Paying off a mortgage or investing: Which is better?

Whether you have some extra money left over in your budget each month or experience a bit of a windfall, you may want to make the most of the extra cash you have on hand. Which is why instead of buying a new car or taking a luxurious trip, you may be in the midst of a hot debate about whether or not to pay off a mortgage or invest. Being mortgage-free sounds pretty sweet, but so does benefiting from investments and enjoying the power of compound interest for decades to come. 

Is it better to pay off a mortgage or invest? When you're trying to decide whether to invest or pay off your mortgage, it's all about opportunity cost. Consider how much money you currently have saved and how quickly you may be able to pay off your mortgage versus how much money you could potentially make by investing in something else.

Those looking to earn more from their savings can benefit greatly from investing, but those who prefer to pay it safe will likely prefer to make progress on paying off their mortgage loan.

Paying off your mortgage early

If you’re thinking of hustling to pay off your mortgage early, here’s some pros and cons to keep in mind. 

Pros

• Minimal risk: There is a chance that by investing your extra savings that you’ll earn more in the market than you spend on interest on your mortgage loan, but there are no guarantees with investing. That’s why some people see paying off a mortgage as a less risky move to make. 
• Smaller interest payments: The faster you pay off your mortgage, the less you’ll spend in interest. Paying off your mortgage can save you a lot of money in interest payments and even if you can’t fully pay off your mortgage, making extra payments here and there means you’ll spend less since the interest you pay is based on the principal balance of the loan. 
• Less debt: Paying off your house in full leads means less debt, which can free up a lot of room in your budget each month towards other expenses. If the burden of a mortgage stresses you out, that's another reason to pay it off early. The peace of mind can go a long way.
• More access to equity: When you pay off your mortgage, you have the ability to leverage all of the equity you built in your home by opening a home equity line of credit (HELOC). It could also help down the line when you sell your house, and need to buy a new one.

Cons

• Less diversification: If you can’t afford to pay off your house early and invest in the market, you may find that all of your eggs are in one big investment basket.
• Possible prepayment penalties: Some mortgage lenders charge a prepayment penalty fee for paying off a home loan early. Double check with your lender to see if you’ll end up incurring a fee for paying your mortgage off in full before the end of the loan term and crunch the numbers to make sure you’ll save enough money on interest for that move to make sense. 
• No home tax deduction: Paying mortgage interest can lead to a big tax deduction each year. Being able to write-off mortgage interest can help lower your taxable income and can increase how much you receive in a tax refund each year.  

Learn how to pay off your mortgage in five years

Investing your money instead

If you have extra money in your savings that you want to make the most out of, you may also consider investing it instead of making extra mortgage payments. 

Pros

• Potential higher rate of return: If you have a low interest rate on your mortgage, you may make more money by investing in the market than what you would save on interest. There’s no guarantees here, but you can start by comparing your interest rate to the historical rate of return on stock market investments, which has been about 10% per year on average for the past century.
• More asset liquidity: If you need cash, it is much easier to sell an investment such as a stock or bond than it is to sell your house. You can also choose to sell just a small portion of your investment portfolio, whereas if you focus on paying off your mortgage early, you would have to sell your entire home. 
• Employer match on contributions: If you choose to invest through an employer-sponsored retirement account such as a 401(k), many employers match some or all of their employee’s contributions. This is free money that can help you boost your potential earnings. 
• Tax benefits: Investing in certain retirement accounts can lead to tax savings now or in the future. 

Cons

• More risk: When you pay off your mortgage, you own your home and as long as you can keep paying your property taxes, you have a secure place to live for the rest of your life. With the stock market, you can make a lot of money if all goes well, but you can also lose money, especially if you are not an experienced investor. Paying off a mortgage is much more secure than investing in the market. Even if the house loses value, you at least have a place to live. 
• Builds equity slower: The longer it takes you to pay off your mortgage, the slower you build equity in your home, which can give you a lot of financial flexibility. 

Should you pay off a mortgage or invest?

Whether or not you should pay off your mortgage early and invest the money instead depends on your financial goals, personal circumstances, as well as your preference for risk.

Make sure your personal finances are in order

Before you pour your money into a mortgage pay off or extra investments in any form, think about whether those funds wouldn't be better served elsewhere. You should only consider paying off a mortgage or investing if

• You have an emergency fund: You have a healthy amount nested away to help with unexpected expenses for about three months.
• You contribute regularly towards retirement savings: You don't want to take away from funding a retirement account.
• You've don't have any high interest loans: Credit cards and other forms of unsecured debt typically come with high interest rates, above 12%, so you should make a point to repay the balance every month if you have the extra cash before you start investing that money elsewhere. Same goes for any private student loans with interest rates higher than your mortgage.

Decide how long you'll live in the house

Whether or not the house is your forever-home can help you decide whether or not you should pay off the mortgage or invest the funds instead. If you are not planning on living in your current home for a long period of time, it may not be beneficial to pour all of money into the mortgage payoff. If you are settled in and have a fixed mortgage rate with a long loan term, then investing instead could be something to consider.

Compare the rates of return

As real estate property, your home is already a low-key investment, one that can help you build your net worth and pass on to future heirs. Home prices also tend to appreciate, too, even during times of inflation. Going back to 1990, home prices have had an annual appreciation of about 4%, and it has continued to increase in recent years, and even more so for in certain hot markets.

On the other hand, the historic annualized average rate of return for the S&P 500 is much higher, at about 12%, which means you could earn more by investing. Individual stocks and alternative assets could yield even higher returns, but may be more volatile. Knowing your appetite for risk is integral to how you approach investing, or whether or not you should at all.

Consult with a financial planner

Paying off a mortgage is easy; investing by contrast is hard. Higher risk investments, like stocks, have the potential to yield a higher investment on returns. Other lower-risk assets like bonds or CDs (certificates of deposit) are less risky, but may not net you as much profit. If you decide the invest instead of paying off your mortgage, you can always diversify your portfolio so you have a mix of both assets. Unless you have experience playing the stock market, you may want to hire a financial planner to help you decide what assets to invest in.

Related: What is the 1% rule in real estate?

Consider refinancing first

Another way to have it both ways is to refinance your mortgage to a lower rate or better terms. With a lower monthly payments, you can use any potential savings towards investments of your choosing. One easy way to do this is to simply funnel more money into your retirement account like a 401(k) or IRA.

When weighing whether to pay off a mortgage early or invest elsewhere, bear in mind that some combination of both would likely yield greater financial stability than either choice alone. Again, consider speaking with an experienced financial advisor who can help guide you through this decision process so that you can make an informed decision about what makes sense for your own personal circumstances and goals.