If you have money left over after covering your bills, you might decide to get ahead by either focusing on paying off your mortgage or investing the extra funds. While both of these goals can benefit you, they each come with pros and cons — and the best option for you will depend on your financial goals and current circumstances.
Here’s what you should know when deciding if you should pay off your mortgage or invest.
Should you pay off your mortgage or invest?
There are several factors to consider when deciding whether paying off your house or investing would be better for your situation.
Paying off your mortgage early can be the better option if:
- You want to get out of debt sooner and reduce your monthly expenses.
- Your mortgage rate is on the higher side, or it’s similar to your potential investment returns.
However, investing can be a more ideal choice if:
- You want to build your retirement nest egg, and you can comfortably afford your monthly mortgage payment.
- You plan on selling your home soon.
- The interest rate on your mortgage is below 4%.
Tip: It can also be a good option to balance both of these goals instead of choosing between them. For example, you might contribute enough to get a 401(k) match from your employer or maximize your individual retirement account (IRA) contribution limit. Then you can periodically make extra mortgage payments to speed up your payoff timeline.
Pros and cons of paying off your mortgage over investing
Here are the advantages and disadvantages of making extra mortgage payments instead of focusing on investing:
Pros
- Interest savings: Making extra mortgage payments reduces the interest you pay over the life of the loan. You’ll save the most if you start as soon as you get a mortgage, which is when the bulk of your monthly payments goes toward interest.
- Peace of mind: You might simply want to know there’s no debt hanging over your head. With no mortgage, there’s one less bill to pay each month, and you own the home outright. This can be especially appealing if you’re either risk-averse or nearing retirement and want to minimize your expenses.
- Improved cash flow: Reducing your monthly expenses is also helpful if you have variable income or you live on a tight budget. Once you’re debt-free, you’ll have more money in your pocket for other financial goals or discretionary spending.
- Increased home equity: You grow your home equity — which is how much of your home you own — every time you put money toward your mortgage principal. This gives you the option of borrowing money with a home equity loan or home equity line of credit (HELOC) in the future.
Cons
- Illiquidity: Tying up your money in a nonliquid asset (an asset that can’t be easily accessed as cash) can be risky. When financial emergencies arise, you could have to sell your property or tap into your equity to access your funds. You might consider boosting your emergency fund instead so you can afford surprise bills in the future.
- Opportunity costs: When you put more money toward your mortgage, you have fewer funds each month for other financial goals, such as retirement savings.
- Potential penalties: Lenders might charge a prepayment penalty if you pay off the home loan early. Before you chip away at your principal balance, ask your mortgage lender if additional fees apply.
Pros and cons of investing over paying down your mortgage
Investing can be more appealing when you want to focus on your long-term financial goals. Here are the pros and cons to consider first:
Pros
- Potentially higher returns: Your investment returns could exceed the interest you save by paying down your mortgage early. This outcome is more likely if you have a low mortgage rate or can invest in assets with high growth potential.
- More liquidity: Investing in liquid assets, such as stocks, provides more financial flexibility. You can typically sell your positions quickly when you need money for urgent expenses.
- Tax-advantaged contributions: Contributing to a tax-deferred 401(k) or IRA reduces your taxable income for the current tax year. However, you might have to pay income tax plus a penalty if you take distributions early.
Cons
- No guarantees: Historical investment returns can help estimate your portfolio performance, but the actual results will vary. You may lose money in some years.
- Still need to pay off home loan: When you direct money toward investments instead of your home loan, you’ll remain in debt longer.
- Potential penalties: If you take distributions from your retirement account before retirement age — usually 59 ½ — then you’ll likely be penalized. A taxable brokerage account could be a good option if you need to make withdrawals.
Saved up $10,000? Here are five popular ways to invest it.
How to decide what’s best for your finances
The best course of action is different for everyone, so it’s important to evaluate both your short-term and long-term financial needs. It’s also a good idea to compare your potential interest savings to your estimated investment gains.
When paying off your mortgage is best
Paying off your mortgage early might be the better choice if you want to get out of debt sooner and you have a higher interest rate.
“By eliminating this significant debt, you can free up future cash flow, reduce monthly expenses and gain a sense of ownership over your home,” says Jorey Bernstein, founder and CEO of Bernstein Investment Consultants.
According to Bernstein, an early payoff can also:
- Protect against market fluctuations and potential economic downturns.
- Provide stability and a stress-free living situation.
- Allow you to focus on other financial goals with a sense of security.
Example
Let’s say you buy a home for $300,000 with a down payment of 20% and a 30-year repayment term. Instead of investing, you opt to put an extra $300 per month toward your mortgage. Here’s how much time and money you could save based on the loan’s interest rate:
Keep in mind: It’s still important to continue contributing to your retirement accounts as you pay down your mortgage debt.
When it’s better to invest
If you prefer the long-term financial security of earning passive income and have a high risk tolerance, investing can be the better option.
“Investing has the potential to generate higher returns over the long term, allowing you to build wealth and achieve financial independence,” Bernstein says.
By focusing on investing, you can:
- Diversify your investment portfolio and reduce risk.
- Leverage the power of compounding.
- Take advantage of market growth.
- Achieve your retirement goals.
Example
Say you open an investment account with $300 and then contribute another $300 each month. Here are the potential gains you could expect with different rates of return and varying investment timelines:
New to investing? An online brokerage platform could be a good place to start.
Alternatives to paying down your mortgage or investing
Other financial moves can also be worth pursuing and can make your disposable income more productive. Here are some other goals you might consider focusing on:
- Build a cash cushion. Increasing your emergency fund to cover three to six months’ worth of living expenses can give you peace of mind. You also won’t feel pressured to sell investments or your house if you need to make ends meet. There are a few types of savings accounts that can help you build up your savings — for example, a money market account can earn a competitive interest rate and provide ample liquidity.
- Pay off high-interest debt. Paying off high-interest debt, such as credit cards or personal loans, helps you save on the cost of interest. This could be a good option when the interest rate on your debt is higher than the rate on your mortgage. If you have good credit, you might consider consolidating your high-interest debt if you can take advantage of a lower interest rate than what you’re currently paying.
- Plan for upcoming expenses. Setting aside cash in a high-yield savings account insured by the Federal Deposit Insurance Corp (FDIC) can help you avoid going into debt for expensive purchases.
Frequently asked questions (FAQs)
The main disadvantage of putting more money toward your mortgage is having fewer funds for other financial goals. For example, you might have to make large catch-up contributions later on if you don’t save enough for retirement. It’s also possible to miss out on higher returns when you’re focused on mortgage debt instead of investing.
Your mortgage lender will notify your county recorder that you paid off your home loan. You should receive a lien release form in the mail confirming this event.
From a financial perspective, you’ll have more cash flow to save, invest or spend on other priorities after paying off your mortgage. However, you’ll also be responsible for paying property taxes and homeowners insurance premiums.
When you refinance a mortgage, you take out a new home loan with different terms. This could be a good option if you can qualify for a better interest rate, which can reduce your overall interest costs and potentially help you pay off your home loan faster.
If you’re thinking about refinancing, make sure that the resulting savings will outweigh your closing costs, which are typically 3% to 6% of the loan amount.
The best investment option for you depends on your current portfolio allocation, personal goals and risk tolerance. Aggressive investors might prefer growth stocks, which are more volatile but have above-average returns over the long term compared to low-risk investments.
Risk-averse investors and individuals with a short-term investment horizon, on the other hand, could consider money market funds, which are more likely to offer consistent returns. However, keep in mind that the average return for this type of account is usually lower than what you see in the stock market because of the lower risk.
Regardless of what you invest in, having a diversified portfolio is essential to managing risk and optimizing your portfolio performance. Most online brokers offer stocks and fixed-income investment options to satisfy nearly any investment strategy.
Compound interest is the interest that’s calculated on both the money you contributed and the interest you earned. Essentially, it’s interest that you earn on interest.
