close, and, in many cases, pay several thousand dollars in closing costs.
- Credit score: Credit mix, which is the variety of account types you have open, makes up 10% of your FICO score. Paying off your mortgage will reduce your score slightly unless you have another installment loan. Whether that reduction will have any practical effect depends on your credit score. Dropping from a stellar 850 score to an equally stellar 820, for example, should have no effect. Dropping from a 650 to a 620 score, on the other hand, puts you in a different credit score range that could result in you being denied some types of credit or paying higher interest rates.
- Tax deductions: Taxpayers who itemize deductions can write off real estate taxes, mortgage interest, and mortgage insurance premiums. Paying off your mortgage means you’ll lose some of those real estate deductions.
Pros of investing
Instead of paying off the mortgage, you could put some of that extra money into investing. Some of the advantages of this option include:
- Higher rate of return: On average, and over time, investing has the potential for a higher return than paying off low-interest debt like a mortgage. How much higher depends on the investment portfolio. The historic average for all-stock portfolios is 10.29%, according to Vanguard, over the last 94 years, whereas the average mortgage rate as of May 2022 is 5.23%.
- Build wealth for the future: If you invest in a tax-advantaged retirement account with the extra money, there’s a bigger potential for a larger nest egg in the future, thanks to compounding returns and tax efficiency. And the earlier you start, the better. In an example offered by Vanguard, someone who saves $10,000 a year from ages 25 to 40 will have about $1,059,000 at retirement. If, on the other hand, you wait until age 35 but save for twice as long, you’ll only have about $838,000 at retirement.
- Increased liquidity: When using a taxable investment account, such as a brokerage account, to invest in the stock market, you have more liquidity. If you need access to capital, it’s easier to sell stocks and access cash than it is to tap into the equity in your home. What’s more, you can generally sell stocks immediately or almost immediately, and if yours is a self-directed account with a discount broker, you probably won’t pay commission on the sale.
Counterpoint: Because stocks aren’t backed up with something tangible, like a home, and due to price volatility, you could see dramatic drops in your portfolio, which could result in losses if you sell during a crash.
Cons of investing
- Risk: Investing can be risky — very risky if you’re investing in high-growth securities like stocks. Although stocks historically have averaged over 10% a year, they’ve lost money in 26 of 94 years, which means you could wait a long time to see a return on your investment. In the meantime, you derive no benefit from your portfolio. Compare that to your home, which has myriad benefits beyond its monetary value.
- Security: The sense of security you get from a fully paid mortgage comes from debt elimination — your costs to live there are nominal regardless of the home’s value. Investing only provides that same security if the value of your portfolio can cover your mortgage payment for the remainder of the loan.
- Inflation: The practical effect of inflation is a reduction in your investment portfolio’s purchasing power. If the portfolio earns 10% but inflation hits 8%, you only net 2%. To stay ahead, you need larger future gains on the money you save today. That’s the opposite of the effect inflation has on your mortgage. So, for example, even if prices are 10% higher than they were when you took out your mortgage, every dollar you pay toward the principal reduces the principal by $1 even if today’s dollar is only worth 90 cents.
Check out: Should You Get a Cash-Out Refinance to Invest?
How to decide between paying off your mortgage or investing
Before deciding to pay off your mortgage or invest, it’s important to consider your own financial goals and priorities, and decide what matters most to you.
Here are some factors to mull over before you make a final decision:
- Return: The stock market is likely to provide you with better long-term results. Gains often outweigh interest savings from low mortgage rates, and home appreciation in most areas doesn’t keep up.
- Comfort level with debt: If your main motivation is to be completely debt-free, then it might be worth paying off your mortgage first, if only for that peace of
- Retirement: Think about your timeline for retirement. Depending on the situation, it can make sense to invest and build a retirement portfolio, especially if you can still pay off your home by retirement without aggressively tackling the mortgage.
- How long you plan to stay in the home: It might make more sense to pay off the mortgage instead of invest if you plan to stay in the home long-term. But if you know you’ll be moving in a few years, and your interest rate is low, you might be better off holding onto the cash or investing it.
Find Out: Should You Pay Off Your Mortgage Before You Retire?
Putting $1,000 toward your mortgage vs. investing it
Let’s run through a couple of scenarios showing what might happen should you put an extra $1,000 toward your mortgage or the stock market.
Say your mortgage balance is $200,000 with an APR of 3.25%, and you have a monthly principal and interest payment of about $870. If you put an extra $1,000 toward your mortgage each month, you could pay off your home in 10 years and six months and save $77,300 in interest.
But if you invested that $1,000 in a fund tracking the S&P 500 index, you’d likely see a far greater return. Assuming a 10% annual return, you’d end up with $191,249 in the same time frame. That’s more than double the amount you would have saved on interest had you decided to put that money toward your mortgage.
Credible is not an investment advisor, so be sure to speak with an investment specialist beforehand to see if the numbers work for you.
Other uses for your extra funds
Sometimes it’s not just about paying off your house or investing. Depending on your financial circumstance, there might be better uses for your money. Here are some other options you might consider.
Build out your emergency fund
If you don’t have an emergency fund, consider beefing that up with your extra money. That way, you’re less likely to need to tap into your home’s equity or liquidate your investment account in an emergency. Your emergency fund can help shore you up against problems in the future.
Pay off high-interest debt
Tackling high-interest debt, like credit card debt, before paying off the mortgage or investing might be your smartest financial decision. A high interest rate on your credit card can cost you more in the long run, and stock market returns rarely beat high interest rates on debt.
Another option: Refinance to a shorter loan term and invest
Think about refinancing your home loan to a shorter term. If refinance rates are low, and you cut your term down to 15 or 20 years, you can potentially save thousands in interest and be done with your mortgage sooner.
Plus, you might still have some money left over each month to invest, giving you the best of both worlds. Review your options to see what’s available, and what’s most likely to benefit your financial situation.
Keep Reading: How to Refinance Your Mortgage in 6 Easy Steps
If you think refinancing is the right move, Credible makes it easy. You can compare multiple lenders and see prequalified rates in as little as three minutes without leaving our platform. Use the table below to get started.
