You've got a mortgage payment, a little extra income to work with, and you're curious how you could best use that money to find financial freedom.
Specifically, you're dealing with the "pay off mortgage or invest" predicament. On the one hand, paying off your mortgage could lighten your burden, while you might be able to generate more wealth if you invest.
We're going to look at whether paying off mortgage faster or investing is the wise long-term choice today. Hopefully, the information below will help you get a better idea of how to best use your funds.
It might seem like the obvious option to just pay extra money into your mortgage. After all, the more you pay into your mortgage loan, the less money you'll have to pay in interest over a long period of time.
Regular small contributions to the principal value of your loan can cut down on years of interest payments. Additionally, the sooner you're out of debt, the sooner you can start to direct all finances toward other investments.
That said, a closer look at the numbers could tell a different story.
When you explore expected returns on certain investments over time, you might find that those returns exceed the value that you'd save in interest if you paid into your mortgage. The returns you make might even be enough to cover the remainder of the loan at once and still have significant cash.
Let's look at why investing is often a better choice.
Let's say that you buy a two-hundred thousand dollar home with a fixed interest rate of 4.5%. You're paying around $1,000 per month for 30 years.
The total interest that you expect to pay is upwards of $165,000 over that 30-year period. That might be startling, but it's relatively low for an investment like that over such a long period of time.
Let's also say that you've got a regular $300 of additional income to work with and put toward your financial future. If you put that money toward your mortgage, you'd pay off the loan in nineteen years. In doing so, you'd also save yourself almost $70,000 in potential interest.
That said, there are index funds that consistently bring in returns of 8 to 11%. Markets fluctuate, but it's possible to make long-term investments with a relative amount of certainty for returns.
If you were to contribute $300 every month to an index fund that paid back 8% for the same nineteen years, you'd end up with over $160,000.
You would have been paying your mortgage for that period, and the value of the loan would be down to just over $100,000. If you wanted to, you could use your investment to pay off the entirety of the loan and have almost $60,000 to keep.
In this equation, a smart investment would offer you a lot more money than paying down your mortgage.
Another thing to consider is that you don't have access to your money when you put it into a mortgage. Sure, you could refinance or sell, but those options take a long time and require that you take out new loans or lose your home.
An investment can be withdrawn quickly. Sometimes withdrawing your investments could trigger a tax event, but the fact remains that it's still there for you to have.
In the event of an emergency, it's always good to have a significant amount of liquid cash at your disposal. Liquidity is just the ability to have money if you need it, rather than it being tied up in immovable investments like a mortgage.
Additionally, you might come upon a better investment opportunity and want to put your money toward it. You can't do this if all of your money is wrapped up in the home.
Another factor to consider is putting some of that money into your RRSP. Doing so can reduce your amount of taxable income, and the money is still going toward investments.
While there can be big advantages to investing rather than paying into your mortgage, it's still beneficial to pay off the mortgage faster than you have to.
Investments aren't as reliable as money put into your mortgage, for one. When you add additional money into your loan, it's there. It can't go anywhere and it reduces your interest right away.
Investments can go sour in difficult times. As we all saw over the last year, economies can shift quickly, leaving investments and savings in tatters. We can depend on safe investments over the long term, but there's always a slight risk that things could turn sour.
Another reason to pay off your mortgage faster is that you'll be out of debt. The sooner you're out, the sooner you're finished with that burden. Debt in old age can be stressful and diminish your quality of life.
That's especially true if your retirement fund is tight. The last thing you want is to throw big portions of your pension or retirement fund into your mortgage.
You should be able to enjoy your retirement and focus on the things that matter.
So, while there's a good chance that an investment will pay you more in the long run, the safer bet is to cover your mortgage first. There are financial securities and personal advantages to simply having the mortgage off of your plate so you can move on to other things.
Now that you had a look at the benefits of both paying your mortgage and investing additional income, it's time to think about what you're going to do with that cash.
The smart choice will come from a close look at your financial situation as well as the conditions of your loan. Further, the opportunity for a great investment might also change the decision you make.
You should first take a look at the interest rate on your mortgage and calculate the amount of interest that you'll pay over the lifespan of the loan. The example above was a hypothetical with a pretty good interest rate.
Some people might have different situations with massive interest rates. If you've got an exorbitant interest rate, you will probably benefit from paying your mortgage first.
For example, shaving ten years off of a mortgage with a high rate could save you hundreds of thousands of dollars. That might be a lot more than you could ever expect to get from an investment.
Also, make note of how much money you can reasonably invest. The example above was $300 per month, but not everybody can make that contribution. When your monthly contribution is low, pitching into your mortgage tends to be the smarter choice.
Investments in index funds have to reach a certain value before they start to bring in large returns. If your contributions to investments won't reach a high value before your mortgage is up, the smarter play might be to put them toward your mortgage payments.
If you're on the other side of the equation and have some disposable income along with low-interest rates, an investment might be the smarter option.
The difficulty is finding the right investments to put your money into. Financial advisors can be a huge help in this process, and the nominal fee you give them will more than pay for itself in the returns that you receive over that time.
You should also keep an eye on the market as you go through the process, making sure that things don't take massive turns. Note that there are no guarantees when you make an investment, there's always an element of risk.
We should also mention that it's possible to change your mortgage rates. If your rate is high right now, refinancing at a different time might allow you to get a low rate. If that happens, you could change your situation and start investing rather than putting money toward your mortgage.
There's no one particular way to complete this process, as your financial situation will likely change. As you change, it's smart to reassess how you're handling your finances.
The life of a mortgage constitutes three decades in a lot of cases. Odds are that your financial situation will ebb and flow over that period of time, so you can adjust your approach as you see fit.
If you're wondering "how do I invest," We've got more information for you to work with. The pay off mortgage or invest dilemma is just one of the many financial riddles that many of us are faced with.
Fortunately, we're here to help. Have a look at our financial blog to learn more about investing, interest rates, loans, mortgages, and more.