Thirty years is a long time. The typical first-time home buyer is 33 years old, according to the National Association of Realtors (NAR), which means if they get a 30-year mortgage, the end of that loan seems like a lifetime away. .
Thirty is also a career, the difference between entering the workforce and starting to think about retirement.
So when you have recovered financially after saving for the down payment and setting aside some money for when the furnace starts the bucket, you might start thinking about paying some extra capital in order to be free from the clutches of the bank before you’re retired.
But is paying off that mortgage to get out of debt the best thing to do with your extra money? Experts say there might be a better option, especially if you’ve taken advantage of historically low mortgage and refinance rates in recent years.
“The reality is that not all debt is created equal,” says Aleksandr Spencer, chief investment officer of Bogart Wealth, a financial planning firm based in Virginia and Texas. “Some, like mortgages, depending on certain factors, can provide significant economic benefits.”
Investing that money in the stock market could earn you a better return, despite today’s volatility in financial markets, experts say, leaving you with more money in the long run than if you paid off the mortgage faster. This is basic arbitrage – borrowing money at one rate of interest and investing at a higher rate in return.
“With a 30-year fixed mortgage, you have 30 years to beat the bank,” says Bruce Hyde, partner, chief compliance officer and wealth adviser at Round Table Wealth Management, a financial advisory firm. “That’s pretty long and I would say most people can generate a return above the interest rate.”
So should you put more money on that mortgage capital or invest it instead? Here’s what some experts have to say.
How Mortgages Work
A mortgage is a loan by which a bank or financial institution provides the borrower with the money needed to purchase real estate, with the property itself serving as collateral. These are usually long term loans – 30 and 15 year mortgages are the most common.
As for the interest rate of the loan, it can be either fixed, that is to say that it does not change throughout the duration of the loan, or adjustable, changing after a certain period and fluctuating with the market. Mortgage rates are generally lower than many other types of consumer debt, especially credit cards.
Pay off your mortgage earlier to save on interest
Your 30-year mortgage doesn’t have to last 30 years. You can pay more than your minimum payment and reduce the principal faster than it appears on your amortization schedule – which tracks how much of your payment will go to interest and principal each month of the loan.
There are a few ways to do this.
- You can change your payment schedule from monthly to bi-weekly, paying half of your monthly payment every two weeks. Because there are 52 weeks in a year, for 26 biweekly payments, you make the equivalent of 13 monthly payments per year instead of 12.
- You can also schedule automatic payment of an additional principal amount each month along with your regular payment.
- Or you can make one-time lump sum principal payments.
You also need to determine if your mortgage has a prepayment penalty. These aren’t as common as they once were, but your loan could still have one. Talk to your loan manager first to make sure those extra payments are allocated to the principal and you won’t have a headache.
At the beginning of your loan term, you will pay more interest than principal. “Generally, if you want to put money towards the principal balance of your mortgage, it usually makes sense to do so early because you have a bigger impact by making additional principal payments earlier in the term of the loan. “, says Cassandra Kirby, COO and Private Wealth Management Advisor at Braun-Bostich & Associates, a financial planning firm in Pennsylvania.
Invest in the stock market
If you have extra money each month, you can do other things with it. You might invest it in hopes of getting a return on that money. This return could be quite good, depending on what you invest in, but it can also be risky.
Returns can be significant. Consider the S&P 500, an index that tracks the performance of about 500 of America’s largest publicly traded companies. It has averaged a return of more than 10% since its inception in 1926. Other investment options, such as bonds, offer lower returns but also less risk, says Spencer. With a balanced portfolio of low-cost, diversified index funds, you can expect an average return of around 6% or more per year.
Choosing to invest instead of paying more for your mortgage means taking risks as markets go up and down. Experts say you should think of it as a long-term deal and focus on expecting returns over 30 years. “I balance risk and return to make sure I have positive arbitrage, but I don’t put too much risk in the portfolio,” Hyde says.
Compare investment gains to interest saved on the loan
As with most things related to money, your arbitrage may vary.
Consider these numbers, for a $300,000 30-year fixed rate mortgage with an interest rate of 4%.
|Additional principal per month||Total interest paid||Time to repay the loan|
|$100||$186,862||26 years, 6 months|
|$500||$123,194||18 years, 4 months|
Instead, consider if you invested $100 or $500 per month for 30 years and got a 7% return each year:
|Amount invested per month||Total after 30 years|
This difference – a saving of $30,000 compared to a possible return of $117,000, or a saving of $92,000 compared to a possible return of $588,000 – is significant, but it could in practice be even greater. , said Hyde. Mortgage interest payments are tax deductible up to a certain amount, while if you invest in a tax-advantaged retirement account such as a Roth IRA, there could be investment tax savings.
Of course, your return might not be 7% and your mortgage interest rate might be lower or higher than 4%. Experts say the higher your mortgage rate, the harder it is for your investments to beat interest savings. Whereas if your mortgage rate is lower, even safer assets like bonds can generate a good return. “Choosing which path to take really comes down to your mortgage rate and the threshold you need to meet, as well as your risk tolerance,” says Spencer. Of course, if your mortgage rate is much higher than the current rate, consider that refinancing at a lower rate could save you a lot in the long run and change the calculations on whether you should invest or pay off faster.
Should you pay off your mortgage or invest?
Before deciding, the experts say be clear where that choice stands on your financial priorities. When you receive extra money and decide what to do with it, a few other things should take priority.
First, those credit card bills. “Higher interest debt is the top priority before you hit your mortgage,” says Kirby. This has a higher interest rate, probably one you probably can’t beat in the market. Second, make sure you have an emergency fund or some other form of cash reserve that you can access quickly. Third, Kirby says you should prioritize setting aside money for retirement by contributing at least the maximum amount toward your 401(k) that your employer will match, if you have one.
The prospect of a higher return means that in the long run, investing will likely leave you with more money, potentially significantly more, than paying off your mortgage faster, experts say. “As a general rule, if your mortgage [rate] is less than 5%, it makes sense to explore some of these other options because you’re only taking on incrementally more risk,” says Spencer.
Beyond the higher return on your investment, Spencer says a benefit of investing is that your money is in a more liquid asset than paying off the mortgage. It is easier and faster to sell some of your investments, especially if they are stocks or funds, than to take out the equity in your home through a home equity loan or a home equity line of credit, which can be longer and longer. complicated process that comes with a new interest rate.
Paying off your mortgage sooner can provide certain benefits, including the psychological benefit of being debt-free. It’s also much less risky than investing, especially if your mortgage rate is high enough. “If you think you can earn more by investing than the interest rate you have on your mortgage, you should probably invest,” says Kirby. “It’s tough. It’s kind of market timing. It’s really hard to tell what the market will do at any given time.”
It also depends on how long you plan to stay in your home, Kirby says. If you’re only staying there for a few years, it makes more sense to invest. Paying off the loan earlier is a better idea if you’re going to be there for a long time, she says.