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You have additional income or received a large sum, maybe through a raise or inheritance. The question comes up, is it better to pay off your mortgage or invest the money?
Many people have a strong opinion on this issue.
However, the answer is highly personal. It's worth going through the pros and cons. Some considerations are objective, requiring mathematical comparisons, and others are subjective, based on your personality, values, and stage in life.
From a purely mathematical approach, the answer to should you pay off your mortgage or invest is simple. Which decision results in the higher return on your money?
For example, you have a 30-year mortgage at 4% and are in the 25% tax bracket. You have 10 years left and only owe 50k. After receiving an inheritance you are faced with a decision to invest 50k in the stock market or pay off your mortgage. Let's assume you believe that you can get an 8% average return in the stock market.
The actual math is more complex, but a simple calculation looks like this:
- If you pay off the mortgage you save 3% in interest. 3% is the effective after-tax mortgage rate (4% reduced by the tax bracket).
- If you invest the money instead, you could make a 6% after-tax return (8% and assuming you pay the full amount of taxes on the growth every year 25%).
By this calculation, you should invest rather than eliminate the mortgage. Most calculations will show that you should always invest rather than pay off your mortgage. Because of this, the majority of advice tells you the same thing.
Real life isn't this simple.
Hypothetical returns make assumptions about the future. For example, the stock market never returns a flat percentage every year, stocks carry risk, and you could lose money on your investment.
There are a lot of other factors to consider.
Reasons to Pay Off the Mortgage
- Save on Interest: The interest paid over the life of a loan can add up to a huge amount. (A $300k 30-year mortgage at 4% interest will cost $515k over the length of the loan.). See how much interest you could pay with this mortgage calculator.
- A Sense of Security: You may sleep better at night knowing that the home is paid for. There is peace in completely getting out of debt.
- Reduce the Monthly Budget: If you can pay off your mortgage it eliminates what is typically the largest expense in your budget. Plus not having a mortgage lowers the amount of income you need in retirement.
Reasons Not to Pay Off the Mortgage
Loss of Income Tax Deduction
If you itemize, your home mortgage interest generally reduces your taxable income. Paying off your mortgage early means you lose this tax deduction.
Higher Return of Other Investment
Other investments may provide a higher return on your money. If you have a low-interest rate, you might be better off to invest the money, despite the additional risk.
It's easy to put money into your home, but it's difficult to get it out if you need it. In order for you to access the money in your house, you have to take out a loan or sell your property.
Your home is often one of your largest assets. By putting additional money into your house, you are concentrating a significant portion of your net worth in your home. Homes can be at risk of falling property values and non-insured risks. Earthquakes and floods, for example, are rarely covered by homeowners insurance.
Other Options for the Money
If you decide not to eliminate your mortgage, what are the other options that you have available? It can be difficult to resist the urge to waste money. Here are some beneficial ideas to save or invest.
- Retirement Plan Contribution: Take full advantage of your company's 401k match, don't leave “free money” on the table.
- IRA Contribution: Funding a traditional IRA gives you another tax deferral while contributing to a Roth IRA allows for potential tax-free growth.
- Build an Emergency Fund: There are lots of reasons to have an emergency fund. Use the money to protect yourself from the cost of appliance replacement, job loss, or the dreaded cell phone in the toilet.
- Pay Off Credit Cards: Paying down credit card debt should be a no-brainer. The revolving interest on credit cards is far higher than mortgage rates.
- Fund Children's Education: Are you funding your children's college fund? Put extra money into a tax-advantaged college savings strategy, like a 529, to help save for school. Or teach them about investing by buying your children some stock.
Should You Invest or Pay Off Mortgage?
The decision to put money towards your mortgage or another savings goal is a personal one. Take time to evaluate your financial situation, taking the pros and cons into consideration.
Whatever the decision, know that there is no absolute “right” answer, only what is right for you!
How about it, would you pay off your mortgage or invest? Please comment below.