One of the longest-running debates in personal finance is whether it makes more sense to pay down your mortgage early or invest.
If your goal is to maximize your wealth, investing makes more sense than paying down the mortgage early if the expected return on investment is higher than your mortgage rate. Investing also improves your liquidity when compared to making extra payments on a mortgage.
That is the short answer. However, there is a lot to unpack when discussing all of the factors that must be considered before making a decision.
Before you consider either option
Before you get aggressive on investing or paying off your mortgage, you need to ensure your financial house is in order. Before choosing either option, you should have the following.
All your non-mortgage/high-interest debt paid off.
Already be allocating at least 15% of your income to retirement savings.
Once you have the financial essentials handled, it’s time to decide which is better investing or paying off the mortgage.
Breaking down the numbers
Let’s say you have a $500,000 mortgage with an interest rate of 4% that is set to be paid off in 30 years.
Your mortgage payment would be $2,378 per month.
Over that 30 years, you would pay $856,000, of which $500,000 would be principal payments and $356,000 would be interest payments.
If you wanted to pay the mortgage off in 10 years aggressively, you would pay $607,000, of which $500,00 would be principal payments and $107,000 would be interest payments. This would save you $249,000 in interest payments.
To pay off the mortgage in 10 years rather than 30 years would require you to increase your monthly payment to $5,055, an increase of $2,677 per month.
How much money would you expect to have after 30 years by investing $2,677 per month? Assuming a 6% annual return, you would have approximately $2.69 million. Which is a better-expected return than paying off the mortgage quicker.
So far, this is not an apple to apple comparison. When your mortgage is paid off, you will no longer have a mortgage payment. That means you can increase your investment contributions by the amount of your old mortgage payment.
In the example above, once you’ve paid off the mortgage, you will have an extra $5,055 each month. What happens if you dedicate that new cash flow to investing?
If, after you pay off the mortgage in 10 years, you invest the entire $5,055 (your previous mortgage payment) for the next 20 years, you would have $2.34 million. Add in the $249,000 saved from paying off the mortgage earlier, and you have $2,589,000.
While this makes the math much closer, you still have more expected wealth after 30 years by investing.
Now let’s discuss some practical considerations when running the numbers.
Paying off your mortgage in 10 years rather than 30 years is extremely aggressive, and the math favors investing. The math would be even more favorable towards investing in a scenario where the mortgage was paid off in 15 or 20 years rather than ten years.
This is because, in the example above, investing has a higher expected return than paying down the mortgage. The longer it takes for you to pay off your mortgage, the more time the investments have to compound.
If you decide to invest and maintain the 30-year amortization on your mortgage, your investments are compounding for 30 years.
If you decide to pay down your mortgage in 10-years and hold off on investing, your opportunity cost is lower because your investments will have less time to compound. This assumes, of course, you begin investing as soon as the mortgage is paid off.
The longer it will take you to pay off your mortgage, the more the math will favor investing over paying off the mortgage.
Your mortgage rate and expected return on investment
I used a mortgage rate of 4% in this example. At this rate, the math is close when it comes to paying your mortgage off in 10 years compared to investing.
If your mortgage rate is locked in at less than 4%, the math would strongly favor investing.
If your mortgage rate is higher than 4%, the math will begin to favor paying off the mortgage.
I also assumed an annual rate of return of 6% on your investments. That implies a reasonably aggressive investment with a large number of risky assets like stocks. The higher the risk, the higher the expected return.
If you’re not prepared to invest in risky assets like stocks, you might be better off taking the guaranteed return on paying down the mortgage.
Other factors that favor investing
There are two factors not yet discussed that favor investing over paying down the mortgage.
Liquidity is a technical term that simply means having cash available to you. The more cash you can easily access, the more liquid you are.
Making additional payments on your mortgage to pay it down faster reduces your liquidity. Once the money is paid against the mortgage, you cannot access it again.
Compare that to investing in the stock market through a low-cost index ETF. You can cash out your investment and access that money at any time you want.
Yes, you might have to pay some tax or even risk selling at a loss if the market is down, but you will be able to access at least a part of your original investment at all times.
The most significant benefit of paying off your mortgage is getting rid of your monthly mortgage payment. Once your mortgage is paid off, your monthly cash flow (money in minus money out) will increase by the amount of your old mortgage payment.
In the long run, paying off a mortgage early can help your monthly cash flow. Here’s the problem: making additional principal payments will do next to nothing for your cashflow until your mortgage is paid off completely.
Again, this is in stark contrast with investing in index ETFs, which pay dividends and interest that contribute to your monthly cash flow from day one.
Other factors favoring paying down the mortgage
There are two factors not yet discussed that favor paying down the mortgage over investing.
Behavioral risk of saving and investing
Psychological benefits of living debt-free
Behavioral risks of saving and investing
When you line up the numbers on a spreadsheet, it seems like a no-brainer decision to invest rather than paying down a mortgage.
However, life is not a spreadsheet.
Investing is only a better option than paying down the mortgage if you actually follow through on saving and investing the extra money. This presents a problem because we know two things to be true.
Most people are great at making their mortgage payments.
Most people do a lousy job at saving and investing as much as they should.
Yes, you could annotate your savings into your investing account to take some of the decisions out of your hand. But, there is no getting around the fact that people are much more likely to make their mortgage payment than save and invest.
Even if paying down a mortgage is not the optimal decision on paper, it could be the best decision in reality if you’re not going to follow through on saving and investing as much as you should.
Psychological benefits of living debt-free
The other factor working in favor of paying off the mortgage over investing is the psychological benefit some people will have when they are entirely debt-free.
Many people simply cannot stand living with any kind of debt, even a mortgage. If you are the type of person that get’s stressed or loses sleep over your mortgage, then paying it off early is probably the right decision.
Managing money is about making the best financial decisions for you, not the best decisions for someone else.
How I approach the choice of paying down mortgage or investing
So, how do I approach the decision to invest or pay down debt? Like with any significant financial decision that I’m faced with, I think about it in the context of my goal of building enough wealth to leave behind so that my son and future generations don’t have to worry about money.
I ask my self if, in 60 years, my son and potential grandchildren will be better off if I pay off my mortgage early or start investing aggressively early? Thinking about it in that context, investing is the better option for me to accomplish that goal. A dollar invested today will be worth $36.27 in 60 years at a 6% annual return.
That does not mean investing is the right decision for you. It means that you need to make the decision to invest or pay down the mortgage in the context of your financial goals.
Take all relevant factors into consideration before making your decision
Speaking strictly from the perspective of which option is likely to maximize your lifetime wealth, it’s usually a better idea to invest rather than paying down a mortgage early.
The lower your mortgage rate and the higher your expected return on investment, the more the numbers favor investing.
Investing provides greater liquidity and does more to increase your cash flow in the time before your mortgage is completely paid off.
However, these calculations are worthless if you don’t actually follow through on your investment plan. If you simply don’t save enough or you are likely to sell your investments when the market takes a downturn, then paying down that mortgage will probably be a better choice.
Whichever choice you make needs to be made within the context of your financial goals. My primary financial goal is to build generational wealth, so investing is the clear choice for me. You need to think about what your primary financial goals are and make the decision that will move you closer towards those goals.