Most personal finance bloggers tout the benefits of debt freedom, but in some cases, you are better off doing something with your money other than pay off debt. It may seem counterintuitive, but you can actually end up with more money by paying interest to the bank.
But that is not always the case. To decide if you are better off paying your mortgage or adding to investments, follow this guide.
The Benefits Of Going Debt Free
The benefits of debt freedom are immense. Imagine living without a rent or mortgage payment every month! That is absolutely possible, and new people pay off their mortgage every day. However, in most cases that mortgage payoff takes decades. If people were to focus all of their financial energy on paying off the mortgage, many more people could be debt free.
While homeowners would still owe property taxes and need homeowner’s insurance, paying off a mortgage has a massive financial impact on most people. Imagine what you could do if you didn’t have to make that payment each month. You could save and invest more – a smart idea. You could add an additional vacation each year – a fun but less savvy idea. The opportunities are endless!
But that doesn’t mean getting there is easy. While debt freedom is a great concept, it is a pipe dream for many, but focus on the long-term. Adding an extra $20 per month to your mortgage payment saves you interest every month and shortens the life of the loan.
Bump it up to $100 extra, throw in annual bonuses from work and tax refunds, and you’ll be on the way to debt freedom before you know it. But that may not be the best use of your dollars.
The Benefits Of Investing
On the surface, investments and mortgages have little to do with each other. One costs money, the other earns money. One is for people who owe, the other is for people who own. Regardless of your homeowner status, the benefits of investing are clear.
If you put away money every month in investments, you are building a nest egg of savings that you will be grateful for in the future. But the reason you put money into investment accounts, such as a 401(k), IRA, Roth IRA, or regular brokerage account, is to do more than save. Thanks to the power of the stock market and compound returns, your money will grow by more than simply what you contribute each month.
For example, let’s say you have a moderately aggressive portfolio and can invest and earn an average 7 percent annual return every year. Adding $100 per month yields more than $1,200 in savings per year, you would end up with $1,243 thanks to the power of compound interest.
After 30 years, you would have put $36,000 into your investment account. But thanks to a 7 percent return, you would have $122,820.44. That is a massive return on your investment!
Make a Math Based Decision
So, let’s say you have an extra $100 per month in your budget and you want to compare investing that $100 compared to making a bigger mortgage payment. How should you decide to invest? Make a decision based on the numbers.
The average mortgage rate today is around 4 percent, according to Bankrate. Meanwhile, the compound average annual return of the S&P 500 is more like 10 percent over a long-time horizon. That is a 6 percent difference between the two.
If you make an extra payment into your mortgage, you are paying down a loan that charges 4 percent. A penny saved is a penny earned, so this is just like investing at 4 percent. Investing $100 for 30 years, a typical mortgage length, at 4 percent would yield $65,692. After subtracting the $36,000 you put in, that is a $29,692 interest savings on a mortgage.
But if you were to put that $100 into the stock market for 30 years instead and earned an average 10 percent per year, you would end up with $228,927. After taking out your $36,000 investment, you earned a $192,927 profit. That is about six and a half times as much as you save with an early mortgage payoff.
But what if your investments did even better? If you had a breakout portfolio and earned 16 percent (this is not realistic for most people, just a hypothetical example), you would end up with $902,870. That’s a capital gain of $886,870.
While the “return on investment” from an early mortgage payment is at a fixed interest rate, your possibilities from investing are limitless. Over time, a 10 percent return has proven reasonable for low-fee index fund investors.
Hypothetical investment returns investing $100 per month for 30 years at 4%, 10%, and 16%. The power of compound interest in action! Calculate your own savings with the Investor.gov Compound Interest Calculator.
As you can see, there is a big financial incentive to invest rather than pay down your mortgage. However, in real life nothing is that black and white. Some years the markets offer a great return, while other years the markets go down. Further, you can’t really make an additional $100 payment on a mortgage every month for 30 years, it would be paid off early, so your savings would be slightly lower.
There Is No Right Or Wrong, Just What’s Right For You
Getting access to an additional $1,000, $2,000, or whatever your monthly mortgage payment requires each month is hugely valuable, but so is a massive return from stock market investments.
When investing, there is a possibility you won’t hit your target 10 percent return. You could do a lot better, but you could do a lot worse. If you return anything better than 4 percent, you are mathematically better off in the stock market, but it is possible you could lose money too.
Everyone’s finances look a little different, so there is no right or wrong answer in the savings vs. investments question.
When it comes to investing or paying off your mortgage early, which would you consider doing first?