Mortgage Assumptions:
Mortgage: $250,000
Length: 30 years
APR: 3.5%
Monthly Payment: $1,122.61
The homeowner is taking the standard deduction where deducting interest doesn’t provide additional benefit.
Investing Assumptions:
Growth Rate = 6%
As a homeowner, it is hard not to dream of the day when I will no longer share ownership of my home with my friendly neighborhood (mega)bank. For most Americans, a mortgage is often one of the largest monthly expenses they have in their household. Over the course of a traditional 30-year mortgage, the monthly payments mark time towards a goal of financial independence. For those individuals contemplating retirement, being mortgage-free is a signal that planning an exit from the working world can now start in earnest. For those reasons, it's hard not to think about how to be mortgage-free faster. If you have surplus cash on hand, paying extra to speed up the process can be tempting. But does it really make sense to pay extra?
Recently I sought to answer that very question after looking at just how little principal has been paid off on my mortgage since we refinanced last year. In the following paragraphs, I walk through two scenarios: paying an additional lump sum to your mortgage principal vs investing that same amount. For simplicity, I will be using round numbers and fixed investment growth rates (assumptions below).
That total interest really stings, adding close to 2/3 more money on top of the principal over the full 30 years of the loan. But we can do better, so let’s dive into our first option to squash this mortgage faster.
Now we’re making some progress. Using Option 1, a lump sum payment of $10,000 directly to our principal, we cut our mortgage by 24 months and paid $17,487 less in interest. Having an extra $17k in your pocket at the end of your mortgage is a substantial gain if you have the surplus cash on hand to pay down extra principal today. Can investing really do better than that? Let’s take a look.
WOW. By investing our $10,000 at a relatively moderate growth rate, we end up with nearly 3X as much money. Clearing investing seems to be the best option, but maybe we’re cheating by assuming a much higher growth rate than our mortgage interest rate. If we run that same calculation at a 3.5% growth rate (same as the mortgage interest) what are the results?
Still a winner. Even when we assume a very conservative growth rate for our $10,000 investment, the results prove that investing is a better use of free cash. In fact, you would need to make an annual return of just 2% on your $10,000 investment to make the extra payment to your mortgage a more worthwhile investment.
The moral of the story here is that investing, even at a very moderate growth rate, will be the best way to build incremental wealth in conjunction with the normal payment of a mortgage. The exception to this will be any high-interest debt such as credit cards or other loans with rates of interest. Interest rates that exceed your expected investment returns should be the priority before putting money into the market. The higher the interest rate the more likely you should focus your efforts on paying a loan down.
It is worth noting that when it comes to building wealth, there is never one perfect strategy that serves everyone best. While mathematically, investing is clearly the better choice, in the realm of personal finance it rarely captures the whole story. The ‘personal’ matters here, which is why your own preferences will matter the most. Logic and math will only take you so far if your emotions steer you in a different direction. Know that no matter what, either choice is a positive step towards building a solid financial path for the future.
Good luck!
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