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Should You Use Extra Income to Pay Off Your Mortgage or Invest?

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Budgeting

Should You Use Extra Income to Pay Off Your Mortgage or Invest?

If you have any extra income that you want to save, you might use it to pay off your mortgage or invest it since savings account interest rates are so low. You are probably here because you realized it can be a difficult decision to determine what is the better option to get the most value out of your hard-earned money.

What should you do? We’ll show you the advantages of

We’ll show you the advantages of making extra mortgage payments and investing so you can see both sides of the coin.

Advantages of Extra Mortgage Payments

What qualifies as an extra mortgage payment? Any payment in excess of your minimum monthly payment. For example, if you pay $650 a month instead of the minimum $600 a month, you pay an extra $50 each month and an extra $600 a year. On a 30-year mortgage, that’s one extra mortgage payment every year that will save you $11,000 in interest payments as your loan will be paid off five years sooner.

Extra mortgage payments give you the following financial advantages:

  • Own your home sooner
  • Save thousands of dollars in interest payments
  • Potentially be debt-free once mortgage is paid in full and you have no other loans

Savings Increase With The Larger The Payment and Longer the Term

Extra mortgage payments will save you the largest amount of interest when you have a 30-year mortgage. For the first 10 years of your mortgage payments, the majority of each monthly payment pays the accrued interest instead of the principal.

Most homeowners do not realize the mortgage amortization repayment schedule for a 30-year mortgage and how much interest is paid in those first few years. If you are going to begin making extra payments, it’s better to make those extra payments as early as possible when most of your payment is being applied to the interest instead.

Even if you are in year 20 of a 30-year mortgage or year 5 of a 15-year mortgage, you can still save a large chunk of money by paying an extra $50 or $100 a month. If you can financially swing it, you might even decide to pay an extra monthly payment each month so it would be a $1,200 payment instead of the usual $600 payment.

Become Debt Free Sooner

If you don’t like debt, you might also prefer making extra mortgage payments because once you make the final mortgage payment, you may never be in debt again. Once you own your house, you can then invest the dollar amount you used to send to your mortgage lender all those years. Now, your money can begin working for you, and, your monthly expenses will drop as well.

Calculate How Much You Can Save

While you will benefit the most from extra mortgage payment if you are at the beginning of a 30-year mortgage, any extra payment will help you save money and pay off your mortgage sooner. To find out exactly how much you can save in interest, use a mortgage calculator and try entering different payment amounts that align with disposable income and debt payoff goals.

Advantages of Extra Investments

The primary reason to make extra investments is that current mortgage interest rates are at historic lows. An applicant with good credit can easily qualify for a 3.25% interest rate. On average, most stock and mutual fund invests have annual returns of at least 8%. That means your money can theoretically be 5% more productive by investing because a $50 investment will earn more in interest at 8% than a $50 payment will repay interest at 3.25%

Using an investment calculator, you can compare your potential investment earnings to the interest you will save through extra mortgage payments. As an example, investing $50 a month with an 8% interest rate will be worth approximately $67,679 in 30 years. With extra mortgage payments, you will only save $11,000 on a $250,000 mortgage of 30 years. By investing instead of making extra mortgage payments, your extra income can be worth $55,000 more because of the higher historical investment returns.

Compound Interest

In addition to earning more interest, your investment will earn compound interest with dividends. For example, if your $1,000 investment earns $80 in dividends this year, your investment will now be worth $1,080 and can continue to grow. Since you are essentially “earning interest on interest,” you would earn $86.40 next year with an 8% return rate and the amount will continue to increase as long as you own the same investment.

Compound interest can literally mean the difference between retiring as a millionaire and not.

You Have Liquid Capital

Have you ever heard the expression “You can’t eat your house.” One downside of making extra mortgage payments is that you can never get that money back unless you sell the house. If you suffer a financial emergency or lose your job and need cash to pay the bills, you might have to sell your house to make ends meet.

Although investments can decline in value in the short-term, they generally earn a profit when held for at least five years. More importantly, you can sell an investment today and be able to access the cash tomorrow if you are in a financial bind. If your finances are somewhat shaky, you might decide to invest your extra income because investments for the financial flexibility since the average investment rate is double the average monthly mortgage rate.

When To Make Extra Mortage Payments

Here are a few times it makes sense to make extra mortgage payments:

  • You don’t want to worry about stock market volatility
  • Being out of debt sounds more appealing than investing and earning compound interest
  • Your mortgage interest rate is comparable to the average mutual fund 8% rate of return
  • A mortgage is a high percentage of your monthly expenses

Once you repay your entire mortgage, do everything possible to “catch up” by investing the same dollar amount that you used to be your monthly mortgage payment. By investing the extra $50 a month, your money could be potentially worth $55,000 more. While you might own your house sooner, you might have to work an extra year or two to make up the difference.

Of course, if you live on a limited income and not having a house payment will greatly improve your quality of life because you will no longer have the stress of living paycheck to paycheck or even having to work a second job just to afford the mortgage payment, the extra mortgage payments can be more beneficial. As long as you are at least investing something (i.e. your employer’s 401k match) while you make the mortgage payments, you are still saving for the future.

When To Invest Extra Instead

From a numbers standpoint, investing your extra income is more lucrative given the current economic climate since history tell us you can usually earn at least double in interest than you will save with extra payments.

Here’s why you might like to invest instead:

  • Investment historical yields are usually higher than the current mortgage interest rates
  • You want to continually earn interest as long as your money remains invested
  • Investments are easier to sell if you need cash quickly

Investments continue to generate passive income for a lifetime. While you might be making a mortgage payment for the next 30 years, your money will theoretically be more valuable because it can earn a higher interest rate compared to how much interest accrues from your mortgage each year. If you still want to be able to access your cash for any reason, investing is also the better option since there’s guarnatee how soon you will have to sell your house, how much you will earn from the sale, and how much your new living conditions will cost if you have to sell your house to make ends meet.

Summary

Neither decision is wrong as they both greatly improve your long-term financial situation compared to unnecessarily spending the money or keeping it a savings account with a paltry interest rate. Whether you decide to pay your mortgage early or invest the extra cash will greatly depend on how soon you want to become debt-free and your current financial situation. Take a side and congratulations on making your money work smarter.

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