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Should We Invest or Pay Extra on the Mortgage?

Do you currently own a house? Are you still making payments to the bank? Have you ever thought about making additional payments to get that loan paid off faster? What if you invested the money instead? Most people would not be asking these questions, and since you are, I can tell that you’ll be a great financial position very soon! Let’s explore the question, “Should we invest or should we pay extra on the mortgage?”

What If We Invest Our Extra Money Rather Than Pay Down the Loan?

I’ve received quite a lot of advice about how to handle our new home loan. Some say that instead of paying extra money toward my house, I could earn a higher yield in the market. While it is true that I would most likely earn more than a 3.75% (the current interest on our soon-to-be loan) in the market, I am not fully convinced that this is wise. Here is my reasoning:

  1. I do not like the idea of the bank owning my house for 15 years (we will have a 15 year loan). If I make all the payments for 14 years, but suddenly lose my job and can’t make any more payments, the bank still has the right to take my house away from me. I’d rather own it free and clear as soon as possible.
  2. While I may earn as high as 8% in the market right now, 8% of a small amount is a VERY small amount. Whereas, 3.75% of $70,000 is most definitely a lot! I suspect that paying down our house debt is wiser for security purposes, and for monetary reasons!
  3. There is no guarantee that the market will earn money. We’ve all seen the market go down, and it can certainly happen again. There is, however, a guarantee of a 3.75% “earnings” if I pay down my loan early.

Extra House Payment Scenario

After the down-payment, our home loan will total somewhere around $70,000. We plan on signing up for the 15 year loan, but the payments will still be quite low. I figure that we’ll be able to pay an additional $1,100 per month toward this debt, which will allow us to pay off the house in just under 4 years, saving us $16,273 in interest.

Investing Instead of Debt-Payoff

Now, what if we invested the extra $1,100 into the market and earned an average of 8% per year?

As you can see by the table above, even by earning 8% on your investment for 4 years, you still come up short of the $16,273 we saved by paying off the house early! Plus, you will still be paying off your house for the next 11 years! Sure, you have some money in the investments, but I’d much rather have a paid-for house.

Are You Saying I Shouldn’t Invest?

I’m not saying this at all. While paying off debt can avoid thousands of dollars in interest payments, it’s not always good to have all your eggs in one basket. The housing market could flop again, and so could the stock market. Spreading your money around is always a good principle, and I would suggest it for this scenario as well.

Personally, my wife and I are placing about 10% toward our retirement investment accounts, and the rest of our earning will be used to pay down the house. This way, we’ll have a nice next egg in the future, and we’ll have a fully paid-for house.

What do you think about this article? Did it surprise you that the investment did not surpass the interest savings? I’d love to hear your thoughts!

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36 comments to Should We Invest or Pay Extra on the Mortgage?

  • In my opinion, a fully-paid principal residence is a better hedge. A mortgage is just one more big bill you won’t have to worry about.
    101 Centavos recently posted..Travel Journal – United Kingdom

  • Having the house paid off in 4 years is a great plan. You and your wife are young enough that you can then sock all of the money you were paying on the mortgage into a savings/investing fund and make some serious money then.
    Melissa recently posted..Menu Planning- 6-11

    • My goal is to have the house paid off by the time I’m 30, which would be the 4 year target. My wife will only be 27! The rest of our lives is going to be amazing! Take the hard route early, and life will just keep getting easier and easier! :)

  • We do both. We had a $740 mortgage for 15 years at 5.375% starting in 2007 and paid $900 total so we would pay off the house in 11 years. Then we refinanced this year to a $505 mortgage for 15 years at 4.5% interest and are still paying $900 total so we’ll have it paid off in 10 years total or less (by 2017).

    We also invest at least $3000 a year in the stock market via Scottrade, $4000 a year in a target date mutual fund with my 401(k), and $10,000 a year into our Roth IRA’s – $5000 gets put into a different target date mutual fund and $5000 is invested in high divendend stocks.

    I like having all of our bases covered. Good luck!
    Crystal recently posted..Love Drop June 2011

  • Brad

    I don’t think you really did an apples-to-apples analysis. The interest saved from pre-paying the loan is comparing a 15 yr time frame to a 4 yr time frame.

    A more appropriate analysis would be to compare both options at the same point in time. Using the same monthly cash flow (minimum mortgage payment of $509.06 + $1100), here is how the options would compare after four years…

    Option 1 – pay minimum on mortgage and invest $1100/mo at 8%:
    $61,995 (savings) – $55,997 (loan balance) = $5,998

    Option 2 – pay $1100/mo extra towards mortgage:
    $0 (savings) – $0 (loan balance) = $0

    Investing ends up winning by $5,998 after 4 years. You could also look at a 15 year time frame…

    Option 1 – pay minimum on mortgage and invest $1100/mo at 8% for 15 years:
    $380,642 (savings) – $0 (loan balance) = $380,642

    Option 2 – pay $1100/mo extra towards mortgage and pay off in 4 years, then invest $1609.06 for 11 years:
    $338,836 (savings) – $0 (loan balance) = $338,836

    Investing wins by $41,806 after 15 years.

    A couple of notes:
    1. 8% return on investment in a 4 year time frame is probably unrealistic. One benefit to paying down your mortgage is that you KNOW what your return on additional payments will be, but investment returns are uncertain.

    2. A true comparison of the two options should include tax implications (deduction for mortgage interest and taxes on investment earnings).

    • Nice analysis Brad! In these scenarios you have set up, investing wins, but what if we factor in capital gains tax on the investment earnings? Also, the house will most likely increase in value as well, which would make it the clear winner.

      As for the investment earnings, I chose 8% because it’s the highest realistic return right now (maybe almost high enough to be called unrealistic!). I wanted to make the comparison interesting.

      Thanks so much for the detailed comments. I love it!! I hope to see a comment from you again soon! :)

  • I do both and I have a really low mortgage rate of 2.40%. I have this discussion with co-workers sometimes. I look at it this way, the mortgage is guaranteed savings with significant compound growth. When I reach the 50K or so, or an amount that is easily payable with other sources, then I may play the interest rate game a little more. Not for now and it has to do with the ability to be independent. I think you need to have seen the impact on economic downturn to possibly favor being mortgage free. (I survived 4 layoffs in 3 years at our office).
    The Passive Income Earner recently posted..Short List of Stocks for June 2011

  • I’d have to say that I’d pay for the house first, using the logic that you stated at the beginning – no one can take it away from you when you dont own money on it. The fact that market returns cant beat what you’ll save on interest is just icing on the cake.
    Jeff @ Sustainable life blog recently posted..Spending and Stability

  • If you compound 3.75% interest for 15 years, and 8% interest for 4 years, then of course the growth in your investment account wouldn’t beat the savings in paying off your mortgage early. The mortgage has an 11 year advantage.
    JT recently posted..The 12 Types of Passive Investors

  • Johannah B

    I vote – pay the house off. There is so much freedom after that! By the way 3.75% – 15 year fixed loan – are the rates down that low! Not having a mortgage, means I am not paying attention to those rates. My first house was 8 or 8.5%.

    • I always like the way you think Johannah. Plus, you’ve been there! You’ve paid for houses with cash! I bet it’s wonderful! By the way, yes, the interest rates are down to 3.75%. It’s a great time for us to buy! :)

  • Depending on the circumstances, I would do both. Actually, I do both! I max out my retirement savings and pay addition principal to pay mortgage off. The 8% should be thought of as an average over a very long period. The key with investing isn’t the yield in a particular time frame, but getting the money in as early as possible to have it grow for 30-40 years.
    krantcents recently posted..KC Awards- Weekly Recognition

    • Out of anyone that would have picked up on that, I figured it would be you krantcents. ;) You’re right, the investments over time would become quite valuable, but your house will increase in value as well. I do both as well too. I invest and I will pay down our loans early. It’s best to spread out the risks of each investment.

  • Daniel

    Personally I prefer to invest. Thinking about your point #1 for paying house off early instead of investing. You are correct that if you make all 14 years house payments but then lose your job and can’t afford more payments that the bank could take your house. But I am investing instead of paying extra on the mortgage. So in that scenario I’ve got a ton of money now invested after 14 years that I can cash in and afford my last years payments on the mortgage.

    I think either way you are doing more than the majority of people and will be better off than most people. Whether paying off the house early or investing or both, you will definately be alot better than most people.

    • Daniel, I understand your logic, but pulling investment money out costs money in transaction fees, capital gains tax, and eliminates all future earnings. Money earned in your property is not taxed (for average sized homes anyway) and all of the earnings are kept.

      Be careful when comparing yourself to others. Yes, you may be better than the average person, but why not start comparing yourself to a millionaire? Your life will turn out much differently.

      Thanks for the comment! Hope I wasn’t too hard on you.

  • The interest rate is so low, I don’t really want to pay down the mortgage. But I still do! While we are making pretty good money, we might as well pay it down.
    retirebyforty recently posted..Save By Sharing One Car

  • you should definitely settle the house first – looking at your 4 yr express payoff plan, there is no better option right now! good luck..
    B Kelly recently posted..Investing 101 For Kids

  • I like the 4 year plan to get out of mortgage debt. Consider the psychological factor as well, and think about how great it would feel to be free of that.

  • Mortgage over investing ANYTIME. I have a 200k mortgage that I took out in 2008, hopefully it will be paid for in 2013-2014. Your lifestyle security is priceless and with your mortgage of 70k it will be easier to pay it off.
    BeatingTheIndex recently posted..Financial Risk in Leveraged Investing

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  • I think you should have it invested. That’s my opinion, okay. But That’s the way I could think in terms of that kind of problem.
    Jocelyn Ramirez recently posted..Lead Generation Software

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