At some point, you reach a certain level of financial stability.
Your credit card debt is paid off. You’ve got a handle on those student loans. You bought a house with a low-rate mortgage. You’re adulting like a champ.
But what comes next? When you feel like you have breathing room and a couple hundred extra dollars a month, you want to put it to good use.
You might be asking yourself, “Should I pay off my mortgage, or is there something else I can do with the money?”
Before you throw extra money at your low-interest debt, it’s a good idea to run the numbers. Find out whether or not you should pay off your mortgage or invest.
Guaranteed vs. potential returns
A common piece of advice is that you should treat paying off debt as an investment with guaranteed returns.
In other words: If your mortgage rate is 4.15% APR, paying off your mortgage early is equivalent to 4.15 percent annual return.
But what if you could do better?
Consider this: What if you invest your extra money instead of paying off the mortgage early? With indexing, you could take advantage of something like the S&P 500, which has an average annualized return of pretty close to 10 percent.
Do you want to pay off your mortgage early for 4 percent returns when you have the chance to earn 10 percent annually?
Let’s say you have a 30-year mortgage of $200,000 at 4.15% APR and you’re currently paying $972 per month on it. Using a mortgage calculator, you can figure out how much extra you’d need to pay per month to save on interest.
If you would like to pay off your mortgage in 15 years instead of 30, you would need to start making a second monthly payment of $522.45. If you did this, you’d cut the amount of interest you pay back by over $81,000.
When you look at those interest savings, things look pretty good. But what if, instead of making an extra payment each month, you invested that money?
MoneyChimp offers a look at the possibilities if you take that extra $522.45 and invest it for 15 years, assuming an 8 percent annualized return:
When you invest, you could potentially earn more than $100,000 extra. That’s pretty good. Keep adding that money to your account for 30 years, and you could end up with over $767,000.
Don’t forget about tax breaks
But don’t forget about taxes. Your mortgage interest is tax deductible when you itemize. This means that the interest you pay doesn’t actually cost you as much as you think.
Not only that, but there are tax advantages to investing, especially when you do it for retirement. You can receive an immediate tax benefit when you contribute to a traditional IRA or 401k.
If you decide to contribute to a Roth account, you need to understand that the benefit will come later. Even though you don’t get a tax break today, the money in the account grows tax-free, so you won’t be taxed on your gains.
Your money grows more efficiently when you invest using tax-advantaged accounts. Choosing to invest instead of pay off your mortgage can be a smart financial play.
Paying off debt vs. investing
Just because something is a smart financial play doesn’t mean it’s always the right move for your situation. Consider all of the potential outcomes before deciding.
First of all, with investing, you’re looking at potential returns. The stock market hasn’t seen a net loss over long periods of time. Sometimes things look choppy at the day-to-day level.
However, when you look at the Google-powered stock chart over a period of years — or even decades — the trend line smooths out.
However, for some people, that image doesn’t offer much comfort. They don’t like the idea of having any obligation hanging overhead. Even if it’s a tax-deductible obligation.
Another worry has to do with investment losses. Even though the stock market, as a whole, tends to trend higher, individuals worry about their personal situations. What happens if the market tanks just before you retire? Your personal finances could suffer a great deal.
Don’t forget about risk tolerance. Maybe you can’t stand the uncertainty of stocks. The daily rollercoaster ride might make you feel sick. Even though there are ways to reduce the risk of investing, some consumers don’t want to deal with it.
Paying off the mortgage is definitely a safer bet. Plus, you get to enjoy the feeling of freedom that comes with being completely debt free.
Should I pay off my mortgage early?
In the end, it’s up to you to decide on the best use of your money. Paying off your mortgage might give you peace of mind, but it doesn’t offer you the chance to build long-term wealth the same way.
If you will have better peace of mind paying off the mortgage, it can make sense to super-charge your debt repayment. However, even if you are more comfortable tackling the debt first, you don’t want to neglect your future.
Consider reducing what you put toward early mortgage repayment and using the rest of the money to invest in your retirement. That’s a win-win.
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