My husband and I are having this debate now. He wants to pay down our mortgage faster with additional principal payments each month, and I want to invest the cash in equities and high-yield savings account instead. My husband’s intentions come from a very good place — to minimize his family’s future financial obligations should anything happen to either of us. I’m motivated by my FIRE-fiend partner (not 🔥, but Financial Independence Retire Early) to maximize our net worth for all financial decisions.
Spoiler Alert: I had some trouble convincing him, so I built a model. And the winner is: invest!
Let’s assume we have a mortgage with the following terms:
Loan: $500,000
Interest rate: 5.0%
Loan term: 30 years
Payments per year: 12
Our monthly payment according to these terms would be $2,6841. Part of this payment would go to interest, which is the 5% divided by 12 months, multiplied by the outstanding loan balance. The remainder goes toward the principal.
Over the 30 year term, the interest portion each month would gradually reduce as the loan balance goes down. The monthly payment would remain the same, with a higher portion going to principal.
Our total interest payments over the life of the loan would be $466,279.
Now let’s look at an example where we pay our mortgage off faster.
Using the same assumptions, let’s say we more aggressively pay down our principal. In addition to the $2,584 monthly payment, we put an extra $500 a month toward principal.
Our loan balance gets smaller faster, so that we pay less total interest. Our total interest payments would amount to $313,378, which is a reduction of $152,901. And, we would pay off our mortgage faster — by 8.7 years!
This scenario yields a guaranteed 'return' – avoiding the payment of interest that would otherwise have accrued. It's a valuable sum, especially for individuals who may not have a high-risk tolerance or a clear investment strategy.
By these numbers, it’d be a no-brainer to accelerate your mortgage payments, provided you have the cash to pay that extra principal. Paying down the mortgage faster is a psychological win by removing a significant debt sooner.
But wait, there’s more. Let’s look at a different example where we invest the cash.
Alternatively, placing additional funds into a diversified investment account can provide a significantly higher return, particularly over longer horizons. Let’s assume you can get an 8% annual return from the equity markets. And let’s say that instead of paying the additional principal of $500 per month, you invest that.
You won’t pay your mortgage off any faster, and you won’t realize the reduction in interest of $152,901. But, over the life of the mortgage (30 years), your total investment of $180,000, with 8% compounded annually, could yield total returns of $565,180.
In this specific example, the total returns more than offsets the higher total interest paid. Your cumulative net value actually increases to $98,901.
When we compare the two scenarios, it's pretty clear that investing (Scenario 2) results in more net value than paying off your mortgage early (Scenario 1). Both scenarios are better than doing nothing -- paying your regular mortgage (ie your Base Case). Accelerating mortgage payments increase value by $152,901 from the Base Case, and investing increases your value by $565,180 from the Base Case.
One important thing to note is that Scenarios 1 and 2 are not truly apples-to-apples: After paying off the mortgage with accelerating payments, we have 8.7 years where we are doing nothing with the would-be monthly payments. If we were to invest those payments, we would get an additional $123,023 in value. Scenario 1 would then have an increase in value of $275,924 from the Base Case. Still though, Scenario 2 wins out.
The above example indicates financial math that strongly supports investing over accelerating your mortgage payments. But this isn’t always true.
Here are situations where it may make more sense to pay down your mortgage faster:
If you’re considering buying a house now (March 2024), you’re looking at interest rates at around 7%. That is very high. A $500,000 mortgage at 7% would require total interest payments amounting to $697,544. In this case, paying an additional $500 per month toward principal would save you $252,536 in interest payments and shorten your mortgage by 9.3 years.
If you choose to invest the $500 instead, you could create more value, but there’s also inherent risk in that approach. When the spread (difference) between your mortgage rate and interest rate is small, that risk becomes a bigger factor. Suppose actual investment returns turn out to be just 7%. You'd be about even with paying your mortgage early. But what if the returns are worse at 6%? Your decision to invest will have generated lessvalue than accelerating your mortgage payments.
I’ll mention here again: there is risk to investing in equities. If you are seeking higher returns, the cost is taking on higher risk. I used the 8% rate assumption based on the average stock market returns of the major financial indices over the last 10 years:
S&P 500: 10.2%
Dow Jones Industrial Average: 8.7%
Nasdaq Composite: 13.8%
They are all upwards of 8%, so I am comfortable using this as a forecast. But, it’s not ‘guaranteed’ as a fixed mortgage rate would be.
If you are risk-averse, you may not be warm to the idea of investing in equities. A safer option might be a high-yield savings account that is FDIC insured, where you can currently (March 2024) get up to a 5% interest rate. If your mortgage rate is 5%, whether you put invest in 5% savings or accelerated payments is a small difference, financially. The savings account may offer you more flexibility for a rainy day; the additional mortgage payments may force you to be more disciplined so that you are not tapping into that ‘extra’ cash.
In the end, reconciling the balance between risks and opportunities will be the deciding factors. Whichever option you decide on, you need to have a solid understanding of what each alternative means financially. For me, modeling out the scenarios helped me quantify the outcomes to show my husband which got me his buy-in. We just opened an E-trade account!
This analysis is built on the core principal of money management: opportunity cost. Opportunity cost represents the potential benefits you would miss out on when choosing the next-best option. If you decide to pay down your mortgage early, the cost is the potential earnings from investments you didn't make. Conversely, if you invest additional funds instead of paying down your mortgage, the opportunity cost is the interest savings you forfeit. Recognizing and evaluating opportunity costs is crucial for making informed financial decisions that align with your long-term objectives and risk tolerance.
References
1 https://www.bankrate.com/mortgages/mortgage-calculator/#calculate-mortgage-payment
2 https://www.nasdaq.com/articles/heres-the-average-stock-market-return-over-the-last-10-years
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